Will mid-cap stocks outperform in 2023?

This article was produced in partnership with Manulife Investment Management.

As the markets face yet another year of uncertainty, more investors are looking for options that steer clear of small-cap risk while offering an alternative to big caps whose long run may slow.

The solution, suggests Jeff Mo, portfolio manager with Mawer Investment Management, is a diverse selection of mid-cap companies that can provide a balance of both security and growth.

“It's been a great run for the S&P 500 for the last 15 years,” Mo says. “But it hasn't always been that way – up to 2008 it wasn’t always a fun time to be a passive shareholder in large caps.

“If we’re entering a flat market with single-digit growth, you need more active stock-picking to push in the right places, and then that's where Mid-Caps come in.”

Mo oversees Manulife’s U.S. Mid-Cap Equity Fund, which is sub-advised by Mawer Investment Management. He sees several market trends converging that may make Mid-Cap stocks a promising opportunity this year.

What is a mid-cap?

Before explaining his investment outlook, Mo took a moment to explain how he differentiates mid-caps from their smaller and larger alternatives. “The traditional view of a mid-cap was any company with a market cap of between $5 billion and $10 billion,” he says.

“But if you look at the Russell Mid-Cap Index, the constituents range from $500 million to $56 billion, so our target is in that range at the time of our purchase, with no more than 20% of the portfolio drifting outside due to stock price blips or something like that.”

Mo says the wide range of companies within the mid-sized market provides a wealth of choice for investors seeking stable growth without being confined to a smaller selection of Big-Caps with limited upside.

Active management

Addressing those investors who have passive holdings within the S&P 500 index, he highlighted the over-concentration of investment in certain tech stocks.

“Because companies like Amazon and Tesla have done very well, they've become a really large weight – so now maybe six out of 10 large caps are tech-related, and that’s a lot of concentration and not enough diversification for a passive investment strategy.”

To reduce their rising exposure to a limited number of large companies, Mo says investors should consider switching out of passive index trackers and seek a more active management of their investments.

“If you have passive exposure to US large caps, we think you should balance that with active exposure to mid-caps, where you can find very robust, defensible companies but with the benefit of an active manager who can protect you from landmines.”

Why US mid-caps?

Big tech stocks have enjoyed a long period of growth thanks to a well-deserved reputation for stable returns. But with widespread layoffs reflecting a slump in consumer demand, the tech sector may be facing headwinds that could bring their market-leading run to an end.

“Two years ago, sectors like information technology and some of the more cyclical companies were really hot,” Mo says. “Now investors are becoming hesitant, and they're pricing in some pretty pessimistic assumptions.”

Mo says he’s keeping an eye on the continued recovery from last year because these are conditions when mid-caps usually shine.

“It's very possible that we are still in a period of recovery after the bear market of 2022, and mid-caps tend to lead large caps out of a market downturn historically. We expect that to be the case this time as well.

“Diversifying from large caps and the S&P 500 into mid-caps could be prudent given just where we are in the cycle.”

Mo also likes the set-up for the US market, as government stimulus continues to fuel activity and China takes a back seat.

“Ample exposure to the US makes sense right now. A lot of the stimulus should start to come through in the next couple years, while other parts of the world are getting a little bit trickier.

“China, for example, has gone from an attractive place for capital, to a place with inconsistent regulations.”

Finding Success

Mo cites the benefit of investing in a mid-cap fund that has an active manager who is always hunting for opportunities.

“We’re not focusing on macroeconomic variables,” he says. “Instead, we’re making a prediction about a specific company, about how long and how strong their competitive advantage is compared with rivals.

“We're predicting whether our companies will have competitive advantages in five years. We’re not predicting where the price of oil will be in five years.”

Mo says one company that demonstrates a robust competitive advantage now and in the years to come is Humana. The combination of business strategy and management, corporate fundamentals and industry landscape make it an excellent example of the types of companies that we look for this strategy.

“Over the last 10 years, Humana has grown about one percentage point more than industry average and they're embarking on a really interesting strategy, pushing hard into value-based care.

“The Affordable Care Act made it a lot more feasible for, say, the $1,000 a month that the government would normally pay a patient, to instead go through an organization, which then takes on all the costs of the patient’s healthcare.

“If they do a more efficient job of providing care, then they can keep the extra profit. If they do worse, they take the loss to take care of this person and their health. Because of their scale, data, and focus on seniors, Humana is really well positioned for value-based care.”

Mo believes Humana is just one example where an actively managed fund can identify bright spots amid a relatively gloomy outlook for equities. And with Big Tech stocks finally showing signs of slowing down after an impressive run, he says Mid-Caps may be the next market to outperform.

_{Sponsored by Manulife Investment Management, as of May 2023.}

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