Mid-cap stocks have come into their own in recent months, outperforming both large- and small-cap shares.
"What's driving it? The takeovers," said Chuck McQuaid, chief investment officer of Columbia Wanger Asset Management. "The lights are all green."
McQuaid, the lead portfolio manager of the Columbia Acorn Fund, said 26 companies within the fund were taken over last year, "clearly a record," and so far this year takeovers already total 13, "twice the annualized rate."
"Private capital is still flush with cash, and banks are still willing to lend" to finance the deals, he said. "As long as that continues, the trend is going to continue to run its course."
Jeff Tjornehoj, a senior research analyst at Lipper Inc., dates the acceleration of investor interest in mid-caps to the fourth quarter but added that the mid-cap market "really gathered momentum" in the first quarter.
Investors began to sense at the start of the year that recent strong performance by small-cap shares "would not last forever," but were not convinced that large-caps "were ready to take the baton," he said.
"As we transition into a slower economy, mid-caps find their momentum," Tjornehoj said. The longer the economic transition, the "longer the inflection point [supporting mid-caps] will last."
According to an analysis of the first-quarter performance of U.S. diversified equity funds released by Lipper, mid-cap funds advanced an average of 4.4 percent in the first quarter, compared with an overall equity fund gain of 2.1 percent. Large-cap funds eked out a 0.73 percent average gain, while small-caps funds were up 2.9 percent.
"Historically, mid-caps don't take the lead for long - a year perhaps," said Tjornehoj, but the shift marks a transition in investors' view of the economic climate.
"Mid-caps are hard to put a finger on; they're a less-volatile version of small caps," he said.
Jack Ablin, chief investment officer at Harris Private Bank in Chicago, points out that cheaper valuations of mid-cap shares have added to their appeal.
For example, the Russell 2000 index, a benchmark for the small-cap market, has a forward price-earnings ratio of almost 24, Ablin said, while the Standard & Poor's MidCap 400 is trading at a "substantial" discount of roughly 17 times forward earnings.
Characterizing the shift into mid-caps as "very aggressive," Ablin said "investors will continue to move up in [stock] quality and size as economic concerns permeate the scene."
Ideally, mid-cap stocks blend the stability and strength of large-company shares with the faster growth capacity of smaller companies.
Mid-caps' range of market capitalization - the share price multiplied by the number of shares - generally is between $1 billion and $5 billion, although some analysts put it as high as $7 billion.
"We shifted to mid-caps a year ago, which was a little bit early," Ablin said. He noted that "a lot of small-cap managers have to stay within the small-cap space [to keep within the parameters of their fund], and mid-caps fit that bill."
Mid-caps' size often is small enough to fill in for small-cap funds and frequently have parallel trends, analysts said.
But speculative interest in small-caps remains, Ablin said, fueled by merger and acquisition activity, liquidity flow and cheap financing.
"Generally, deals are reasonably priced," McQuaid said. "As shareholders, we'd like to see more premium. We enjoy it more when deals are priced at a 50 percent premium ... than a 15 percent premium.
"People are concerned about the small-cap cycle," which has had a long upward run, since about 1999, McQuaid said. "The concern is that they are getting a bit pricey. But as long as the takeover phenomenon continues ... it will extend the cycle," he said.
In addition, earnings expectations for smaller-cap companies generally are higher than for large-cap firms, Ablin said.
Earnings will be the key to overall stock market performance, said Sam Stovall, chief investment strategist at Standard & Poor's. Although overall earnings increases are expected to pull back this year, "earnings growth has been pretty good in mid-cap companies" and is expected to continue to increase, he said.
Many analysts predict slower large-company profit growth of roughly 6 percent to 7 percent this year, Ablin pointed out. Earnings of some small- and mid-cap firms could go much higher.
Stovall said his current outlook is for a 7 percent increase in earnings-per-share growth in the large-cap S&P; 500 this year, with small-cap earnings growth at about 10 percent and mid-caps at 14 percent.
Looking at the overall equity market, "Investors have looked at the [recent] increase of volatility as a buying opportunity, so it appears stocks are undergoing a pullback, not a new bear market," Stovall said.
"We remain single-digit bulls," said Stovall, with the S&P; 500 projected at 1510 by the end of the year. U.S. interest rate reductions could help create stock market gains, he said, but not until midyear.
"Mid- and small-caps have had a good run," but, "large-caps still look more attractive from a valuation [P-E ratio] standpoint," he added.
Has the mid-cap market grown too expensive?
"Not necessarily," Stovall said. "Some things are meant to trade at a premium."
Since 2000, the S&P; MidCap 400 has been trading at an average market premium of 7 percent above what S&P; considers to be their fair value, and that premium has grown to about 22 percent, Stovall said, "because mid-cap earnings are expected to grow more rapidly" than those of large-cap companies.
"Just don't overweight" a portfolio's exposure to the sector, Stovall said. "Bring down your mid-cap exposure to your benchmark," whatever that is, he recommended. "For small-caps, bring it down to less than your benchmark."
Based on projected 2007 earnings, "extreme valuations" will level out by the end of this year, he added.
Suzanne Cosgrove writes for the Chicago Tribune.