Goldilocks learns an investment lesson

Goldilocks complained when the chair was too big and she complained when it was too small. She complained when the porridge was too hot and she complained when the porridge was too cold. Then there was that incident with the bed. For Goldilocks, the middle was her ‘sweet spot’. While aiming straight down the middle has its advantages, investors sometimes need to be more nimble.

How Goldilocks invested the royalties from selling her three bears encounter is the part of the fairy tale not often told. When Goldilocks buys shares in companies, she insists that the company not be too big and not be too small – the so-called ‘mid-caps’. The ‘mighty mid-caps’ are often referred to as the sweet spot in the investment universe because they combine the attractive attributes of large and small companies.

Some mid-caps can be former small-caps that have grown up. They balance spirit and safety. They have experienced management teams, established brands and client bases, infrastructure already built, and access to capital markets – advantages that small-cap companies may lack.

At the same time, they benefit from flatter management structures, entrepreneurial drive and quick decision-making so can adapt more quickly than their large-cap counterparts.

Mid-caps are not business giants with a huge market share that make it impossible to grow more than a few per cent. Mid-caps still have room to capture market share, offer new products, enter new markets, gain economies of scale or obtain intellectual property quickly. They also have a much greater potential of being taken over than large-caps have. In addition, analysts cover large-caps in such depth there are no hidden gems to find.

The S&P/ASX Index Series defines mid-caps to be the stocks ranked from 51 to 100 by market capitalisation. The following graph shows the mid-cap index outperforming other key indices over the long term.

Below we present this data in a different way. The rolling returns show the performance results over each previous period. In other words, in chart 2 each dot point represents the return for the previous 12 months, in chart 3 each dot represents the returns of the previous 5 years.

What is evident in both is that there are times when the mid-caps underperform the larger-caps. If we focus on chart 2, the last few months are a good case in point. In March this year, mid-caps were the best performing index for the previous 12 months. It was the second highest 12-month performance ever recorded by an S&P/ASX index. Fast forward three months and the mid-cap index is back in-line with the large-caps indices. Price fluctuations tend to be bigger in mid- and small-caps as the below table shows. Referring to the table below, the S&P MidCap 50 has the highest best month and best quarter, but the second lowest worst month and worst quarter.

Goldilocks, like any investor, does not like to lose money, but recognises that timing the market, is impossible.

As with any investment strategy, diversification reduces the risk without, according to Modern Portfolio Theory, giving up too much of the return. Goldilocks is learning that ETFs are useful trading tools for portfolio construction – a lesson almost as important as not stealing, not vandalising furniture and not falling asleep in your victim’s bed.

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