Jason Stipp: I'm Jason Stipp with Morningstar. We recently sat down with management from Legg Mason ClearBridge Mid Cap Core Fund to talk about opportunities in mid-caps today after a strong relative performance among mid-cap funds over the trailing five and 10 years.
Stipp: What is behind the outperformance of mid-cap stocks over the past five and 10 years?
Derek Deutsch: Well, it's interesting that you mention that. Actually, if you look at mid-caps over virtually any time period, the outperformance is fairly significant versus both small and large-cap stocks.
And so, whether it is one, three, five, 10, or even 20, mid-cap stocks usually have shown out performance over any time period, and I think there are a couple of reasons for that.
One is that when you think of just the corporate life cycle, mid-cap companies are companies that have graduated from their more risky startup phase. They have an established business model. They have achieved a billion dollars in market cap. But at the same time, they have many years left until they're a mature company.
And so, they're kind of in the sweet spot, if you will, of their corporate life cycle, and that makes for a very interesting time for investors to be focusing on these companies. So we think that this is a situation that has existed in the past, and there is no reason why it shouldn't also exist in the future.
Stipp: How do valuations look today?Read Full Transcript
Brian Angerame: I would say valuations are no less demanding today than they were even a year ago. What's interesting is if you look at the performance of mid-caps both during and the 24 months subsequent to the last three recessions, mid-caps have done very, very well.
And so, even though we try not to predict short-term performance, if you look at our expectations for the next 24 months, if the trend holds, mid-caps should do pretty well.
Stipp: How do you factor risk into your portfolio plan?
Angerame: I would say from a portfolio contribution standpoint, what we're trying to do, as I said before, is to minimize all other risk in the portfolio other than stock selection. What keeps us up at night more so, and is probably topical today, are those influences that we can't control. For instance, regulatory or legislative risks coming out of Washington when it seems like politicians are being more reactive than active.
And so, what we try to do is understand how some of these influences could impact day-to-day operations for a company and make sure that that is factored in to our valuation work on a stock-specific basis. But, we don't want to manage the portfolio from a top-down.
Deutsch: I'd say, in general, we're constructive about the portfolio. We feel very good about the stocks that we own. We understand that times are somewhat uncertain right now, given the state of the economy.
However, we feel that the businesses that we have invested in should do well over a multi-year time period, even if we go through a period of soft economic results over the next 12-24 months.
Angerame: There's also a piece of the puzzle, I think, that has been missing for the last, really going back to August of 2007. Mid-cap stocks have long made attractive acquisition candidates for large-cap companies, any company, really, that's got a strong balance sheet.
And since the capital markets, and especially the debt markets, have been shut off, really, since the summer of 2007, we see them coming back, behaving in a more healthy manner. And that will more than likely result in CEOs and boards approving M&A activity.
We think that mid-cap stocks, and also small-cap stocks, will benefit from that trend. And the types of companies that we own with strong balance sheets, strong cash flow attributes, often lend themselves to being on the right side of a deal like that.