Don't Forget The Middleweights
The heavyweight fight still rates the top of the card at the boxing arena. But often you'll find better athletes a few weight classes lower.
In the Jan. 3 issue of the Forecasts, we wrote about the fundamental strength of the largest U.S. stocks. But while large-caps have strong investment appeal, shrewd investors will consider some cues from history and look for opportunities in all corners of the market.
Over the last 12 months, the S&P 400 MidCap Index and the S&P 600 SmallCap Index have more than doubled the price change of the S&P 500 Index of large-cap stocks. The smaller indexes have also outperformed over the last three years, a trend that should not surprise us. After all, from 1926 through 2009, small-company stocks have returned an annualized 11.9%, versus 9.8% for large-company stocks.
But while smaller stocks tend to have higher return potential than larger stocks, investors shouldn't just assume â€œthe smaller, the better.â€ Since January 1989, the S&P 400 MidCap Index has returned an annualized 11.3%, well above the S&P 600 SmallCap Index's 9.2%, as well as the 6.9% of the S&P 500.
As a group, midcap stocks can't match the fundamental strength of larger stocks, which currently earn higher QuadrixÂ® scores and trade at more appealing valuations. But the average stock in the S&P 400 is expected to deliver per-share-profit growth of 14.1% in the next fiscal year, versus 12.9% for the average S&P 500 stock. The average S&P 600 company boasts even higher growth projections â€” as well as higher P/E ratios and greater volatility of returns.
There is no universally accepted standard for what constitutes a midcap stock. Stocks in the S&P MidCap 400 average a stock-market value of $3.0 billion, with a maximum of $9.5 billion and a minimum of $457 million. For information on all the stocks in the midcap index, visit www.DowTheory.com/go/Midcap. The Forecasts generally classifies stocks with market values between $2 billion and $10 billion as midcaps.
There's a place for quality midcaps in most equity portfolios, though midcaps do tend to be riskier than large-caps. Focus your attention on midcaps with strong fundamentals and the potential to exceed expectations. The linked table lists 13 attractive midcaps from Dow Theory Forecasts and our sister publication, Upside, which focuses on smaller stocks.
Three of our favorites are reviewed in the following paragraphs.
Advance Auto Parts ($62; AAP) operates about 3,500 stores that sell vehicle parts and accessories to individuals and commercial garages. The stock has risen 54% over the past year, despite a pullback from December highs. Sales of new cars gained traction last month, prompting some concern that the aftermarket for auto parts could begin to weaken. Also, shares of auto-parts retailers tend to perform well in a weak economy, so improving expectations for U.S. growth may have triggered some selling in the group.
Nevertheless, the company enters 2011 with strong operating momentum. Several macroeconomic factors tilt in Advance Auto's favor, including fewer new-car dealers, an increase in miles driven, and Americans' willingness to hang on to their cars longer. Revenue climbed 9% in the first nine months of 2010, putting Advance Auto on pace to report its strongest sales growth in five years. Same-store sales have grown in eight consecutive quarters, surging 9.9% in the September quarter. For 2011, Wall Street sees profits climbing 17%.
At 14 times the consensus 2011 profit estimate, the shares trade 13% below the average automotive-retail stock in the S&P 1500 Index. Advance Auto Parts is a Long-Term Buy.
AmerisourceBergen ($35; ABC), the smallest of the three leading U.S. drug distributors as measured by revenue and stock-market value, holds an estimated 25% to 30% share of the domestic market. More than its peers, Amerisource focuses on specialty drugs, a niche expected to outgrow the broader pharmaceutical market going forward. Specialty drugs account for an estimated 20% of Amerisource's revenue and should help drive growth going forward.
Consolidation among retail pharmacies has contributed to the loss of two big contracts, combining for about 3.2% of total sales. In the year ahead, opportunities could emerge for Amerisource to scoop up new business from the Veterans Administration (contract potentially worth about $3.8 billion) and Independent Pharmacy Cooperative ($2 billion to $8 billion). Amerisource reported sales of $77.95 billion in fiscal 2010 ended September, up nearly 9%.
Amerisource's stock has returned 33% over the last year, outperforming its larger rivals. Set to report December-quarter results on Jan. 24, the company is expected to report earnings of $0.54 per share, up 4% on 3% sales growth. Amerisource is a Buy and a Long-Term Buy.
Vishay Intertechnology ($16; VSH) makes electronic components and semiconductors for end markets that range from consumer electronics and telecommunications to hybrid vehicles and solar energy. With a stock-market value of $3.1 billion, Vishay, recommended by our Upside newsletter, resides at the smaller end of the midcap group.
The company's fundamentals have steadily improved over the past year. Free cash flow has advanced for five straight quarters. Revenue jumped 42% to $2.04 billion in the nine months ended September. The $1.01 billion backlog, more than twice that of a year earlier, should help sustain growth if the semiconductor and electronics industries, cyclical by nature, fall on leaner times.
While Vishay boasts excellent fundamentals, it is cyclical and volatile, and somewhat riskier than the norm for Forecasts stocks. Earning a Value score of 90, the shares trade at 12 times trailing earnings, a 33% discount to the average electronic-components stock in the S&P 1500 Index. Vishay, which last week broke out of a five-week trading range to hit its highest point since July 2007, earns a Best Buy rating in Upside.