SET Monthly Issue February 2017
Marching Into Midcaps
There’s nothing new about the allure of midcap stocks. Historically they have been the neighborhood market investors move for growth. The streets are lined with undiscovered stocks and high yield profits. But each of these attractive upsides comes with risk, so investors who march into midcap stocks should embrace a long-term horizon. There should also be diversification to mitigate the risks.
Because the companies are smaller, they tend to be more agile. They can innovate more quickly and respond more rapidly to changes in the market. But they may also be vulnerable.
And they may be outmuscled by a larger competitor who can grab market share by cutting prices.
They might be out innovated by a larger firm with a deeper bench of research and development talent. They could be cash-strapped and unable to secure the financing they need for growth on attractive terms.
There may be burdensome debt on their balance sheets and there could be overreliance on a handful of revenue sources.
But for all these challenges, good companies with sound strategies and solid management can deliver outsized results to handsomely reward growth-oriented investors.
This is why we are recommending the Vanguard Mid-Cap Index Fund Investor Shares (VIMSX). The ETF provides exposure to companies in sectors ranging from real estate to retailing, and by focusing on smaller firms, provides investors with the opportunity to enjoy returns than can beat the broader market.
GOING FOR GROWTH
VIMSX is designed to mirror the CRSP US Mid Cap Index.
This index is broadly diversified and it tracks 334 stocks in virtually every industry sector. Annual turnover is 15%.
Because these are smaller companies, the focus is on growth.
Where does the growth come from? In many cases, these are stocks where the company has made a mistake and is clawing its way back. There could be situations where management lost focus, or where the company was late to market with a new product or misjudged a product cycle.
When these miscues are straightened away and the right fix is put in place, the growth can be significant.
But not all these companies are turnaround plays. There are many that continue to perform well, but are not large… which can be a benefit in a number of ways. Right now, because larger companies are doing business globally, the strength of the U.S. dollar is limiting profitability in overseas markets. This is an advantage for smaller companies which often aren’t as reliant on exports or global markets.
When it comes to the prices of midcap stocks, there are typically wide swings in the P/E ratios. Some sell above the market, some below. Most of the time, midcap stocks do not come with a premium like we’d expect with Alphabet (GOOG) or Apple (AAPL).
But there are exceptions, and mid-caps aren’t exactly value stocks. Yesterday, the P/E ratio for the ETF’s top holding, Equinix Inc. (EQIX), was a lofty 344. The P/E ratio for the #2 holding, Fiserv (FISV) is a more modest 26.8.
Many of these companies are unknowns. Undiscovered stocks usually come with lower valuations and almost always come with stronger growth prospects than S&P 500 stocks.
But when you look at the ETF’s performance, you see much the same trend that comes with Blue Chips. Over the past ten years, mid cap stocks have moved in lockstep with the broader markets.
A CLOSER LOOK: INSIDE THE VANGUARD MID-CAP INDEX FUND INVESTOR SHARES (VIMSX) ETF
The ETF has $79 billion in assets. The expense rate is 0.20%.
It is broadly diversified with 343 holdings, less than 7% concentrated in the top ten.
The top five holdings…
| Company Name | Sector | % Weight | ||||
| Equinix Inc. | Real Estate | .78% | ||||
| Fiserv | Technology | .70% | ||||
| Electronic Arts Inc | Technology | .69% | ||||
| M&T Bank Corp. | Finance | .67% | ||||
| Newell Brands Inc. | Consumer Products | .66% | ||||
| 02/06/17 | ||||||
PROFILE: THE TOP 5 HOLDINGS
Equinix Inc. (EQIX)
Equinix is a REIT, a real estate investment trust that provides data center services to banks and content providers. Its holdings are global. Services include colocation services, operations space, storage, interconnection, and managed IT infrastructure services.
Fiserv Inc. (FISV)
The financial services technology firm markets credit card processing, card and print personalization services, investment account processing, fraud and risk management, and other related products and services. It markets to banks, credit unions, investment management firms, leasing and finance companies, and retailers.
Electronic Arts Inc. (EA)
The firm has been developing and marketing electronic games since 1982. Titles include Madden NFL, FIFA, Star Wars, Battlefield, The Sims, and Need for Speed.
M&T Bank Corp. (MTB)
Based in Buffalo, the 161-year-old bank has 800+ branches in the U.S. and provides traditional banking services ranging from savings accounts to mortgages.
Newell Brands Inc. (NWL)
The name Newell may not be well known but its consumer products are. The firm manufactures and markets office supplies such as Sharpie, Paper Mate, and X-Acto. Home products include Rubbermaid and Levolor, and baby product brands including Graco.
Just 3.64% of the ETF’s holdings are in these top 5 stocks. Less than 7% of the assets are concentrated in the top ten holdings.
The top five sectors the index reflects…
- Basic Materials
- Consumer Goods
- Consumer Services
- Financials
- Health Care
THE ROLE OF VIMSX IN YOUR ETF PORTFOLIO
How large a position of this ETF should you acquire? Two factors come into play. If you are investing for income rather than growth, this is probably not appropriate. If you are primarily looking for income and can allocate a portion of your portfolio to growth, Vanguard’s Mid-Cap Index Fund makes sense.
It is best suited to a portfolio where there can be a long-term hold. In the case of VIMSX, look at holding the ETF for at least five years. Here’s one reason why this ETF is not a good short term investment.
The top performing stocks are by nature volatile. These stocks don’t represent big positions in the ETF, but they can make big moves.
The year-to-date performance leader is Arconic Inc. (ARNC), which has been in the ETF since November. YTD it’s up 40%. In 2008, Arconic traded above $90, then it plunged and hasn’t traded over $40 since.
Invest in mid-caps with the understanding that the Vanguard Mid-Cap Index Fund is built to offset the wild swings with diversification.
It’s best to make your core holdings the large cap stocks, and for investors with a thirst for income, the large cap dividend stocks. This is why we have recommended the PowerShares Dividend Achievers ETF (PFM) and the Vanguard High Dividend Yield ETF (VYM).
Successful asset allocation means a sprinkling of growth stocks makes sense, which is what you’ll get with Vanguard’s Mid-Cap Index Fund.
Trade Alert
Buy: Vanguard Mid-Cap Index Fund (VIMSX) up to $37.50
Recent Price: $37.20
Price Target: $42.00
Stop Loss: $36.25
52-WEEK SECTOR PERFORMANCE
| Consumer Discretionary | XLY | +3.10% | |||
| Consumer Staples | XLP | +1.27% | |||
| Energy | XLE | +25.43% | |||
| Financials | XLF | +19.03% | |||
| Health Care | XLV | -5.15% | |||
| Industrials | XLI | +16.52% | |||
| Materials | XLB | +13.47% | |||
| Real Estate | XLRE | -2.19% | |||
| Technology | XLK | +11.33% | |||
| Utilities | XLU | +11.02% |
PORTFOLIO UPDATES
. . . . SPDR S&P Pharmaceuticals ETF (XPH) – HOLD
Pharma stock prices continue to be impacted more by what’s expected in health care policy change than through earnings or product issues. The policy breezes have been blowing in different directions, pushing our ETF up and down. Over the past week, XPH has made up for lost ground, but we would not be surprised to see another dip before a longer-term uptrend locks in.
. . . . Vanguard REIT ETF (VNQ) – BUY
The ETF has been trading in a narrow range lately and is still well below its highs of last summer. The dividend yield is a healthy 8.2%.
. . . . PowerShares Dividend Achievers ETF $PFM – HOLD
PFM is another one of our holdings that has been trading in a narrow range. Current yield is 4.06%.
. . . . First Trust ISE Global Engineering & Construction Index Fund $FLM – BUY
Our investment to profit from anticipated increases in government infrastructure spending continues to be narrowly traded. In mid-December, the ETF hit a high of $50.92. It has given back some gains, and we continue to look for stronger performance in the months ahead.
. . . . Vanguard High Dividend Yield ETF $VYM – BUY
No significant changes. The ETF remains below the buy up to price of $77.00. Current yield is 2.91%.
. . . . First Trust ISE-Revere Natural Gas Index Fund $FCG – BUY
Natural gas prices have once again slipped, and the ETF has dipped below our buy up to price of $27.70. This is a good opportunity to acquire shares at a reasonable price.
. . . . PowerShares S&P SmallCap Energy ETF $PSCE – HOLD
We will continue to hold despite signs of profit taking in the sector and a slowdown in momentum.
. . . . Utilities Select Sector SPD $XLU – HOLD
No changes. Continue to hold. This ETF remains a core position.
Portfolio Changes
- Buy Vanguard Mid-Cap Index Fund (VIMSX)
Category: SET Monthly Issues
