Although they have had a relatively tough 2014 things could get even worse for mid-cap stocks next year, according to FE Alpha Manager John Chatfeild-Roberts, who manages Jupiter’s Merlin fund of funds range.
Mid-caps have had a difficult year so far, after returning significantly more than large caps over 2013 and 2012 as markets bounced back from the depths of the financial crisis and the losses of 2011 during the European sovereign debt crisis.
According to FE Analytics, both the FTSE 100 and the FTSE 250 are up over 2014 but the former has gained almost double the latter.
Performance of indices in 2014
Source: FE Analytics
While Chatfeild-Roberts believes mid-caps can outperform in longer term, he expects them to take a significant hit as central banks raise interest rates from their near historic lows over the medium term.
The manager argues that part of the recent outperformance of mid-caps over large-caps has been because of loose monetary policy and quantitative easing.
Since the beginning of QE in the UK, the FTSE 100 has gone up 94 per cent and the FTSE 250 has gone up 200 per cent. But with the market now expect the days of ultra-loose policy to be drawing to a close, the manager sees this leg of support being pulled from mid-caps.
Performance of indices since Jan 2009
Source: FE Analytics
“When there is significant monetary easing the FTSE 250 seems to do well and then when you start to get tightening it tends to pull back. Our expectation is that you will get more outperformance from the larger caps,” he said.
He says this has led him to sell out of mid-cap heavy funds over the course of 2014.
“We are now positioned, and have been since March this year, for the FTSE 250 not to do well relative to the FTSE 100, despite it not doing too well recently.”
“You can see recently that the FTSE 250 has picked up a bit but that may be to do with greater monetary easing in Europe or the potential for monetary easing.”
Chatfeild-Roberts says that buying heavily into mid and smaller-cap companies when credit is tightening could spell disaster and herald a prolonged period where investors become forced sellers.
“If you took that position in 2008 you would have been fired. When there is, essentially, no liquidity in the market, the further down the cap scale you go,” he said.
“In 1987 if you had a portfolio of smaller caps, in 1988 you could have gone away for three years because you wouldn’t have been able to do anything. The makers had disappeared because the liquidity has dried up.”
Over the longer term mid-caps have made huge returns. For example over 20 years the FTSE 250 is up 716.11 per cent while the FTSE 100 gained 334.39 per cent.
Performance of indices over 20yrs
Source: FE Analytics
Several other managers are retaining a bullish outlook for mid and smaller-cap stocks as rates rise.
The likes of Miton’s Gervais Williams, Fidelity’s Alex Wright and Franklin Templeton’s Mark Hall have all been finding attractive valuations in mid-cap names after their recent underperformance.
Hall says: “One area where we’ve found some opportunities is in small and mid-cap stocks, which have had a rough ride this year. By way of background, small- and mid-cap shares had been materially outperforming their large-cap counterparts for almost two years until February, when small and mid-cap stocks fell from favour and large-caps began their assent.”
“Many market forces have contributed to this role reversal. First, some of the recent relative weakness in small and mid-cap stocks was a rational reaction to the bull market they had enjoyed over the past two years.”
“As a result, valuations had become stretched, and we saw some profit-taking as some investors began rotating out of their small and mid-cap holdings and buying more attractively valued large-cap shares”.
He adds while some investors took those profits and rolled them into new issuances, he thinks the expanding small-cap universe had started to suffer from a huge wave of newly listed companies during the first nine months of the year.
“Finding small and mid-cap shares that offer the kind of valuation attractions we look for has been more challenging during the first half of the year than it was two years ago, when the run-up in prices began.”
“The rerating seen in the market over this time period naturally means there aren’t as many undervalued situations to take advantage of,” Hall said.
“However, after this period of mid and small-cap underperformance, we are starting to see investment opportunities emerge with valuations that seem undemanding given their growth potential.”
“One of the greatest advantages to investing in this area of the market is the large investment universe and the opportunity to find valuation anomalies whatever the prevailing economic backdrop.”
