Have mid-cap firms had their moment?

Medium-sized UK companies led the pack until Brexit angst changed all that. Does a recent bounce herald a return to form?

Medium-sized companies used to be the favoured stomping ground for active managers. Small and nimble enough to grow, but large enough to withstand the ebb and flow of the economic tide, they were seen as the sweet spot for investors. Respectable academic studies backed up this view and for many years, mid-cap-focused UK equity funds headed the pack in performance terms.

But then came Brexit. Disproportionately focused on the domestic economy – which encompassed many areas perceived as difficult, such as high street retail and housebuilding – the mid-caps suffered. The view was that they were in the eye of the storm should Brexit derail the UK economy – and as global investors exited the UK stockmarket, mid-caps took much of the pain.

Devalued sterling

There were technical reasons as well. Around 50% of the earnings from companies in the FTSE 250 index come from the UK, with the remainder from abroad. This compares to 70-80% of the FTSE 100 constituents’ earnings that come from abroad. When sterling devalued, it flattered the international earnings of larger companies and sent their share prices higher. This phenomenon has continued to support the relative performance of larger companies over mid-cap companies in the almost three years since the EU referendum.

The result is that mid-caps have lagged. The FTSE 250 index has gained 25.5% over the past three years, well behind both the FTSE 100, which is up 31.2%, and the FTSE Small cap, up 36.1%. The majority of mid-cap weakness came in 2016, when the FTSE 250 lagged the FTSE 100 index by 12%, and in 2018, when it dropped by some 5% more than its larger equivalent. This has seen a lot of formerly top-performing mid-cap funds slide down the rankings in the UK all companies sector – Schroders UK Mid Cap, for example, is now 200th out of 259 funds in the sector over three years. The specialist funds from Allianz and Threadneedle have been similarly weak. Aberdeen UK Mid Cap Equity stands out as a notable exception.

The start of 2019 has seen a small bounce back. It is tentative but may herald better times ahead for the sector. Gervais Williams, manager of the multi-cap Diverse Income trust, says that a number of consumer discretionary companies – Dunelm, Greggs and JD Sports – have done well, along with some industrial companies, such as Travis Perkins. This has happened in spite of the uncertainty over Brexit and suggests that investors may be taking a more discriminating look at the sector.

Mid-cap funds worth a look

        Total returns over:  
Name Morningstar Rating Fund size (£m) 1 yr (%) 3 yrs (%) 5 yrs (%)
Aberdeen UK Mid-Cap Equity *** 37.2 3.43 33.47 29.25
Allianz UK Mid Cap * 43.6 -13.65 13.85 17.49
AXA Framlington UK Mid Cap *** 295.0 -1.39 23.11 34.32
BMO UK Mid-Cap **** 60.3 -0.39 24.57 37.20
FP Octopus UK Multi Cap Income   4.5      
Franklin UK Mid Cap *** 952.9 -0.76 27.70 29.62
HSBC FTSE 250 Index Retail Inc *** 1,039.6 -1.60 24.12 28.91
iShares Mid Cap UK Equity Idx (UK) *** 567.6 -1.02 24.69 30.19
L&G UK Mid Cap Index   241.1 -1.91    
Merian UK Mid Cap *** 3,148.7 -14.20 27.04 43.77
Royal London UK Mid-Cap Growth **** 392.0 -0.62 25.19 33.80
Schroder UK Mid 250 * 1,050.1 -7.68 18.16 6.39
Threadneedle UK Mid 250 Ins ** 60.4 -6.33 12.80 27.40

Source: Morningstar to 28 February 2019

Mid-cap premium near lows

Georgina Brittain, co-manager of the JPMorgan Mid Cap Investment Trust, is clear that the relative valuations of mid-cap companies look attractive and that good has been thrown out with bad in the sector. Mid-caps have historically traded at a premium to both large and small-cap stocks, but it has been a price investors have been willing to pay for the attractive balance of risk and reward they offer. However, this premium is near the lowest it has ever been.

She also believes that the problems may have been overdone in some cases. She points out that there is now a real disparity between consumer confidence – which is falling – and the pound in consumers’ pockets, which is growing quickly. Should there be any resolution on Brexit, spending may snap back quickly, benefiting many of the mid-cap names. At the same time, valuations are low enough for investors to take the risk. “It is easy to be negative on UK retail, but it is all about the individual companies,” she argues.

In spite of its reputation as a repository for troubled domestic companies, the mid-cap sector encompasses a vast range of companies. The largest company in the index is food delivery platform Just Eat, whose fortunes are certainly linked to consumer trends but also to various other factors. The largest weighting is in financials: these are not banks, but include insurance groups Phoenix and Jardine Lloyd Thompson, broker Investec, peer-to-peer lender Funding Circle and investment platform AJ Bell. Investment trusts are heavily represented, as are housebuilders. These sit alongside consumer-exposed companies such as Dixons Carphone and Domino’s Pizza.

This mix provides one of a number of longer-term reasons to hold mid-caps. Williams points out that an allocation to mid-caps can provide important diversification in a portfolio: “The nature of the FTSE 100 is that it is dominated by a narrow range of sectors. These have done well more recently, but the issue of correlation is worrying. In Europe, the large-caps are dominated by similar companies.” This means investors may not be getting the diversification they need simply by investing around the globe. Instead, they could look to small and mid-cap companies, where a far wider range of companies is represented.

Brittain says: “The FTSE 100 companies are predicted to grow their earnings by around 3% in the year ahead, while the FTSE 250 companies are expected to grow at 6%. This is a scale thing: it is simply a lot easier to grow at £1 billion than at £5 billion. But by the time a company gets to be a mid-cap, it has grown up in the public markets. It is likely to have more than one leg to its story, and more stability.”

The dividend picture is more mixed. Part of their historic appeal has been the ability of midcaps to grow their dividends faster than their peers. However, they were outpaced by the FTSE 100 in 2018, once ‘special’ dividends were excluded. The blue-chip index’s payouts were 9.3% higher than the previous year on average, while mid-cap dividends were just 1.4% ahead. The Capita Asset Services Dividend Monitor predicts that mid-caps will yield less than large caps in 2019 too, at 3.3% versus 5% for the FTSE 100.

However, the authors of the report said that the slow growth was confined to key sectors within the mid-caps, notably telecoms, retail and support services, and was not universal to mid-caps.

Access overseas revenues

While there are lots of logical reasons to contemplate a reallocation to mid-caps, Justin Oneukwusi, head of retail multi-asset funds at Legal & General Investment Management, sounds a note of caution: “The Brexit risk is very real, and the first place Brexit is felt is via sterling…if you are worried about sterling, larger caps will do better than mid-caps. If managers conclude that there will be a harder Brexit, they will move up the capitalisation spectrum to get access to overseas revenues.” Of course, he says, the opposite is also true and if there were to be a soft Brexit and sterling rallied, mid-caps would be likely to outperform .

In summary, there are plenty of structural reasons that support an allocation to UK mid-caps – better diversification, stronger growth and lower valuations. Mid-caps may not emerge from this tough patch until Brexit is resolved. However, historically it has been a challenge to buy into the sector at reasonable valuations and, with a longer-term eye, this might prove an opportune moment to do so.

Active vs passive for mid-cap exposure

Most passive mid-cap investments are based on the FTSE 250 index. As passive benchmarks go, this is a good one. It is well-diversified: the largest sector is financials at 26%, but oil and gas, industrials, consumer goods and basic materials are all well represented. Investors still won’t get a lot of exposure to areas such as technology, but it is a broader index than the FTSE 100. The iShares Mid Cap UK Equity fund sits mid-table in the IA UK all companies sector and has an ongoing charge of 0.16%. There’s also the Vanguard FTSE 250 Ucits ETF, which has an ongoing charge of just 0.1%.

However, this is a diverse sector and should reward stockpicking. Certainly, there is real disparity in the performance of individual active funds. For example, the Aberdeen UK Mid Cap fund is up 36.7% over three years, compared to Neptune UK Mid Cap, which is up by just 1.3%. Investors also need to be wary of funds that are too large in the mid-cap sector, where liquidity is a greater consideration than it is for the mega caps. This is an argument in favour of some of the investment trusts – for instance, Schroder UK Mid Cap or JPMorgan Mid-Cap.

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