Many UK mid-caps sell into the domestic market and have recovered as the latter has too, while there are a number of high-end engineering, technology and industrial stocks which are doing well in globalised industries.
However, some investors worry that it is yesterday’s story, and that investors buying into the sector now are paying too much.
Performance of indices over 3yrs
Source: FE Analytics
FE Alpha Manager Mark Martin, who runs the five FE-crowned Neptune UK Mid Cap fund says they are wrong to be concerned. Here are his top four reasons to believe mid caps are going to continue to make investors a lot of money.
M&A activity can make you a lot of money
Martin points out that there has been a large uptick in the amount of mergers and acquisitions in the UK mid cap space, and this looks likely to be a theme of the coming year.
Companies that are taken over are done so at a premium to their market price, giving investors an immediate boost to their returns.
“We are expecting a pickup in M&A, We are seeing it on a fairly regular basis, just recently there was Weir Group talking about tying up with Metso,” Martin said.
“We have had a lot of success with M&A in the past [in the fund], eight companies being taken over for a significant premium.”
“I think when I look at the fund it’s possible that just about every single company could be taken over, although it’s never a primary reason to buy a company.”
One major reason to expect M&A to pick up is the rise in interest rates that is foreseen for the end of this year or the beginning of the next one.
“In this environment in which we are just starting to see interest rates increase a lot of companies will be thinking that it could be a good time to lock in cheap financing,” Martin said.
“If they believe rates will be higher in a year or two they will be wanting to lock in low rates now.”
Martin has recently opened a position in TalkTalk, and says he wouldn’t be surprised to see Vodafone show some interest in it in the future as it looks to enlarge and avoid becoming a target for a larger US firm.
It’s a way to avoid political risk
“M&A is a speculative reason to hold mid-caps, but an interesting area for me is political risk, which is on the increase,” Martin said.
“The general election is coming up and Ed Miliband has been talking about utility companies, while we have seen what has happened to life insurance companies recently.”
Martin is referring to the reforms announced to pensions last month in the budget, which are widely expected to see a massive reduction in the number of savers purchasing annuities.
Although FTSE 250 company Just Retirement was among the companies hit by the news, Martin admits, most of the pain was felt by the large cap life insurers which have become a popular way for managers to get financial exposure in a world with dodgy UK retail banks.
Performance of sector and market since Budget
Source: FE Analytics
“Political risk in the mid caps and the small caps is less than in the FTSE 100,” he said.
In fact, the political pressure is behind some of the sectors in which the mid-cap sector is strong, Martin adds.
“The wider sector, the make up of the 250, you have lots of housebuilders who have been getting political help, industrial engineering companies and high tech exporters,” he said.
“The government is quite keen, particularly Vince Cable, on incentivising exporters and talking up the importance of exporters to the UK.”
Martin cites the “patent box” policy, which seeks to encourage companies to develop and produce ideas in the UK. The scheme sees companies pay a lower rate of tax on patented inventions. Qinetiq, the defence company, and Vectura are two stocks he owns which he says are set up to benefit from this.
The UK economy is genuinely improving – and outside London too
“What we are seeing in the market isn’t a distortion of reality, it reflects the fact that economic outlook right now in the UK is really quite exciting,” Martin said.
“It has been a really long, slow recovery from the 2008/2009 downturn, but we are just starting to see signs the recovery is taking root and that the recovery is starting to extend geographically, not just in London and the South-East.”
Martin says that he has been buying baker Greggs, which does a large part of its business in the Midlands and the north East.
Performance of stock vs index over 2yrs
Source: FE Analytics
“It’s an interesting self-help story,” he said. “They have been closing down underperforming stores.”
“They are also geared to the economic recovery in the construction sector because of the demographics of the people who go to Greggs.”