Zacks Investment Management

In last week’s column, I talked about rich valuations in the equities markets, but I also made the argument that stocks had more room to run. With the equity yield above the bond yield, an expected earnings rebound in the next six months and risk assets flowing to the relatively strong U.S. economic shores, I posited that valuations could (and should) move higher from here.

So where to invest? For some ideas, I thought it’d be a good idea this week to interview a key member of Zacks Midcap Core Strategy, Manish Jain. Our team has guided this strategy into ranking in the top 1% out of 349 managers in the Morningstar Mid Cap Blend Universe (as of 6/30/16), while also outperforming the Russell Mid-Cap Index since inception. In other words, it has delivered exceptional, consistent performance.

Below are some of the highlights of our interview, which will give investors an inside glimpse into how the strategy is managed and Manish’s current outlook for Mid-Cap stocks (it’s a positive outlook).

Let’s get right to it – why invest in Mid-Cap stocks right now?

Manish: I’ll get to the “right now” part in a moment, but first I think it’s important to look at why Mid-Cap stocks are attractive as a category in general. When you think about it, they are kind of in a sweet spot. These are companies that have typically been around long enough to have lengthy earnings records and management tenures, but they’re not so big that they’re always in the spotlight and subject to the forces of big institutional trades. On the other hand, they’re not so small that they carry more business cycle risk and endure volatile earnings. They’re right snug in the middle.

In terms of why we like Mid-Cap stocks right now, I think you can look at 2 factors in play in this environment:

1. Risk assets are flowing to the U.S. – with Brexit, uncertainties over China and Emerging Market growth potential, investors are increasingly favoring the relative (and largely underappreciated) growth in the U.S. As earnings and growth numbers surprise to the upside (which we believe they will continue to do), investors’ appetite for risk should also increase. As investors seek more risk to generate higher returns, they should move along the capitalization curve away from the biggest names and towards Mid-Cap names, creating fresh tailwinds.
2. Earnings Surprises – I alluded to this in point #1, but a scenario where earnings come in better than expected is good for stocks. And that’s what we’re seeing now. To be sure, within the Russell Mid-Cap Index, reported year-over-year, earnings growth is negative so far at -5.4%. We expect that number to be negative even after all companies have reported. But, the key here is that earnings are not as bad/negative as the market anticipated. You can measure this by comparing actual earnings to consensus expectations. When you do that, you find that the “earnings surprise” so far is +5.66%, meaning that companies are doing better than expected. In the stock market, when reality exceeds expectations, prices tend to rise.

Liking Mid-Cap as a category is one thing, but how do you actually pick the winners within the space?

Manish: We have developed a sophisticated, quantitative system for ranking stocks that allows us to filter through the entire benchmark and locate what we think will be the best performers. Our benchmark, the Russell Mid-Cap Index, has 800 stocks, but our portfolio only has 100—the 100 stocks we think have the best chance of outperforming their peers on a sector basis. This is different than just picking the top 100 stocks—doing so would mean you might have a bunch of stocks in 1 or 2 categories, with high correlation. That’s a very risky approach. We follow the tenets of diversification—maintaining exposure to each sector in the benchmark—but we can be selective about what stocks we own within each sector and how much portfolio weight we have in each sector.

Tell us a little more about the ranking system.

Manish: The stock market is a reflection of all known information—whether its GDP, inflation, interest rates, and so on—if it’s known then it is already priced into the market. But what is not reflected in the market are surprises, in particular earnings surprises. Surprises to the up or downside have the power to affect prices, and so we look at stocks by their potential to surprise to either side. Zacks developed a model aimed at detecting—as early as possible—potential earnings revisions during the earnings revisions period, and then we try to assess the relative strength of these revisions. Our model is based on four characteristics:

• Agreement – degree that analysts revise earnings in the same direction
• Magnitude – the bigger the revision, the larger the impact
• Upside – the most recent forecast compared to the consensus
• Surprise – the company’s previous earnings surprises can predict future ones

We assign each stock in the index a score (1 – 5) based on these characteristics, and then we take it a step further to differentiate all the 1’s from each other, and all the 2’s, and so on. Think about it like getting a grade in school—getting a B+ is much different than getting a B-, right? We need to look at each stock that way too.

How do you decide how much weight to put into each stock or sector?

Manish: Zacks has a proprietary model called the “Optimizer,” which uses algorithms and inputs from us to look at what the optimal weight to certain sectors and stocks should be, based on outlook and future earnings expectations. This tool also tells us the correlation between positions in the portfolio, so we can do everything possible to control risk by creating a healthy balance of non-correlated and correlated securities.

Bottom Line for Investors

The outlook for equities as a broad category remains positive, in our view. When you start to think on a finer level about what categories to favor, Manish makes a strong case for having an allocation to Mid-Cap stocks, assuming it is consistent with your tolerance for risk and your long-term return expectations.

Disclosure