Shoot For The Middle
Considered riskier than large-caps and slower-growing than small-caps, midcap stocks don’t get as much press as their larger and smaller brethren.
But investors should not forget about these middle children, as midcaps sit on the sweet spot of risk and return. Over the last 15 years, the S&P MidCap 400 Index generated annualized total returns of 11.7%, versus 10.1% for the S&P 600 Small-Cap Index and 7.8% for the S&P 500 Index.
In the wake of 2009’s impressive rally, many investors have rediscovered their taste for risk. So far this year, the midcap and small-cap indexes are up at least 13%, versus 6% for the S&P 500. Midcaps have tended to outperform large-caps over long periods of time, and we like the outlook for select midcaps in the year ahead.
Quadrix works well with midcaps. In rolling 12-month periods since October 1994, the top one-fifth of Overall scorers in the S&P MidCap 400 outperformed the average stock in the index by an average of 3.6%.
Of course, the definition of a midcap ebbs and flows with stock prices. Currently, the S&P 400 contains stocks with market values ranging from $437 million to $8.17 billion, with an average of $2.73 billion and a median of $2.56 billion. By definition, half of the companies are larger than the median, and half are smaller. For Quadrix scores on every stock in the S&P 400, visit www.DowTheory.com/go/Midcap.
For purposes of this story, we consider any stock valued between $2 billion and $8 billion as a midcap. Applying that guideline, 30% of our recommended stocks qualify as midcaps, all of which are listed in the table below. Three are reviewed below.
Improving seasonal trends in the automobile aftermarket seem to be helping Advance Auto Parts ($45; AAP) break out of its doldrums. The stock dropped in February after reporting a December-quarter profit decline when the market expected a gain. However, the shares have rallied 11% since that dip and still appear reasonably valued. Advance Auto has been boosting its online advertising presence and plans to increase the store count by 150 this year, representing a 4% rise in square footage.
In 2009, sales grew 5% and gross margins widened, contributing to 79% higher free cash flow. A regular purchaser of its own stock (the share count is down 14% since the end of 2005), Advance Auto in February launched a fresh $500 million buyback program, representing nearly 12% of outstanding shares at current prices.
Advance Auto said it expects per-share profits of $3.20 to $3.40 this year, implying 7% to 13% growth. Management’s guidance doesn’t account for any buybacks, and Wall Street projections are trending upward. At 13 times estimated 2010 earnings, shares of Advance Auto trade 8% below their five-year average forward P/E ratio. Advance Auto is a Long-Term Buy.
BMC Software’s ($40; BMC) products analyze server-computer performance and automate tasks in data centers. Both Cisco Systems ($27; CSCO) and Dell ($17; DELL) include BMC software on the servers they sell. BMC leverages these partnerships to compete against industry titans Hewlett-Packard ($53; HPQ) and IBM ($129; IBM). At the end of 2008, BMC controlled nearly 24% of the market for server software, ranking it second-largest in the world behind H-P. BMC stands to benefit from a rebound in tech spending this year.
At the end of 2009, BMC held $1.21 billion in cash — or $6.61 per share — versus $341 million in long-term debt. Its strong balance sheet, slate of strategic partnerships, and modest size could make BMC an attractive takeover target for Dell or Cisco, or even Oracle ($26; ORCL), which sells into some of the same end markets. BMC’s valuation is also attractive. The stock trades at 15 times trailing earnings, 38% below its five-year average and 44% below the average software company.
Wall Street is looking for profits of $0.70 per share in the March quarter, implying 9% growth on 6% higher sales. BMC has topped the profit consensus in each of the last four quarters. Slated to report March-quarter results on May 5, BMC is a Focus List Buy and a Long-Term Buy.
Ross Stores ($57; ROST) operates Ross Dress for Less and dd’s DISCOUNTS, off-price retail chains that combine for 1,021 stores, up 5% from a year ago. The company plans to open 35 Ross and 15 DISCOUNTS stores in fiscal 2011 ending January, while closing a handful of locations, which equates to a 4% increase in square footage. Ross operates in 27 states, primarily warm-weather areas, and has plenty of room for expansion within the U.S.
Sales growth accelerated in fiscal 2010 ended January as cash-strapped consumers flocked to Ross and other discounters. By acquiring merchandise late in the buying cycle, Ross can exploit inventory imbalances. Its chains offer brand names at 20% to 70% below department store list prices.
The stock has surged 34% this year but still looks reasonably valued relative to historical norms. Shares trade at 13 times estimated year-ahead earnings, 4% below the five-year average P/E ratio. Ross’s Overall score, currently at 100, has not ended a month below 80 in the last two years.
Ross had grown same-store sales for 14 consecutive months before a January decline. In the wake of that growth, Ross could face tougher comparisons than many retailers this year. But for now, Ross seems poised to thrive in the nascent economic recovery. Same-store sales rose 14% in March and 11% in February, and the company raised its profit guidance in April. Ross is a Focus List Buy and a Long-Term Buy.