The Best Equity Performance May Surprise You

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Stellar Performance
Since 1995 Mid Cap stocks, defined by the Russell Mid Cap index, have outperformed Large Cap stocks (Russell 1000) and Small Cap stocks (Russell 2000) by over 39%. Perhaps more impressive is the consistency that Mid Cap has shown. Looking at monthly rolling five year average returns since January of 2000, Mid Cap has outperformed both Large Cap and Small Cap in a remarkable 109 of 142 periods, or 77% of the time! The data also show that over these same 142 periods, Mid Cap has outpaced Large Cap 85% of the time and Small Cap 92% of the time. This data is through September 30, 2011.

Source: Russell Index Calculator and Baird Investment Management

Underappreciated Asset Class

Historically, most asset allocation models and investors tend to migrate to Small and Large Cap asset classes believing this adequately covers Mid Cap exposure. In our view, the data suggests these investors are missing available return, and perhaps accepting unnecessary risk exposure. Consider the strong Mid Cap returns and an in-line standard deviation, which results in a Sharpe Ratio* of 0.38 compared to 0.29 for Large Cap and 0.24 for Small Cap over the past fifteen years, according to PSN. This simply reflects that Larger Caps continue to miss out on returns, while Smaller Caps have posted relatively weaker returns and more volatility versus Mid Caps.

Source: PSN and Baird Investment Management

We believe asset allocators can leverage this data to improve their business by providing a meaningful source of differentiation. As indicated earlier, most advisors recommend Small and Large Cap solutions and, therefore offer the same advice as everyone else. In our view Mid Cap creates a source of differentiation and provides incremental value as a better performing asset class.

*Sharpe ratio measures risk adjusted return and is defined as excel portfolio return over a unit of risk (standard deviation)

Fundamental Factors Driving the Outperformance

Growth is the largest determinant of long-term returns and Mid Caps have outpaced Large Caps and Small Caps over the past 15 years in both revenue growth and operating income growth. The data is through September 30, 2011.

Source: Bloomberg and Baird Investment Management

With respect to outpacing Large Caps, one key reason this occurs is mathematics – it is simply easier to grow from a smaller base than a larger one. Also consider that Mid Cap companies tend to have greater exposure to developing opportunities or markets with lower penetration. In most cases, mid market companies are more nimble relative to large companies that may not be able to effectively participate in these areas.

Mid Cap companies have general growth advantages over smaller cap companies as well. Mid Cap companies are typically more mature and, therefore offer better cash flow and more stable balance sheets than smaller caps. They also tend to have more experienced management teams and better established brands, products and relationships. And, they are in a better position to participate globally, which will be important in capturing growth over the next several years.

A Strong Story: Baird Mid-Cap Growth

Value-added performance. Baird is known as a top mid-market firm and we have an especially strong understanding of the mid cap asset class. This experience combined with our philosophy and execution has generated value-added performance as our 3, 5 and 10 year numbers all exceed the Russell Mid Cap Growth index.

Quality growth approach. We invest in high quality companies and the majority of our returns are based on bottoms-up analysis of stocks generally between $1B-$10B in market cap. We look for companies that have superior profitability and generate growth through a sustainable advantage, a key market trend or pricing power. Strong balance sheets are also important.

Risk management is fundamental to our process. We seek to limit downside while providing value added returns. In addition to our quality philosophy, a key risk differentiator is our proprietary “Tier Board,” which allows us to look at fundamental and quantitative factors for the entire portfolio at a single glance. This tool fosters team dialogue and helps properly assess capital allocation weightings to control risk and volatility of returns. We believe the tool better positions our portfolios to capture success, while offering investors a smoother ride.

Experienced team. Our investment team averages eighteen years of experience, which provides a wealth of knowledge and consistency to our investment process.

The Best Equity Performance May Surprise You (PDF)

To learn more about our viewpoints on the outlook for Mid-Cap stocks or about Baird Mid-Cap investment opportunities, we invite you to call , we invite you to call Todd Haschker at 414-298-7362. To receive Baird Investment Management’s monthly Viewpoint newsletter, sign up here.

As of 9/30/11 

Gross of fee returns are supplemental to net of fee returns. The Russell Midcap® Growth Index measures the performance of the mid-cap growth segment of the U.S. equity universe. It includes those Russell Midcap® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell Indices are a trademark of the Frank Russell Company. Russell is a trademark of the Frank Russell Company.

Past performance is not indicative of future results. Investments in Mid-capitalization companies often are more volatile and face greater risks than larger, more established companies. The Composite focuses on growth-style stocks and its performance will typically be more volatile than the performance of investments that focus on the types of stocks that have a broader investment style. The Composite may invest up to 15% of its total assets in foreign securities and ADRs. Foreign investments involve risks such as currency rate fluctuations, different and sometimes less strict financial reporting standards and regulation, and the potential for political and economic instability. For more information, please visit bairdinvestmentmanagement.com.