Over the past few years, a growing number of small and large cap managers have crowded into the mid cap space in search of the outperformance the sector has seen, and the top-performing funds in the UK equity income, growth and smaller companies sectors all weight the area significantly. Tepes warns that valuations have risen to historic highs while earnings estimates have remained flat, a divergence in performance last seen in 2007 prior to the financial crash.
“Another way of looking at the current market conditions is to compare the direction and level of the market to the direction and level of earnings,” she said.
“Generally, broadly speaking, the two should move in the same direction. However, there are times of marked divergence.”
“One such time was in early 2007, when the market continued moving upwards despite earnings expectations being downgraded.”
“The second instance since that date was the period starting at the end of 2012 – the FTSE 250 index has rallied strongly while earnings expectations have increased only slightly.”
Data from FE Analytics shows that the FTSE 250 has outperformed the FTSE 100 in the strong rising market since early 2012. Over three years it has made 47.6 per cent to the 25.15 per cent of the larger companies’ index.
Performance of indices over 3yrs
Source: FE Analytics
The analyst notes that the price/earnings ratio [P/E] on the FTSE 250 has risen to 16.4 times while the large cap FTSE 100 is on 13 times earnings, representing a 26 per cent premium for the punchier stocks.
Mid cap and large cap valuations
Source: FE Analytics
That mid cap P/E has risen from around 12 times in early 2012 to its current level, but earnings estimates have barely moved.
Tepes says that there has to be limited scope for multiples to expand from their current level, but current earnings are also at historic highs.
This means that they would have to hit new records in order for share prices to continue to rise.
Tepes’ research shows that on a three-year view, investors should be concerned about this mismatch in valuations.
When mid caps have been 20 per cent or over more expensive than large caps, they have underperformed 84 per cent of the time over rolling three-year periods.
However, the results are very different over five years: 100 per cent of the time that valuations have been this stretched, mid caps have still managed to beat large caps over a five-year period.
The results over one year are closer: 59.5 per cent of the time you would have made more money in mid caps than large caps if you had bought and held for a year when valuations were at these relative levels.
Tepes says this shows that for investors with a longer investment horizon, being in mid caps could still be worth the valuations risk.
For investors who are happy to take on this risk, she continues to prefer the £173m Schroder UK Mid Cap trust, run by Andy Brough and Rosemary Banyard.
The trust has outperformed the other dedicated mid cap fund, JP Morgan Mid Cap, over three, five and 10 years, according to data from FE Analytics.
Over the past three years, the trust has made 102.69 per cent in share price terms, more than any other UK growth trust, and 78.3 per cent in NAV terms.
Performance of trusts vs sector and index over 3yrs
Source: FE Analytics
Tepes notes that the managers of the JP Morgan fund are relatively new at their posts, with William Meadon joining in 2009 and Georgina Brittain in 2012. There is less of a track record to judge, she points out.
However, she notes that investors who want exposure to the mid cap story could get it through most small cap funds, which typically have around 30 to 40 per cent in mid caps at the present time.
For investors who are more concerned about the valuations on that sector and the possibility of a pull-back, Tepes says there are a number of options.
Investors could go for an all-cap fund which has the ability to shift out of the mid cap area, but this is not her preferred option.
“If you want to hold them but you are not so convinced there will be a strong rally, I would go for BlackRock Throgmorton,” she said.
The £231m trust is run by FE Alpha Manager Richard Plackett, along with Mike Prentis. The latter is responsible for the stockpicking on the small and mid cap fund while Plackett runs a portfolio of contracts for difference worth around 30 per cent of the portfolio.
These derivatives should allow the trust to make money even when the market is falling, Tepes says.
Our data shows the fund has made 74.1 per cent over the past three years compared with the 65.25 per cent of its peer group average.
Performance of trust vs sector over 3yrs
Source: FE Analytics
Tepes says that she can’t call which way the market will go from this point, with the wobble of the last few days possibly a momentary pullback in a bull market or possibly the start of a sustained market fall.
“It’s hard to tell if we are at the top of the market or there will be a continuing rally,” she said.
“But looking at history, the odds are against you at the moment.”
“You are paying a big multiple for high expectations and there’s little room for error. It’s hard to withstand shocks like Argentina or Turkey.”
