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That’s evidenced by the Chicago center’s data showing that mid-caps have delivered comparable com- pounded annual returns to small-caps (11.03% versus 11.47%) from 1926 through 2010 with consistently much lower volatility. Both asset classes have outperformed large-cap stocks, which had an annualized return of 9.34% over this long time frame.

“With mid-caps, essentially you have ‘de-risked’ smaller-cap com- panies,” Mr. Peters says. “They’re small-cap companies that have made it to mid-cap size, validating their business models. They’re still rela- tively early in their growth cycle, but you have much more data about how their businesses have evolved.”

Another factor driving mid-caps’ relatively higher returns has been mergers and acquisitions, Mr. Peters says, which may accord some pre- mium pricing.

“Small-caps often may be too risky for acquisitions by larger com- panies and too small to make much of a difference for their acquirers,” he says. “And very few companies are large enough to take over another large company. But mid-caps may be considered a manageable, bite-sized acquisition for a larger company.”

Evolving Stocks

Because T. Rowe Price funds span the market capitalization spectrum, managers believe they have an edge investing in mid-cap companies as the rm’s analysts may have covered certain stocks for years before they grew to that size.

For example, ask Mr. Berghuis where he has found many of the best ideas for his fund, and he answers without hesitation: two of T. Rowe Price’s small-cap funds, the Small- Cap Value Fund and the growth- oriented New Horizons Fund.

“Within the several hundred companies in those funds, there are certain companies that over time will grow in size,” Mr. Berghuis says. “They’ve consistently provided us with great ideas. Particularly when you get a company that goes from small-cap value to small-cap growth to mid-cap, you can get sizable stock gains because of the expansion of its price-to-earnings ratio.”

As an example, Mr. Berghuis cites Whole Foods Market, the food chain, which, as an analyst, he recommended to the New Horizons Fund in 1992 when it had just 12 supermarkets and a market cap of $90 million.

“The thesis was that, while many viewed the company as a fringe con- cept, we believed that it would grow as baby boomers’ healthy food focus became more mainstream,” he says.

Whole Foods grew to the point that in 1998 it was large enough for its stock to be bought by the Mid- Cap Growth Fund, which still owns it. Today, the chain has 302 stores and a market cap of $10 billion.

the rm’s small-cap funds, including Human Genome Sciences and FLIR Systems, a defense contractor.

Some companies—such as Amazon.com; Starbucks; and Danaher, a global manufacturing conglomerate—were rst owned in T. Rowe Price’s small-cap funds, then in the Mid-Cap Growth Fund, and then in large-cap portfolios, with analyst coverage over several decades.

“Sometimes companies come in for meetings,” Mr. Berghuis says, “and we bring in the analyst who

  • rst covered them 25 years ago

and all the other analysts who have covered them since.” Earnings of mid-caps tend to

  • uctuate more than those of larger

  • rms, and small-caps could offer

greater growth potential. The stocks mentioned by Mr. Berghuis made up 2.7% of the Mid-Cap Growth Fund as of March 31, 2011. The fund did not own Amazon.com.

Mr. Berghuis estimates that at least half of the stocks now owned in the fund similarly have “graduated” from

Relative Valuations of Mid-Caps to Large-Caps Ratio of Mid-Cap Price/Earnings Ratio to Large-Cap Price/Earnings Ratio December 31, 1991, Through March 31, 2011

1.4

  • Relative Valuation

  • Median Valuation

1.26X

1.2

Relative Valuation Ratio

1.0

0.8

0.6

0.4

0.2

0.0

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Mid-caps are represented by the S&P MidCap 400 Index and large-caps by the S&P 500 Index. Price/earnings ratios are based on 12 months’ expected earnings.

Source: T. Rowe Price.

www.troweprice.com 7

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