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With the stock market notching so many record highs this year, you might think that it’s in perfect health. But when we give it a check-up, we can see that it’s not quite as healthy as it seems. In fact, I think we could safely diagnose the stock market with a case of increasingly bad breadth.
Funny term, serious implications
It sounds like halitosis, but market breadth (not breath) can often be used to determine the health of the broader market. The problem with simply using index returns — like the record-high-setting S&P 500 — as a proxy for the health of the entire stock market is because of a quirk in their compositions.
The S&P 500 and Nasdaq Composite are both market-cap weighted indices, which means that larger companies account for a disproportionate amount of the index’s return.
Here’s an example. Below are the weights of the top five companies in both the S&P 500 and the Nasdaq, along with their representative weights in each index.
|Companies||S&P 500: Weight||Nasdaq 100: Weight|
You can see how the major indexes are becoming dominated by the performance of just a few companies. Think about it — for the Nasdaq 100, more than 40% of its daily returns are based on just those five tech giants! Other big companies aren’t performing as well as those five, but their underperformance is getting obscured by the strong performance of Big Tech.
Even more worrisome is that many of these tech companies are now trading at elevated valuations, which means investors have high expectations for their business performance. It seems like Big Tech is priced for perfection … and if/when those companies disappoint investors, it will affect the entire index.
If you’re only invested in big tech companies — or in an index fund that tracks the S&P 500 — there are some ways you can protect your money from a Big Tech crash.
Investing in mid-cap stocks is one way.
What’s a mid-cap stock?
The definition for a mid-cap (or small-cap or even a large-cap) stock is often a source of debate.
Back in the 1980s, any company with a market capitalization of more than $1 billion was considered a large-cap stock. These days, it’s more like $10 billion to $25 billion. And today’s small caps are generally regarded as having a market capitalization of less than $1 billion to $2 billion.
So most market watchers consider mid-caps companies to be the ones with market capitalizations between $1 billion and $10 billion.
Why you should invest in mid caps
Depending on how big a company is, its investors will be exposed to different levels of risk and potential return. Traditionally, investing in large-cap companies has been considered less risky and less volatile because they have many assets and are vital to the global economy. However, investing in large caps traditionally required a trade-off: It was widely accepted that investors needed to sacrifice growth for that stability.
(Big Tech has mostly rewritten the rules here because those companies have been able to profitably scale at tremendous levels. Investors continue to reward these tech titans, and now their valuations are at record highs. And therein lies the risk. At some point, Big Tech will eventually be unable to grow into those lofty valuations. Slowing growth and rich valuations could lead to sharp selloffs, which will impact the greater market because of their disproportionate representation in the indices.)
Small caps have the exact opposite risk and return profile. Small-cap companies, like many Big Tech stocks of yesteryear, have tremendous potential for mind-boggling growth. However, small-cap investing is much riskier.
In fact, buying shares of many micro-cap companies (aka penny stocks) is more like gambling than investing because these companies usually have no profit — many don’t even have a viable business model.
Even if a smaller company is profitable, it can quickly fail if larger companies move into its business, suppliers raise prices, or customers abandon its limited products.
Mid caps exist in a sweet spot between these two extremes. These companies often have a history of performance and growth (like large-cap companies), have high-quality management teams that have executed on their business models, and have strong future growth potential (like small-cap stocks).
Here’s the deal: Great mid-cap stocks offer you a combination of stability and growth. And these three are well situated to eventually grow into large-cap stocks.
Innovative Industrial Properties
To complicate things even further, the first mid-cap company isn’t even a stock.
Innovative Industrial Properties (NYSE: IIPR) describes itself as the leading provider of real estate capital for the medical-use cannabis industry.
In other words, it’s a landlord to weed growers.
IIPR shares have been on fire and are now worth more than 10 times its IPO price of $20 per share. And yet it’s still just a $6 billion company, which gives it ample opportunity to keep expanding.
Like all investments, Innovative Industrial Properties has risks. Despite wide approval for medical marijuana from voters and increased state legalization, marijuana remains an illegal narcotic in the eyes of the federal government.
Counterintuitively, marijuana’s semi-legal status works well for Innovative Industrial Properties. Right now, the company doesn’t have to compete with banks and other large capital providers that are afraid of running afoul of federal laws. At the same time, its reputation as a medical marijuana REIT (real estate investment trust) has allowed it to operate with little interference from federal entities, regardless of which party is in control.
(Technically, Innovative Industrial Properties is a REIT. These are publicly traded investment vehicles that own, manage, and operate real estate with the goal to return income to shareholders. Per law, REITs must return 90% of taxable income to shareholders.)
Because it doesn’t have to compete with other providers, IIPR’s leasing terms are very favorable when compared with other industrial REITs. If (or when) marijuana is legalized at the federal level, the company will have to accept less favorable rental agreements to compete with new capital providers.
However, legalization isn’t fatal to IIPR’s growth thesis. The company has developed deep relationships with pot growers and cultivators and should be able to be the landlord of first choice when/if marijuana is reclassified or federal laws change.
One of the biggest shifts in the history of your living room is going on right in front of your eyes — literally — as many households are cutting the cord. According to eMarketer, by 2024 more households will be without cable television than will have the service.
However, your viewing experience might not change that much. Networks saw the writing on the wall and began to invest in their pay-streaming offerings and ad-supported video-on-demand apps. Now, Internet-based streaming services and connected TV (CTV) outlets are stealing eyeballs from traditional cable.
The same thing is happening with advertising, and that’s Magnite’s (NASDAQ: MGNI) opportunity. This ad-tech company is well situated to benefit from the shift to streaming services: It already provides support to large streaming providers, such as Disney’s Hulu XP ad platform.
Shares skyrocketed last year, rising 276% as more investors began to understand the massive opportunity. Year-to-date returns have been more modest, barely up since January as investors have been wary of Magnite’s recent taste for acquisitions. (The company bought two other CTV ad-tech stocks in fairly short order: SpotX and SpringServe.)
Despite the stock’s sluggish return so far this year, the company is firing on all cylinders, recently posting 170% revenue growth (79% excluding the SpotX acquisition) in second-quarter earnings. Even better, the company posted a quarterly earnings-per-share gain of $0.26 compared with a loss in the year-ago quarter.
The growth of streaming and CTV is in the early stages, and advertising technology companies like Magnite are in a rare disruptive position. That’s a great place for a $4 billion company to be, and investors could be in for decades of growth.
Coming in at $12 billion, Axon Enterprise (NASDAQ: AXON) could be considered a large cap, but it still has a growth profile more akin to a small-cap company. You might think you’re unfamiliar with Axon … but you’ll change your mind when I tell you that the company’s former name was Taser.
Axon renamed itself to emphasize that it’s more than just a stun-gun manufacturer. Investors have reacted favorably and are looking to its law-enforcement video-capture devices and storage solutions for the next leg of growth — and for good reason.
Jurors are humans and are innately hard-wired for visual experiences. The use of capture devices allows law enforcement agents better make cases and obtain convictions. It also protects people from overly aggressive policing.
Axon’s mission is to decrease the use of lethal weaponry, reduce social conflict, and enable a fairer justice system. The company’s Taser, body cameras, and Axon Cloud evidence-storage division make it easier for law enforcement officers to achieve each of these goals.
Despite the name change and focus, the company is still tethered to its stun gun and cartridge sales. Last year, more than half of its revenue came from its Taser division, but the company is rapidly growing revenue from capture devices and higher-margin Axon Cloud divisions that provide recurring revenue.
The biggest risk to Axon is the nature of its niche customer base. In addition to having longer sales cycles, law enforcement agencies are subject to political considerations and other budgetary constraints. To date, this has not been an issue for Axon and it’s unlikely that funding for cameras and non-lethal devices for law enforcement would be first to be cut in an economic downturn.
Axon has also been seeking out private sector clients and recently landed a large deal with Six Flags to equip its security staff with body cameras.
Make mid-caps part of your investing strategy
Through the end of August, the S&P 500 has recorded 53 record closes, and the Nasdaq has notched 32. Stocks are on fire, and it seems everyone wants in. Yet Warren Buffett once quipped “be fearful when others are greedy and greedy when others are fearful.”
Now seems like a good time to exercise a little caution, and investing in mid caps is one way to balance out some of the risks in the greater market.