Mid-Cap Growth Is the Place to Be

06/26/2008 12:00 am EST

Focus: MARKETS

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, Standard & Poor’s chief equity strategist, says mid-cap growth stocks should show the strongest earnings and share-price growth at this point in the cycle.

If there is a sweet spot in the US equity market, we think it is the mid-cap equity arena. Investors realize they can get higher-octane results from the more nimble smaller-cap stocks, as they typically outpace larger-cap issues when the equity market is on the up swing. At the same time, they also maintain the more defensive qualities that larger-cap, multinational companies traditionally offer during challenging economic periods.

In addition, while the international integrated oil companies dominate the Standard & Poor’s 500 energy sector, it’s the upstream exploration & production companies (those that benefit most from rising oil prices) that dominate the mid-cap benchmark.

S&P equity analysts, who cover about 70% of the companies in the S&P MidCap 400, are projecting a 16% increase in operating earnings for the 400 in 2008, as compared with only an 8% estimated rise for the S&P 500. Plus, despite a higher P/E on 2008 estimated earnings for the midcap index, the PEG (P/E-to-growth) on estimated 2008 results is more attractive for mid-caps at 1.0 vs. 1.8x for the 500.

Our outlook for small-cap issues remains neutral, as the increasing likelihood of a delayed recession is expected to cap earnings growth. While Wall Street consensus estimates call for a 9% rise in operating results, valuations appear a bit stretched at 19x estimated 2008 results vs. 15x for the S&P 500.

S&P equity analysts also have a more favorable investment outlook for large- and mid-cap growth stocks, as compared with their value peers. Mid-cap growth issues should see a 23% advance in earnings, while [mid-cap] value issues are expected to see a 7% advance. For all three market cap sizes, 2008 estimated earnings growth is projected to be substantially stronger for the growth side of the ledger than the value side.

S&P recommends overweighting the information technology and materials sectors, while
underweighting health care and utilities. For technology issues, we see the effects of a mild US recession already largely discounted in current valuations. In addition, the materials group traditionally outperforms during periods of inflationary concerns.

We currently recommend a market weighting on the energy group, however, as we anticipate a decline in oil prices. We [also] recommend underweighting the health care sector, as the group’s defensive appeal appears to be evaporating in the face of sparse drug pipelines and growing margin pressure. Finally, we think utilities may underperform in the period ahead, as a result of a decelerating second-half earnings forecast, combined with above-market P/E & P/EG ratios.

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