Why Buy High Quality Mid Cap Value Today?

Introduction:
This paper makes the case that today is as compelling a time to buy the highest quality Midcap firms trading at below-market prices as it was at the peak of the internet bubble. Our primary points are as follows:

1. A Rare Entry Point: Midcap value has been decimated, creating a rare entry point for an asset class that has a 60-year history of generating high compound returns vs. Midcap & the S&P500
2. The Rise of the Wretched: Low-quality firms have rallied in a manner last seen only into the peak of the internet bubble
3. The Might of High-Quality Midcap Value: Purchasing High-Quality Midcap firms at below-average prices has historically offered investors some of the best risk-adjusted returns

Cheap High-Quality Midcap firms are abundant and compelling today, much as they were at the peak of the internet bubble when they subsequently trounced both the Midcap and S&P500 Indexes.

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A fantastic paper from Mercer Consulting1 documents the long and successful history of value and its unusual struggle in the decade following the Great Financial Crisis. Notable for its resolute advocacy to “stay the course,” Mercer also references the two most common academic explanations for the historical outperformance of value. The first is that value outperforms only because you are being compensated for buying higher risk (lower quality) firms. The second is that investors are prone to behavioral errors resulting in overly pessimistic extrapolation of recent trends in value stocks and overly optimistic extrapolation of growth.

Kailash believes the market today is in the grip of an extreme behavioral error: firms with the least fundamental merit have soared as high-quality firms have been pushed into the bargain bin. This represents a generational opportunity for investors to purchase the best firms at below-average prices. Figure 1 shows the compound return of $1 invested in Midcap Value less $1 invested in the Midcap Index. Contrary to many headlines about a decade of underperformance2 and consistent with our papers Value Investing and Manias, Growth vs. Value, and 60/40 Asset Allocation, as well as research by GMO3, value’s headwinds only began in 2017. Value’s “lost decade” looks more to us like a few years.

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As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “Kailash Capital Research, LLC ”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital Research, LLC . In preparing the information, data, analyses, and opinions presented herein, Kailash Capital Research, LLC has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital Research, LLC , however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital Research, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital Research, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital Research, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital Research, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital Research, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital Research, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.