Small-capitalization stocks receive plenty of attention as an alternative to large-cap stocks. Midcap stocks – not so much.
But ignoring midcaps is a mistake, says Stan Majcher, co-manager of Hotchkis & Wiley Mid-Cap Value Fund HWMAX.
Midcap stocks have the same advantage over large-cap stocks as small-caps do: less research coverage, he says. So more midcap stocks are out there for investors to discover.
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And midcap stocks have the same advantage over small-caps that large-caps do: deeper liquidity, Majcher says.
His fund has annualized total returns of 5% over the past 12 months, 24% over the past three years, 6% for the past five years and 6% for the past 10 years. That tops the Morningstar Mid-Cap Value Total Return Index for one and three years but trails it for five and 10 years.
Majcher chatted with TheStreet about his views on midcap stocks, including the fund’s preferred industries now and three of his favorite stocks. Here’s what he had to say.
Street.com: What’s your investment philosophy?
Majcher: It’s to buy a business worth more than the discounted present value of its future cash flow. We look at out-of-favor stocks. It’s generally ones with temporary weakness or complicated situation, such as capital-structure problems. It’s businesses with an opportunity to generate more cash than they’re now paying the market.
Street.com: What is the attraction of midcap value stocks?
Majcher: Midcap stocks are unique in that they share the market inefficiencies that small-cap stocks have. But they have more liquidity than small-cap stocks, making the cost to invest lower.
As for the market inefficiencies, the smaller the stock, the better the chance it is mispriced. There are more small-cap stocks than large-cap, with fewer people looking at them.
Street.com: What industries are most appealing now?
Majcher: From the bottom up, the most appealing are energy and finance. You can buy businesses that are out of favor but very profitable.
In energy, demand is growing. It’s above prepandemic levels. As population grows, there is more demand for energy, particularly fossil fuels. But energy companies haven’t kept pace with their spending. Industry sentiment is that they won’t need to.
So demand is growing, and supply isn’t keeping up, thanks to the lack of spending. Instead, companies are buying back shares, which is good. Historically, they would take cash to drill more wells, which would bring down prices.
Street.com: And what’s happening in finance?
Hotchkiss & Wiley
Majcher: We like regional banks. They have benefited as short-term interest rates have risen. They are trading at only 5 to 7 times earnings and have good capital ratios.
The value of their Treasurys and fixed-rate loans are down now. But as Treasurys mature, they will reprice at par. And then banks can reprice their Treasurys and loans at higher rates. The banks also have high dividend yields.
Street.com: Do investors need midcap stocks to diversify their portfolios?
Majcher: Yes, presuming they can find an active manager that can take advantage of opportunities. For example, our portfolio has a very low multiple of earnings, probably less than 7 times.
But passive (index) funds are more like 14 to 16. Real estate, staples and utilities comprise about 25% of major midcap indices, and I’m skeptical of that. We’re at 6%. Those industries are heavily leveraged. As interest rates rise, they can have difficulties passing through higher [input] costs and higher financing costs.
Street.com: Can you discuss three of your favorite stocks?
Majcher: 1. Kosmos Energy KOS. It’s an oil and gas producer, primarily offshore. The business they’re in generates over $1 a share in cash flow. They’re producing a lot of earnings for the share price, which is $6.60.
They have a major project, as well as opportunities in liquefied natural gas, that can start next year. That’s worth about $3 a share.
2. Citizens Financial Group CFG, a regional bank. It’s trading at 7 times forward earnings. I think earnings will increase, getting that number closer to 5 times. It’s inexpensive with a good balance sheet.
It has a 6.5% forward dividend yield. It has been under pressure from headlines about rising interest rates. But it will benefit in the long run, as its securities reprice.
3. Ericsson ERIC, the Swedish company that provides hardware and software to the telecommunications industry. The demand from telecom companies for wireless equipment and services is very weak now.
This historically was a high-multiple business, but not now. Customers aren’t spending as much money as they eventually will. In this weak-demand market Ericsson is trading at 15 times earnings. Once demand comes back, that will go to only 4 times, [making the stock very attractive].
It has a great balance sheet with no net debt. It has a temporary issue with earnings. But when demand comes back, margins will rise.
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