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System Says These 2 Relative Unknowns are the Best Mid-Cap Stocks to Buy

Michael J. Carr

Mid-cap stocks, generally defined as companies with market caps between $2 billion and $10 billion, can be among the best stocks to consider in any type of market.

These stocks offer strong growth potential, especially when compared with large-cap stocks. Mid-cap companies will have earnings that are in the millions rather than the billions of dollars, and many will be rapidly growing sales and profits.

Although neither feat is easy, it seems less difficult to increase earnings from $100 million to $200 million than to grow earnings from $10 billion to $20 billion. In both scenarios, the companies would report 100% earnings growth, but investors are likely to reward the smaller company with a higher price-to-earnings (P/E) ratio. Smaller companies should be able to sustain high growth rates for several years while large companies would be expected to level off and report slower growth as they saturate their markets.

When compared to small caps, mid-cap stocks will usually have less risk. That's because they should have proven that their business models are capable of generating hundreds of millions of dollars in revenue, and revenue is always required before profits can be reported. Many small-cap stocks will have an aggressive plan, but might not have demonstrated the ability to deliver sales and profits.

To find the best mid-cap stocks, I used my system that combines technical analysis and fundamental analysis. Some investors limit their approach to one or the other. By combining the two, we should be able to find good stocks by applying fundamental analysis and buy them at the right time with tools from technical analysis.

Because I am using a system, it is possible to test the idea against historical data. Clearly defined buy and sell rules can be programmed to find similar setups in the past, and the results can help evaluate the soundness of the idea. Future results are not guaranteed to be like past results, but the past is often the best guide we have to help us make decisions.

In the past, buying mid-cap stocks with high relative strength (RS) and strong cash flow would have delivered an average annual return of 27.03% a year since 2007, in part because it would have spent most of 2008 sitting in cash when risk was too high. Overall, 68.4% of the trades were winners. The average position was held for six weeks, exiting when relative strength or the company's cash flow rank declined, or a stop-loss of 30% was hit.

Right now, this system is pointing to B/E Aerospace (BEAV) and Covance (CVD) as the best mid-cap stocks to buy.

B/E Aerospace is the largest global maker of cabin interior products for commercial aircraft and business jets and the largest global distributor of aerospace fasteners and consumables. Revenues have grown an average of 20% a year since 2005, while operating earnings climbed an average of 28% a year since then. The company has a backlog of $3.75 billion in orders, or more than one year's sales.

Analysts expect earnings growth of 18% a year for the next five years. BEAV is trading at about 14 times 2014 projected earnings ($4.17 per share), making the company undervalued by the PEG ratio. A PEG ratio of 1 would show fair value and is achieved when the P/E ratio and earnings growth rate are equal. BEAV would be fairly valued at about $75 by this formula ($4.17 x 18), about 26% higher than the current price.

Recommended Trade Setup:

  • Buy BEAV up to $62
  • Set stop-loss 30% below the entry price; testing shows this large stop works best with the system
  • Set price target at $75 for a potential 21%-plus gain in 9-12 months

Covance helps drug companies through the FDA approval process. This is a high stakes process where companies can invest hundreds of millions of dollars and spend years trying to get a new drug approved. Only about 10% of new drugs ultimately win approval, so companies like Covance provide a valuable service by offering expertise in the testing process.

In the past 12 months, CVD reported revenue of $2.18 billion and profits of $94.7 million. Analysts expect the company to grow earnings at about 13.6% a year going forward, but the company has beaten analysts' expectations in each of the past three quarters, which is a bullish sign.

The monthly chart shows the potential upside of almost 30% for CVD. The stock has broken out of a double-bottom pattern and shows a long-term price target of $94 based on that pattern and a resistance level.

CVD Stock Chart

Recommended Trade Setup:

  • Buy CVD up to $76
  • Set stop-loss 30% below the purchase price to follow the system
  • Set initial price target at $81.75 for a potential 8%-plus gain in 3-6 months
  • Set long-term price target at $94 for a potential 24%-plus gain in 6-12 months

Systems are especially useful for spotting companies like B/E Aerospace and Covance that are smaller and not highly visible. Both of these companies are profitable and their stocks offer great value.

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