For Long-Term Wins, Look to Nimble Midcaps

Over full market cycles, midcaps are typically the best performers. Don't be fooled by fluke highs and lows.
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NEW YORK (TheStreet) -- Midcap funds have been leading the parade lately. During the past five years, midcap blend funds returned 0.3% annually, while small-blend lost 0.5% and large-blend dropped 0.7%, according to Morningstar.

Was it a fluke? No, argues Kevin Toney, a portfolio manager of

American Century Mid Cap Value Fund

(ACMVX) - Get Report

. "Midcaps are the sweet spot of the market," he says.

In the 1970s, researchers concluded that small stocks had delivered the best returns. But in recent decades, midcaps have taken the leadership, according to

Zephyr StyleAdvisor

, an investment data firm. During the 20 years ending in June, the

Russell Midcap Index

returned 10.2% annually, compared with 8.2% for the

Russell 2000

small-cap benchmark and 7.7% for the large-cap

S&P 500

.

Toney concedes there will likely be periods in the future when small or large stocks lead the markets. But midcaps are the most appealing long-term investments, he argues.

Midcaps tend to outpace large caps because medium-sized companies provide higher revenue and earnings growth, Toney says. Midcap companies are more nimble, swiftly hiring additional workers and increasing production. That has enabled them to outperform large caps during periods when the economy was growing and markets were climbing. During downturns, large stocks have proven more stable and slightly outshone midcaps. But over full market cycles, midcaps typically have won.

Small stocks may outpace midcaps in bull markets. But midcaps prove more resilient in downturns. "Midcaps have more stable balance sheets and better access to capital," Toney says.

Though they make up a third of domestic equities, midcaps account for only 15% of the assets in equity mutual funds, according to Morningstar. "Investors overlook midcap funds," says Peter Zuger, portfolio manager of

Touchstone Mid Cap Value Fund

. "People buy large caps and small caps, and they figure that they have covered all the bases."

To try a midcap fund, consider American Century Mid Cap Value, which has returned 3.8% anually during the past five years, outdoing 95% of its peers and outpacing the S&P 500 by 4 percentage points. The American Century portfolio managers seek solid stocks that have become slightly depressed because of transitory problems. "Our companies have very good balance sheets, and they are leaders in their industries," says portfolio manager Toney.

A favorite holding is

Republic Services

(RSG) - Get Report

, a trash hauler. An acquisition saddled the company with debt, Toney says, but Republic has strengthened its balance sheet. Now the company is generating strong cash flows from a business that tends to be stable.

Toney also likes

Imperial Oil

(IMO) - Get Report

, which produces oil and natural gas in Canada. The company has a rock-solid balance sheet. Toney says that if the business ever ran into trouble, it could probably get help from

Exxon Mobil

(XOM) - Get Report

, which owns most of Imperial's shares.

Another solid fund is

RidgeWorth Mid-Cap Value Equity

(SAMVX) - Get Report

, which returned 5.2% annually during the past five years, outdoing 99% of its competitors. Portfolio manager Don Wordell favors dividend-paying stocks with price-earnings ratios that are in the bottom third of their historical ranges. Wordell looks for catalysts such as acquisitions or divestitures that can push up depressed stock prices in the next 12 to 18 months.

A holding is

MB Financial

(MBFI) - Get Report

, a Chicago bank that has been scooping up failed competitors. After the bank cleans up its acquisitions, earnings should climb, Wordell says. "This is a stock that can double in the next two or three years," he says.

He also likes

R.R. Donnelly

(RRD) - Get Report

, a leading commercial printer. While the printing industry has suffered because of the recession and the continuing growth of the Internet, R.R. Donnelly has proved resilient, cutting costs and acquiring weaker competitors. The stock pays a rich dividend of 6%.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.