Mid Caps For Mid Cycle

Public companies, like people, follow a lifecycle. The Wells Fargo Special Global Equity team believes that mid-cap companies sit in a “sweet spot” of the lifecycle. They are more diversified and well-capitalized than their small-cap peers, yet more nimble than slower-moving, large-cap companies. We believe this can provide a structural advantage that is strongest in the middle innings of a market cycle, when macroeconomic factors are typically more muted and when companies are better able to control their destinies through accretive capital deployment.

We can see this thesis bear out by examining the past two market cycles. Figure 1 shows the cumulative returns of the Russell 1000, Russell Midcap, and Russell 2000 indexes from dates that are widely considered market troughs—October 9, 2002, through March 9, 2009. Small-cap companies excelled in the early part of this cycle, providing investors leverage to a rapidly expanding economy. Late cycle, investors preferred the defensive characteristics that the larger, more mature and diversified companies tended to offer. We can see that mid caps led in the middle part of the cycle.

Figure 1

cumulative return through a market cycle 2002 - 2009

Source: FactSet
Index definitions

Late cycle and middle innings

Figure 2 shows the performance of the same indexes in the most recent market cycle, from the lows of March 9, 2009, to the trough of March 19, 2020. We highlighted in gray the onset of what we believe to be the middle phase of this cycle, from late August 2011 through the market peak in February 2020. For the full expansion, mid caps outperformed. We think this was, in part, due to muted macro factors and an environment where mid-cap companies had the visibility to deploy capital accretively and shape their destiny. We believe the Special Global Equity team was able to further exploit this environment through stock selection.

Figure 2

cumulative return march 2009 - 2020

Source: FactSet
Index definitions

Middle innings outperformance

The historical record illustrated in Figure 3 shows that, during this most recent mid-cycle expansion, the Wells Fargo Special Mid Cap Value Fund (WFMIX) produced returns in excess of the Russell Midcap Value Index and the peer median of its Morningstar U.S. mid-cap value style category. The team focuses on companies that have underused balance sheet flexibility that can be deployed for accretive capital investment. Such companies have been rewarded most in markets when macroeconomic factors were not dominant return drivers and when capital expenditures expected to generate incremental cash flow streams were recognized.

Figure 3

cumulative return 2011 - 2020

Sources: FactSet and Morningstar Direct
Index definitions

If we look at the current cycle, beginning after March 2020’s COVID-19-inspired lows, we again have seen small caps lead the market. As this cycle matures, we are seeing increasing optimism from the CEOs of companies we directly engage, who are frequently citing opportunities to exploit the strength of their companies’ balance sheets. This reminds us of what we experienced in the last cycle. Timing market cycles is never easy to do, but as investors look toward the future and the current cycle matures, we have increasing optimism for mid-cap companies and for our investment process in the next three to five years.

Originally Posted on June 14, 2021 – Mid Caps For Mid Cycle

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