Value stocks in the US have outperformed during a difficult first half of the year for equity investors, and after several challenging years generally for value equities.
And within this universe, mid caps offer a less-travelled route to stronger return potential with relatively moderate risk, believes AB.
“Value stocks typically do relatively well when interest rates rise, which increases the discount rate used to value the future cash flows of stocks,” said James MacGregor, chief investment officer for US small- and mid-cap value equities, and head of US value equities at AB.
“While this tends to compress valuation multiples of all stocks, growth stocks are particularly vulnerable and value stocks are generally more resilient,” he explained.
Finding balance in the middle
The focus on value has happened despite these stocks being perceived as riskier, which can raise doubts over their appeal amid volatile equity markets and uncertain outlooks for many companies.
Further, large- and small-cap value stocks have pros and cons, with the suitability depending on an investor’s risk appetite and broader allocation profile.
According to AB, mid-cap stocks can provide a good bridge between the two.
“During prior market recoveries, smaller-cap value stocks have outpaced larger-cap peers in the two years after a market bottom. Mid-cap stocks have enjoyed similar recovery rates as small caps,” said Erik Turenchalk, portfolio manager, US small- and mid-cap value equities at the firm.
“Over longer periods, these strong recoveries and have given mid-cap value stocks superior returns to larger caps but with only a modest increase in risk,” he added.
To capture this return potential requires a dedicated focus on mid caps, which account for about a quarter of total US market capitalisation but still have relatively low weightings in US large-cap indices.
“They tend to get relatively less attention from large-cap portfolio managers,” said Cem Inal, chief investment officer for US large-cap value equities at AB.
Yet within the $6bn to $40bn market-cap segment that is considered mid-cap territory, there are more than 500 companies to choose from. “[This provides] ample breadth to discover hidden opportunities and diversify by sector and industry,” added Turenchalk.
Prime targets
AB’s approach to identify mid-cap value opportunities follows the same discipline as with larger- and smaller-cap stocks – seeking those that are facing uncertainty about the sustainability and value of a company’s cash flows.
“The challenge is to correctly identify which have been unfairly punished and can eventually show strong and sustainable cash flows, and then determine when to get in position,” said MacGregor.
In addition to attractive valuations, investors need to understand a company’s competitive landscape, business environment and management capabilities.
Then, MacGregor added, investors should identify a catalyst such as a management change, stock buyback or other improvements that can drive a reassessment of the company’s valuation to push the stock up.
“It’s important to make sure that value stocks are backed by quality businesses with strong fundamentals and sturdy balance sheets,” he said.
“At the attractive valuations we’re seeing today, we believe the lesser-known and underappreciated companies in the mid-cap universe can help bolster investors’ confidence to make value stocks part of a diverse equity allocation.”
