Mid-caps are the sweet spot

By Boyd Peters, Contango Asset Management

In looking to invest outside the top 20 or 30 companies, investors can find a viable opportunity to secure a complementary source of income for their portfolios in the mid-cap sector. We consider mid-caps being those ranked between ASX 50 and ASX 150 by market capitalisation.

While investors may already be receiving some exposure to mid-caps from their managed investments, the reality is that on a dollar and percentage basis, they may have little meaningful exposure to mid-caps, which provides a different sector exposure compared with other parts of the market.

Mid-caps are the sweet spot

Mid-cap companies are often in the sweet spot of their long-term life cycle. They have worked their way through their initial development phase and are now paying dividends, while still also achieving dividend growth.

Mid-cap companies have valuations, which, through investment cycles have the potential to reap the benefits of capital expenditure, business expansion and acquisition-based strategies.

Mid-caps also have a smaller weighting to the financials sector than do large-cap stocks, where the four big banks are prominent. Relative to the small-cap index, mid-caps have less exposure to the Materials sector and greater exposure to Healthcare and Consumer defensive sectors. Furthermore, the mid-cap universe presents strong growth prospects and is typically less researched than the top 30 ASX companies. And compared with small-cap shares, which have much lower market capitalisation, mid-cap stocks generally have stronger balance sheets, deeper capital reserves and attractive prospects.

Getting true mid-cap exposure

It can be difficult managing a portfolio of companies on your own, so delegating your mid-cap investment to a fund manager can be sensible, because they have the resources to ensure portfolios are adequately researched and diversified.

Financial advisers are aware of the value of mid-cap stocks, with options including Contango Mid-Cap Income, SGH20, Bennelong Ex-20 and BT Mid-Cap becoming increasingly recognised. These and other funds that look further afield than the 20 to 30 largest ASX companies and can provide diversified exposure into mid-caps.

To give you an idea of the sort of stocks we are talking about Table 1 looks at the top five holdings in four selected mid-cap fund portfolios

Table 1 - Mid Cap Investment Manager

Manager A	Manager B	Manager C	Manager D
Charter Hall	Ansell	Regis Resources	ResMed
Duet Group	James Hardie	Ramsay Health Care	Primary Health Care
Bendigo/ Adelaide Bank	Treasury Wine Estates	Oil Search	Centro Retail Australia
SP AusNet	Oz Minerals	Worley Parsons	Regis Resources
Ardent Leisure Group	REA Group	Treasury Wine Estates	Duet Group

Source: Contango

How much do you allocate?

An investor's mid-cap exposure can be used as an equities allocation and combined with a number of investment strategies in a portfolio, including:

• Large-cap Australian equities
• Small and micro-cap equities
• Listed property (A-REITs)
• Global equities
• Notes, hybrids and term deposits
• Fixed-income instruments such as bonds.

Although investors' portfolios are specific to their own income and capital needs, it would not be irresponsible to allocate 20-30 per cent of your Australian equities portfolio to mid-caps.

A dedicated mid-cap allocation can bridge the gap between large-cap and small-cap holdings, potentially suitable for those seeking a lower volatility exposure to Australian shares outside the top 30, versus a more-volatile dedicated small companies fund.

Mid-cap funds are most appropriate for investors with a time horizon of five or more years, to enable the portfolio to be invested through a complete investment cycle.

Know the risks

There are, of course, risks involved when investing in mid-cap stocks. These include:

• Concentration risk: Holding too few stocks to enable proper diversification
• Capacity risk: Where a managed fund or LIC might be too large, inhibiting the manager's ability to trade portfolios effectively and therefore limit outperformance
• Market risk: If you chose to apply an index or ETF strategy to obtain mid-cap exposure, you need to recognise that the Resources sector currently represents close to one-third of the S&P/ASX mid-cap 50 index. Resource companies are highly correlated to commodity prices, meaning a fall in prices (such as recently experienced in iron ore) is likely to have a negative effect on performance returns. If using an investment manager, make sure to look at the underlying investment holdings.

Outlook

Although many defensive mid-cap stocks, such as healthcare companies, have already done well this year, not all have been re-rated and investors can still find good future growth in dividend per share in the mid-cap space.

Investors should consider allocating between the large and small-cap holdings to which they probably already have exposure. Many mid-cap companies are quality enterprises that can provide reliable dividend streams and growth potential. An additional benefit arises where these companies can schedule their dividend payments for those periods when the large-cap stocks are not paying dividends.

Allocating to mid-cap stocks should not be done purely to seek higher yield, but rather to find a complementary source of dividends and franking to investors' portfolios, as well as improving portfolio diversification.

With demand for retirement products expected to grow at around $1 trillion, moving from accumulation to retirement through the decade, there is no doubt mid-cap companies will form an increasing part of investment portfolios.

About the author

Boyd Peters is National Distribution Manager at Contango MicroCap (ASX code: CTN). CTN is an investment company investing in a diversified portfolio of 60 to 100 Australian micro-cap companies listed on ASX with a market capitalisation generally between $10 million and $350 million. There are more than 1000 companies in this category. CTN produces a free Quarterly MicroCap Investment Commentary.

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