The sweet spot: Opportunities in mid-cap stocks

Mid-cap stocks are an area where the risk/return equation may be a bit more favorable for investors. That’s why mid-caps are sometimes referred to in the investment industry as the “sweet spot.”

With market capitalizations typically ranging between $5 billion and $20 billion, mid-caps tend to be established companies with seasoned management teams. In many cases, that makes them more stable than most small cap companies.

Mid-cap stocks also often have longer runways for solid growth than most of their large-cap peers. In other words, mid-cap stocks may offer the perfect mix of lower risk than small-cap stocks and higher potential returns than large-cap stocks.

Laying the foundation for growth

Succeeding in the mid-cap market is often about finding emerging companies that can grow into large organizations. Take the online crafts marketplace, Etsy. Etsy is able to compete with the likes of Amazon because it offers something Amazon doesn’t – custom-made, unique products. While the online market penetration for custom-made products is still relatively small, the addressable market is large, giving Etsy plenty of runway for growth.

Etsy is capitalizing on its growth potential by increasing conversion rates – that is, turning customer visits to the site into actual sales. Etsy’s new management team is doing this by improving search, expanding marketing and building trust with its customer base.

For example, the company is tapping into customer search histories and using artificial intelligence to improve the relevance of the products shown to the customer.

Etsy’s management team is also working with sellers to get more accurate timelines for shipping and providing tools to incorporate shipping into the price of the product. Etsy is a growth company that has earned a premium valuation because it is laying a firm foundation for future growth.

Getting real value from "value"

You can often find compelling growth opportunities in the mid-cap space that are also trading at attractive values. A great example is Ally Financial – GM’s former captive auto finance company that was spun off into a separate firm. Ally created an online bank which pays higher deposit rates than banks with branches. That strategy has helped attract more deposit customers, especially young people who prefer to bank online. Despite paying higher rates, Ally is still able to maintain an attractive net interest margin because its costs are lower.

Ally’s auto loan business is also improving as many banks are shrinking their auto loan portfolios. This industry dynamic is allowing Ally to increase pricing on auto loans and improve the mix of loans in its portfolio.

The firm is also increasing the proportion of used-versus new car loans, helping to improve the overall yield of its loan portfolio. In addition, Ally is diversifying its asset mix by expanding into new products, such as home mortgages, commercial loans, and wealth management products, which it can cross-sell to customers as it continues to grow its deposit base.

Ally Financial has all the characteristics of a growth company but is still a value stock because it is early in its transformation. We do not think it will be long before investors recognize its long-term potential.

Finding the sweets in the sweet spot

The mid-cap universe offers an interesting balance between growth and value and risk and reward across many industries.

At Thrivent, the key for success has been to invest in companies that can grow their topline and generate strong or improving returns on invested capital. To identify these stocks, we combine bottom-up analysis with more than a dozen quantitative screens based on valuation, capital deployment, earnings quality, and market dynamics.

It is an approach that has led to solid performance for Thrivent’s mid-cap management team and numerous Lipper Fund Awards from Refinitiv for the Thrivent Mid Cap Stock Fund Class S.

The strategy also requires patience. If you’re going to invest in the mid-cap market, you’ll need a long-term investment horizon at least three to five years. It’s not uncommon for a quality mid-cap stock to move sideways for a period of time, and then quickly provide an attractive return. Our success shows that if you can stick to your process, you may be able to find significant opportunities in the mid-cap sweet spot.