Making Money in the Middle

Investing in midsize companies hardly means settling for midsize returns. Investors often overlook shares of so-called mid caps -- generally stocks with market capitalizations of $1 billion to $10 billion -- as they fixate on the behemoths and runts. But, on average, midsize companies grow faster than the giants and are better priced than small companies. And as small-company stocks finally lose steam and the market waits for big-company shares to emerge from their long slumber, it makes sense to put some money in mid-cap stocks.

Mid caps haven't exactly been slouches. This year to May 14, Standard & Poor's MidCap 400 index gained 12%, handily outpacing both the large-company-oriented S&P 500 and the S&P SmallCap 600. Over the past ten years, the S&P 400 returned 14% annualized, beating the large-company and small-company benchmarks by an average of six and two percentage points a year, respectively. What's not to like?

And as the economy slows, expect mid caps to draw more attention, says S&P strategist Alec Young, because they offer higher potential profit growth. He expects midsize companies to post 13% profit growth this year, compared with 7% for large firms and 9% for small ones. Moreover, mid caps are cheaper than small-company stocks when you compare the average price-earnings ratio with the average expected growth rate of the underlying companies, known as the PEG ratio. The smaller the PEG ratio, the better. Currently, mid caps sport an average PEG ratio of 1.4, compared with 2.4 for large-company stocks and 2.2 for small-company stocks. It's no surprise that Young calls mid caps the market's "sweet spot."

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Happy mediums

Investors who want to own mid caps through mutual funds have plenty of options. Note, though, that fund researcher Morningstar often labels funds that invest in companies of any size as mid-cap funds. If you want pure exposure to the middle of the market, it's better to buy a fund that specifically says it specializes in those kinds of stocks.

Vanguard Selected Value (symbol VASVX) is one of the best. Seasoned bargain hunter Jim Barrow and his protégé, Mark Giambrone, run 80% of this fund, a member of the Kiplinger 25. They seek midsize companies with below-average values and above-average yields, and they often pounce after a company stumbles or some other event temporarily depresses a stock's price. The pair bought Yellow Pages publisher Idearc (IAR) shortly after Verizon Communications spun it off last year. As many Verizon investors dumped their small Idearc stakes rather than try to analyze the new company, the duo scooped up the stock at about $27. (In mid May, it traded at $36.) A major drawback: The fund requires a $25,000 minimum investment.

Investors with less money should consider Janus Mid Cap Value (JMCVX), which has a $2,500 minimum. Managers Tom Perkins and Jeff Kautz are also bargain hunters, and they've found a number of good values among money-management companies. One longtime favorite is Legg Mason (LM). Perkins, who has run the fund since its 1998 inception, bought the stock that year for about $13, then sold it in 2004 for $75, adjusted for stock splits. Perkins and Kautz started buying the stock again at $90 in mid 2006 after the company announced disappointing earnings. Perkins is particularly concerned about minimizing risk. The fund gained 7% during the 2000-02 bear market, while Janus's overheated growth funds suffered huge losses.

Speaking of growth stocks, a top contender among funds that focus on rapidly expanding midsize companies is Turner Midcap Growth (TMGFX). Lead manager Chris McHugh and his team look for companies with accelerating earnings and positive share-price trends. The result is a portfolio filled with supercharged stocks that sell at lofty P/Es. "I'm very happy to buy Under Armour, growing at 30% to 40%, instead of trying to invest in a sleepy retail concept like Sears," he says. McHugh likes the high growth rates of luxury-goods retailers, such as Coach (COH), and believes worldwide interest in gambling -- especially in Macau -- will provide a tailwind for casino operator Wynn Resorts (WYNN). Turner provides good balance for your value holdings, but invest only if you have a strong stomach. The ups (125% gain in 1999 and 50% gain in 2003) are sensational, but the losses (-71% during the 2000-02 bear market) can be downright depressing.

Buffalo Mid Cap (BUFMX) also invests in fast-growing companies, but it doesn't go out on as long a limb as Turner does. Managers Kent Gasaway and Bob Male identify investment themes, such as the aging population, technological advancement and corporate outsourcing, and then find growing companies with little or no debt that fit into those trends and sell at reasonable prices. For example, they think businesses will continue to struggle with tight labor markets. That's why the fund bought outsourcer Hewitt Associates (HEW), a top holding, which handles human-resources functions for large multinationals so that they can focus on their core businesses. Buffalo Mid Cap has trailed other mid-cap growth funds lately because its managers, who have run the fund since its 2001 start, shun energy companies, materials producers and utilities. They find that the volatility of commodity prices makes those sectors impossible to predict. But over the past five years, Buffalo beat its peers by an average of three percentage points per year.