NEW YORK (

TheStreet

) -- Large-cap defensive plays have been touted as the smart investment for most investors throughout the recession. But mid-caps have been the surprise winners of the markets this year, and the rally is just beginning according to Neil Hennessy, chief investment officer and portfolio manager of Hennessy Funds.

The S&P Midcap 400 is up 12% year-to-date compared to a 6% return from broad-based S&P 500. Hennessy manages the Hennessy Focus 30, a mid-cap fund that invests in 30 stocks selected purely on the basis of quantitative formulas.

Hennessy says that investors need to buy mid-caps as the economy comes out of a recession and that mid-caps now offer more bang for the buck than large-cap value stocks.

Here are some on Hennessy's thought's on where the opportunities lie within the mid-cap space.

TheStreet: What do you make of the outperformance in mid-caps? Is there now greater value in the mid-cap sector?

Hennessy:

When you start talking about large-caps, you think about defensive positions, companies that are well capitalized, that are not going to go broke. If they did go broke, it is only going to be a handful it is not going to be the whole sector.

Mid-caps were passed over because you believed you needed defensives

in a recession. But if you now believe we are coming out of a recession, the midcaps are going to do well.

TheStreet: What should investors be focusing on within mid-caps? Should they be more conservative with value picks or should they be looking for growth?

Hennessy:

The difference between value and growth is with growth you are paying for something that might or might not happen in the future. With value you know what you have. It is not going to be the fast grower but it is going to be a grower.

People had the concept for many years that if a company paid a dividend, if it did not have anything better to do with its money than pay a dividend, then it was no longer a growth stock. That was wrong. Nobody will buy a piece of rental property and not rent it out. But that was what they were essentially saying. That if you did not invest all your money you weren't going to grow. People want a return on their investment.

TheStreet: Will mid-caps also be the beneficiary of the rebound in M&A activity?

Hennessy:

There is a lot of money in companies' pockets. It is a lot easier to make an acquisition in the mid-cap range for $2 billion or $3 billion and grow your topline than buy something for $26 billion.

It is not only about the money. Money is the easy part. It is trying to integrate the business- that's difficult.

TheStreet: Are there any sectors within mid-caps that are poised to benefit?

Hennessy:

We are 50% consumer discretionary. If you want to grow topline you might start to look at some of the low end

retailers. Look at

Wal-Mart

(WMT) - Get Report

, for instance. Walmart is looking at not their mega stores but smaller stores in smaller communities. Now we will see how that affects

Dollar Tree

(DLTR) - Get Report

but they are trying to get into that market. You can do it one of two ways. You can buy into it or you can develop it. Wal-Mart just happens to be a company that has the capitalization to do it either way.

TheStreet: At this point, are there enough opportunities in large-cap value stocks given that a significant chunk of them are beaten down financial stocks?

Hennessy:

Well you have a lot of financials but you also have energy, utilities -- you know defensives. Consumer staples like

Kraft

(KFT)

,

Altria

(MO) - Get Report

.

I just don't think the bang for your dollar, you are not going to get it in the large-caps as much as you would in the mid-caps, but at the same time you are still going to make money.

TheStreet: On a more general note, do you think quantitative easing will work?

Hennessy:

When they first came out with QE2 I thought it was a new ship. If Bernanke and the fed goes and buys, the perception is that the government is printing money. That's not true. The treasury prints money. The fed is buying an asset. So when they pay for something they get an asset back. They are just putting money into the system.

We need a little bit of inflation simply because you don't want to be in the cusp of deflation. That is a spiral that is very tough to come out of. If you can get 1% or 2% or 3% inflation it gives you that much room to breathe away from deflation.

And inflation is not going to get out of control, I can tell you that. One of the things that is not around anymore that was around in the late 70s and early 80s was the cost of living increase. And that is not in contracts anymore and that is what got out of hand. You had middle managers making $50,000 a year when inflation is running at 15% and the next year he is making $57,500 and then the next year he is making $68,000. So three years later they are up 50 to 60%. That has stopped.

-- Written by Shanthi Venkataraman in New York

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