Get stuck in the middle
Midcap stocks don’t get the press. They just get results.
Pundits frequently debate the merits of small-capitalization stocks versus large-caps. The argument is fairly straightforward: Over long periods of time, small-company stocks tend to outperform large-company stocks, but at the cost of greater volatility.
The large versus small discussion has merit. But all too often, midcaps are forgotten — a mistake that can leave plenty of money on the table. As the chart below illustrates, The S&P MidCap 400 Index outperformed both the small-cap and large-cap indexes over the last year, as well as the last 10 and 15 years.
During the 15-year period ended July, the midcap index delivered an annualized total return of 11.0%, versus 9.9% for the small-cap index and 7.2% for the S&P 500 Index of large-company stocks. To put that growth in perspective, $10,000 invested in the S&P MidCap 400 Index 15 years ago would be worth about $47,846, versus $41,206 for the small-cap index and $28,374 for the large-cap index. In addition, the midcap index’s returns are less volatile than those of the small-cap index.
The Forecasts tends to focus on large-caps, but we have found a number of opportunities in the midcap space, stocks with market capitalizations between $3 billion and $8 billion. Think of these companies as light-blue chips.
Why have midcaps performed so well? Here are two possible reasons:
Market power: Size matters in most industries, and many light-blue chips — such as Airgas ($58; NYSE: ARG), Oceaneering International ($58; NYSE: OII), and Harris ($53; NYSE: HRS) — enjoy leadership positions in attractive markets. Many midcaps are large enough to enjoy advantages of scale relative to their rivals, yet small enough to deliver excellent growth.
Fundamentals: Midcaps look pretty good, with an average Quadrix® Overall score of 61 for the 428 midcaps in our research universe of roughly 5,000 stocks. The average score for all stocks in the universe is 50. Consensus profit estimates project solid growth for most midcaps, with more than 60% expected to deliver double-digit growth in per-share profits during the current fiscal year.
Five Forecasts monitored midcaps with high Quadrix score are reviewed below.
BMC Software’s ($34; NYSE: BMC) products help businesses manage their technology systems, reducing costs along the way. The company has branched out beyond mainframe software — a source of steady business — and into business-service-management (BSM) software, which has driven much of BMC’s recent growth. In recent quarters, BMC has seen an increase in new BSM contracts and renewals, with bookings rising at double-digit rates.
In the June quarter, BMC bolstered the BSM group with the acquisition of BladeLogic, a company that automates data centers. Service automation is a promising opportunity for BMC as more companies invest in automation software to cut costs.
BMC’s strong product pipeline and business backlog bode well for growth. For fiscal 2009 ending March, management expects bookings and revenue growth in the low double-digits. Consensus estimates project per-share-profit growth of 7% in fiscal 2009, a target BMC should be able to top. BMC is a Focus List Buy.
Despite the slowdown in North American residential construction, Cooper Industries ($47; NYSE: CBE), a maker of electrical products and tools, has reported strong results in recent quarters. The company appears poised for more growth, thanks to a shift in its focus — away from the U.S. residential market, which now accounts for about 10% of revenue.
Cooper is one of the largest U.S. producers of lighting fixtures and fuses. The electrical-products division, which accounts for about 87% of sales, has performed particularly well, driven by strong demand from industrial and commercial customers and international markets. The company generates about 30% of revenue overseas and is working to increase that percentage.
Through an aggressive acquisition strategy, Cooper has expanded into new, high-growth foreign markets, such as China, Eastern Europe, and the Middle East. Cooper seems likely to make more acquisitions to increase its scale. Consensus estimates project per-share-profit growth of 13% in 2008 and 12% in 2009. Cooper is a Buy and a Long-Term Buy.
Manitowoc’s ($24; NYSE: MTW) diverse business segments have delivered solid operating results. Demand for heavy cranes and excavators, which accounted for about 81% of sales last year, has been strong overseas. To capitalize on that trend, Manitowoc is expanding into China. Crane backlog at the end of the June quarter reached $3.52 billion, up 70% from the year-earlier quarter.
Efforts to expand the company’s foodservice-equipment division have not been popular on Wall Street. Manitowoc agreed to pay $2.7 billion for Enodis, a British maker of commercial kitchen equipment. The deal will expand Manitowoc’s presence in foreign markets and broaden the product line, adding such “hot” items as deep fryers to its existing portfolio of such “cold” products as commercial refrigerators and ice machines. However, investors are concerned that an expanded foodservice business will reduce overall company growth, because the crane business has performed better in recent years. Concerns about a slowdown in demand for some cranes in Western Europe have also weighed on the stock, which has fallen more than 35% since the company announced in April its intention to purchase Enodis.
While the Enodis purchase will substantially boost Manitowoc’s long-term debt, the deal should make the stock safer over the long term by smoothing out the revenue stream. Demand for foodservice equipment is steadier and less economically sensitive than demand for construction equipment. Consensus estimates project per-share-profit growth of 29% in 2008 and 11% in 2009. At just seven times the 2008 profit estimate, Manitowoc is a Focus List Buy and a Long-Term Buy.
Specialty-chemical maker Sigma-Aldrich ($58; NASDAQ: SIAL) consistently puts up strong results. The company has posted per-share-profit growth in each of the last 14 quarters, averaging a 16% gain during that period. Analysts expect more of the same. Consensus estimates for 2008 and 2009 are trending upward and project per-share-profit growth of 15% this year and 12% next year.
New products and higher research spending by academic clients are boosting sales of biotechnology products, the company’s most powerful growth engine. Sigma has historically had success acquiring small companies to complement its existing businesses, and it will likely make future purchases in the biotech area.
Another key to growth is foreign expansion. Sigma already generates about 60% of sales abroad, and that percentage should increase over time. The company has tapped such markets as Brazil, China, and India. Emerging markets represent excellent long-term opportunities, as companies in developed countries increasingly outsource research. The weak dollar is also lifting results, as sales generated in foreign currencies translate into more U.S. dollars. Sigma-Aldrich is a Long-Term Buy.
Strong demand for computer hard drives has powered robust growth at Western Digital ($28; NYSE: WDC). Revenue jumped 46% in the June quarter, and prospects for continued double-digit revenue growth look good. As digital content and data-archiving systems become more complex, they require greater storage capacity. The company has launched a series of new storage products in recent years to meet that need.
Western Digital has diversified beyond its legacy business of hard drives for desktop personal computers (PCs) — which now account for less than half of revenue — into drives for notebook computers, data-storage systems, and consumer electronics. The company is seeing growth across nearly all end markets. Original equipment manufacturers account for nearly half of sales, with distributors and retailers providing the remainder.
The hard-drive industry is very competitive, particularly in the desktop PC market, and most producers see prices erode over time. But Western Digital, with its diverse business mix, enjoys more pricing power than most peers. In the June quarter, the company’s average selling price increased. Western Digital is a Buy.