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The case for mid-caps

Wise-owl’s Simon Herrmann outlines the case for mid-size companies, how to invest in this part of the market and his top picks.

In this article I’m going to discuss mid-caps, what they are, why I believe you should consider investing in mid-caps and I will also give you a brief introduction into Wise-owl’s methodology. At the end I will wrap up this piece with some of the best mid-cap investment ideas for 2017. 

Are you ready to discover the blue-chips of tomorrow? 

Introduction: Investing in mid-caps

Every single year, regardless how the stock market indices around the world perform, there are on average 50 -100 stocks that rise 50% or more on the ASX. 

During the calendar year 2016 over 400 stocks rose 50% or more in value. The three largest companies on that list were Fortescue Metals (ASX:FMG), Newcrest Mining (ASSX:NCM) and BHP spin-off South32 Limited (ASX:S32). These were the only companies with a market cap of more than $10 billion at the end of the year – which means the remaining 99% of stocks were small-mid capitalisation companies (and even those three had a market cap of significantly less than $10 billion at the beginning of the year). 

By investing in the stock market you take a significant amount of risk. Period. Therefore at Wise-owl we don’t look at or recommend a company unless we see the potential for at least 50-100% growth in order to compensate for the risk. Some of the best performing stocks in a given year may be large caps, but most of them aren’t. 

In 2008, the year of the Global Financial Crisis (GFC), a total of 15 stocks rose 50% or more on the ASX. With the exception of Origin Energy (ASX:ORG) exclusively all of the companies were small-mid caps. Wise-owl picked one of the top performers being CI Resources (CII). Whilst this single investment would have not saved you from a huge financial loss during that period, it provided somewhat of a cushion and helped you offset some of the losses. 

Including the GFC, the long-term return of the ASX 200 amounts to just over 5% per annum and around 9.5% if you include dividends and re-invested them. A ‘buy and hold the index’ strategy is a proven and profitable strategy. In fact I believe – especially as a beginner – you may be better off investing in a diversified index ETF rather than buying 10 random ASX 50 stocks. Unless you pick the top performers, you would have likely underperformed over the long-term. This simple comparison highlights the importance of stock selection – and that’s where it gets tricky. 

What are mid-caps?

There is no clear definition for a mid-cap but broadly speaking, we consider a stock a mid-cap if the market capitalisation (a company’s total worth, which is equal to the stock price multiplied by the number of shares outstanding) is somewhere between $500 million and $5 billion, whilst some may be valued as high as $7 billion to $10 billion. However the stage of the business as well as an industry are factors worth considering as well. 

In Australia, mid-caps are often being referred to as the stocks on the S&P/ASX 200, not including the leading 50 companies on the S&P/ASX 50. I do also want to mention small-cap stocks which have a market cap of less than $500 million but often offer great growth opportunities as well - we will talk a little more about small-caps a little later. 

Benefits of investing in mid-caps

Mid-caps offer significant upside potential – often in exchange for a higher risk – and that’s why we at Wise-owl are so attracted to this space. It is very common that on the ASX over 100 stocks per year rise over 50%. The investable universe of mid-caps is large and attractive and liquidity is usually sufficient to execute orders at any given time. 

As a small company just turned public, you tend to get a lower valuation multiple compared to a large, established company with a strong track record. 

Small-mid cap world characterised by independent develop domestic gas resources that may be overlook by large caps. These players develop domestic gas resource, taking advantage of a particular trend (BPT, COE).

The Wise-owl 5-point checklist 

The following list is a brief overview of our 5-point checklist. Please note that the stock selection and valuation process is more complex but we believe this list is a good starting point for your analysis: 

  1. Management - Management track record and interest in the company 
  2. Financials - Profit history and trends, funding position, balance sheet
  3. Catalysts - What could make its share price rise?
  4. Share Register -  Who is on the registry and why? Is there a large free float? 
  5. Stock price - In which direction is stock moving - technical analysis can help you understand the company's history. 
Mid-cap investment ideas

Find below a list of investment ideas which have passed our 'health check'. Please note that success can never be guaranteed and you should take additional risk mitigation strategies into account such as diversification or stop losses. The advice given is as of 5 May 2017. 

InvoCare Limited (ASX:IVC)

Wise-owl is attracted to its revenue growth trajectory, income profile and resilient business model. Principal risks include lumpy earnings, cost control and potential to improve margins. InvoCare has a strong record of distributing steady dividends to its shareholders and as the company operates in a fragmented industry dominated by private operators, consolidation is a major value driver. The dividend yields just over 3% and is fully-franked. 

Monadelphous Group (ASX:MND) 

Fully-franked dividend yielding over 4%. MND is strategically placed to leverage from any recovery in mining investments. We are attracted to its long-term earnings growth record, free cash flow profile and management’s interest in driving shareholders’ return. Whilst the near-term outlook for the metal and mining sector looks challenging, MND is well placed to benefit from any cyclical recovery. The stock is trading at an undemanding valuation.

Steadfast Group (ASX:SDF)

Steadfast offers profitable exposure to the insurance sector. GWP and earnings per share growth trends are attractive, while management has successfully integrated acquisitions to date. However, there is no guarantee that equity acquisitions will continue to yield economic benefits nor that premium price contraction won’t continue. The Company is well positioned to take advantage of any cyclical recovery in domestic insurance markets.

Beach Energy (ASX:BPT)

Beach Energy has a strong balance sheet and is highly leveraged to any recovery in the oil and gas market. In the short to medium-term we expect ongoing volatility but looking at the bigger picture, we believe it makes sense to add exposure to this sector at a low point in the cycle. Beach Energy is sensitive to price movements but we believe the valuation is compelling and the risk to reward ratio favourable. 

Cooper Energy (ASX:COE)

Cooper Energy offers speculative exposure to domestic east coast gas demand. We are attracted to the scale of undeveloped resources, upcoming funding decision and balance sheet. Procurement of funding and integration risks are the primary hurdles. Cooper Energy is positioned to address a tightening gas supply landscape in East Australia and the upcoming offtake agreement for the Sola Gas Project could transform the company and present a near-term driver.

Adacel Technologies (ASX:ADA) - Update

Previously this list included ADA but due to a company announcement dated 3rd May 2017 (“Earnings Guidance, Orders Update and On Market Buy Back”) this position has fundamentally changed and we would like to update our recommendation. We resume coverage and recommend to ‘hold’ following the earnings downgrade. The share buyback is a testament to the fundamental strength of the business but we will carefully monitor business activity over the coming 3-6 months to assess whether the slowdown in business is a temporary or permanent stage. 

Final tip

Buy blue-chips after a dip, buy small and mid-caps on the rise. 

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