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What are mid-cap stocks and are they good investments?

by | Last updated 26 Nov, 2022 | Stock Types

Mid-cap stocks are the next step down from large-cap companies. These businesses typically have a stable footing but have yet to unleash their full potential. That makes them a popular investment for individuals seeking a combination of growth without venturing into the risky world of small-cap shares.

Let’s take a closer look at this stock market section and discuss whether investing in mid-cap shares is a sensible idea.

What are mid-cap stocks? 

Mid-cap stocks are medium-sized businesses with a market capitalisation that ranges between £2bn and £10bn. A stable revenue stream has typically already been established with a fairly solid balance sheet. It’s also common to see positive cash flow coming out of these businesses. But there are, of course, exceptions.

While they’re not large enough to be classified as a large-cap company, they’re usually on the way to becoming one. Of course, there is always the risk of the firm failing to remain competitive and could end up going in the wrong direction.

Like all equities, this class of shares are not immune to volatility and is generally considered a riskier investment than blue-chip stocks. However, as they’re still within their growth phase of the business cycle, this elevated risk level comes paired with higher potential returns.

In the United States, an estimated 1,122 mid-cap shares are being publically traded. Here in the United Kingdom, that figure stands closer to 110. But it’s worth noting there are significantly fewer publically listed companies on the London Stock Exchange versus American exchanges.

Is mid-cap better than large-cap?

As previously mentioned, the smaller size of a mid-cap company does expose them to a higher level of risk versus an established large-cap. That’s why conservative investors may see it as an inferior investment.

However, with higher risk comes the potential for greater reward. Most of the mid-caps stocks listed in the US and UK are firmly within their growth phase, enabling investors to reap the rewards if they eventually make it to the blue-chip territory.

Moreover, since many of these firms already have a stable bottom line, it’s not uncommon to see dividends being paid out in addition to share price growth. In other words, mid-cap stocks offer something for both growth and income investors.

It’s worth remembering that all businesses have threats to face. That includes more prominent industry leaders and smaller sector disruptors. Only the companies that manage to deliver a high-quality product or service and protect it with competitive advantages are likely to deliver exciting returns in an investment portfolio.

How much of my portfolio should be in mid-cap stocks?

As with any class of equities, the concentration of mid-cap stocks ultimately depends on the individual and their investment objective, as well as risk tolerance. That’s why there’s more than one answer to this question. However, looking at large-cap growth-focused mutual funds, on average mid-cap shares usually constitute around 40% to 60% of the portfolio.

For an investor with a long time horizon and a strong stomach for volatility, mid-cap stocks may not be as attractive as small-cap stocks or even micro-cap shares. But suppose an investor is looking for more substantial returns than large-cap companies can provide? In that case, mid-cap shares may be an ideal solution that doesn’t introduce too much additional risk.

By investing in a range of businesses from different industries of all sizes, an investor can create a balanced portfolio.

How to pick a good mid-cap stock

Like with any investment, investors need to do their homework to make an informed decision. After all, a poor-quality business remains poor-quality regardless of its size.

With that in mind, here are some valuable things to check that can help eliminate bad businesses from consideration.

  • Is the company generating sufficient earnings and cash flow to cover debt expenses?
  • Are earnings growing in a sustainable way or from temporary short-term catalysts?
  • Is the balance sheet robust enough to endure periods of economic turbulence?
  • Does the management team have a good track record of capital allocation and delivering shareholder value?
  • What is the level of insider and institutional ownership? Higher levels typically indicate confidence from management and mainstream investors about the future of the business.

Obviously, this isn’t a conclusive list, but it should help narrow down the list of investment-worthy mid-cap stocks.

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Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.

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