Opportunities

• Quality Growth Companies: Mid-cap stocks occupy an ideal position—large enough to have proven business models and strong corporate governance, yet small enough to have significant growth potential. Historical data shows mid-caps have considerably outperformed the broader ASX 300 and ASX Top 20.

• Global Expansion Potential: Many Australian mid-caps have successfully expanded internationally, developing globally competitive products that allow them to grow beyond Australia's limited domestic market. Companies with global earnings have delivered approximately 300% returns over the past decade compared to the ASX 200's mere 46%.

• Internally Generated Growth: Companies reinvesting profits at high rates of return (rather than distributing most earnings as dividends) have generated the strongest performance and earnings growth. Examples include Aristocrat (693% EPS growth over 10 years), REA Group (181%), and Breville (134%).

• Market Inefficiencies: The significant reduction of global equity research analysts over the past decade has increased market inefficiencies, with fewer earnings revisions and less coverage of mid-cap stocks, creating opportunities for active managers to identify mispriced securities.

Risks & Areas of Concern

• Valuation Risk: While high-quality mid-caps often trade at premium valuations in Australia, these elevated multiples create risk if companies fail to deliver expected growth. While these high growth mid cap companies have not quite got back to the heady levels of 2021 they no longer look particularly cheap.

• Economic Sensitivity: During market downturns or liquidity crises, smaller companies can experience greater volatility than large caps. Focusing on quality businesses with internally generated growth and high return in investment may mitigate some of this risk.

• Macro Headwinds: Australia faces productivity challenges relative to the US, with declining labour productivity and increased government spending potentially crowding out private investment and limiting economic growth potential.

• US vs. Australian Economy: While the US economy shows strong productivity growth and healthy economic fundamentals (with Trump's policies potentially supporting deregulation and business growth) this could be jeopardized by a tariff war. Meanwhile Australia's economy has seen more challenging conditions with three years moribund ASX earnings growth. Allocating between domestic and overseas growth could be a delicate balance.

Portfolio Implications

• Adding 20% to the Bennelong ex-20 Australian Equities Fund to a typical domestic equity index portfolio would:

  • Reduce exposure to Financials (and in turn exposure to the largely overvalued Australian Banks) by approximately 4%.

  • According to consensus estimates, modestly elevate the Price-to-Earnings multiple, whilst in turn materially increasing the long-term projected EPS growth by almost 2% (from 6x to 8x).

• The higher allocation to Australian mid and small caps provides the portfolio with diversification away from the concentrated, top-heavy ASX 300 (reducing the top 50 exposure from 77% to 69%) while still maintaining an allocation to Australia's largest companies and increasing exposure to potentially higher-growth companies of the domestic equity market.

• The portfolio's reduced exposure to financials and materials, coupled with increased exposure to companies within the healthcare and consumer discretionary sectors, may provide more resilience during periods of heightened market volatility, as evidenced in recent market dislocations.

• If you would like us to conduct similar analysis for your model, SMA or client's portfolio please contact us below.

Economic Scenario Expectations

• Continued Economic Growth

  Mid-cap quality growth companies would likely outperform large caps, particularly those with exposure to international markets like the US and companies with strong reinvestment strategies delivering both earnings growth and potential multiple expansion.

• Mild Recession

  Mid-caps with strong balance sheets and less cyclical business models would likely demonstrate resilience, with sectors like technology, healthcare, and communications potentially experiencing less impact than those tied to consumer discretionary spending.

• High Inflation & Rising Rates

  Companies with pricing power and low capital intensity would be better positioned, with potentially less severe impacts than that in 2022 as current interest rates already reflect inflation concerns.

• Severe Economic Downturn

  Large caps may initially outperform mid-caps due to liquidity concerns, though mid-caps with strong balance sheets could present buying opportunities if market selling creates valuation disconnects.

Conclusion

Mid-cap companies with high returns on capital, strong reinvestment capabilities, and global market potential present a compelling opportunity for Australian equity investors seeking growth. With the ASX Top 20 facing structural growth challenges and trading at elevated valuations, selectively investing in quality mid-caps could offer a path to superior long-term returns.

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