Finding Value With Mid Caps

Often overlooked, mid-cap stocks and exchange-traded funds offer investors exciting long-term growth prospects. More important than excitement are historical data that confirm mid caps have lengthy track records of topping large and small stocks while being less volatile than small caps.

Why Mid Caps?

Some investors may perceive mid caps as being richly valued, as is often the case with small caps, indicating that they have to “pay up” for growth. There are ways for investors to manage mid-cap valuations and they can do so with in passive fashion with the WisdomTree MidCap Earnings Fund (ETF) EZM.

EZM follows the fundamentally-weighted WisdomTree MidCap Earnings Index. That index has an emphasis on core earnings, which “is a standardized calculation of earnings developed by Standard & Poor's designed to include expenses, incomes and activities that reflect the actual profitability of an enterprises ongoing operations,” according to WisdomTree.

In other words, there is a profitability requirement stocks must meet to join EZM's lineup, a methodology that helps the ETF avoid overvalued and unprofitable mid caps.

Methodology, Explored

“WisdomTree measures earnings by S&P Core earnings instead of GAAP earnings, because they believe these more accurately represent a stock's operational earnings. S&P Core earnings remove gains or losses from noncore business activities such as hedging, asset sales, and litigation,” said Morningstar in a recent note.

EZM's top three sector weights — industrials, consumer discretionary and financial services — combine for over 56 percent of the ETF's weight. By comparison, those sectors combine for about 41 percent of the S&P MidCap 400 Index, one of the most widely followed mid-cap benchmarks. That index's largest sector weight is 18.2 percent to technology, which is more than 600 basis points above EZM's weight to that sector.

While there are time frames in which EZM trails the S&P MidCap 400, long-term returns favor the WisdomTree ETF. For example, EZM is up about 415 percent since the start of the current bull market compared to a gain of 336 percent for the S&P MidCap 400. On a risk-adjusted basis, EZM wins as well as the ETF has been only a tad more volatile than the mid-cap benchmark during this bull market.

“Through February 2017, it bested the mid-cap blend category average and S&P MidCap 400 index by 2.9 and 0.5 percentage points annually over the trailing 10 years,” said Morningstar. “Compared to the index, most of this fund's outperformance came from underweighting financial stocks during the financial crisis and adding exposure back post-crisis.”

Morningstar has a “bronze” rating on EZM.

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