The strong UK consumer growth story among other tailwinds has led to full valuations in many pockets of the UK mid-cap market, according to Paul Spencer (pictured). 
The FE Alpha Manager, who is celebrating his 10-year anniversary at the helm of the Franklin UK Mid Cap fund, has tilted the portfolio five percentage points away from the UK towards overseas markets since the start of the year, and has done so through the purchase of three new holdings.
While last year’s less-than-stellar performance of the FTSE 100 has left many investors buying the dips in a bid for value, Spencer points out that this is more difficult within the FTSE 250 space as a result of its strong performance.
In 2015, the UK mid-cap index outperformed the blue-chip index by 12.49 points and the FTSE Small Cap index by 2 percentage points with its annualised return of 11.17 per cent.
Performance of indices in 2015
Source: FE Analytics
This was partially the result of global-facing larger companies being hit by the China slowdown and collapsing commodity prices, while investors became more bullish on domestically-focused stocks due to an improving economic backdrop and business-friendly government.
“If you look at the valuations of businesses you have to weigh up the risk and reward in the investment you’re making,” Spencer said.
“When one is looking for value, one doesn’t usually find it in the areas that are most appreciated by the markets as being areas that are trading really well, because everyone obviously has optimistic views regarding the outlook of these stocks.”
“Equally, if you’re looking for value, it’s not a bad starting place to look in areas where the outlook seems quite pessimistic. We are not remotely pessimistic in our outlook for the economic progress of the UK, but what we are cognisant about is that the valuations of a lot of UK stocks seem quite full. We believe that we’re being offered much better long-term value in overseas stocks where the outlook is more uncertain and rather more cautionary.”
Throughout the whole of 2015, the team on the Franklin UK Mid Cap fund bought 10 stocks, which the manager says is characteristically inactive in terms of repositioning. In the last 10 days alone, he has bought three new holdings, all of which report in dollars.
He says that throughout 2014 and 2015 he was championing UK stocks because he deemed them to be the “least dirty shirt” economically, and now, he says that looking overseas has presented more value opportunities.
Performance of indices in 2014 and 2015
Source: FE Analytics
“The UK consumer appears to have a rising level of discretionary spending at the moment, but that’s reflected in share prices,” Spencer pointed out.
“Our job is to allocate capital into areas where we think the best upside potential is and that’s why we’ve reduced our UK exposure and switched the money to overseas exposure.”
The three new holdings that the FE Alpha Manager has bought cannot be named because they haven’t yet been listed in the fund report, but all of them are currently under what Spencer believes to be cyclical pressure and their prices have responded negatively because of this. While two of the stocks are exposed to oil and gas, the other has exposure to emerging markets.
The two oil-facing stocks have dividend yields in excess of 4 per cent, and all three stocks offer the manager the opportunity to buy the holdings with a “significant” margin safety on the price he is paying.
“They’re all stocks that we believe will do well. We’ve stepped in to buy holdings in what has been a fairly volatile start to the year,” he said.
“We’re buying very well-capitalised businesses with very significant cash balances, and they’re businesses that we don’t think are structurally broken. That’s the point to make with all these three acquisitions. We feel that these cyclical pressures over time will revert to more normal trading conditions and they’re not broken in the sense that you’re buying businesses that are likely to be in terminal decline.”
“When one is taking a contrarian stance to buying a business that’s key to the investment decision – don’t get dragged into value traps.”
While Spencer is seeing opportunities overseas, he points out that he is still positive on areas on the UK market, particularly the housebuilding and pharma sectors.
In terms of the overall shape of the portfolio, 50 per cent of its profits still come directly from the UK. Out of the remaining 50 per cent, he says the US contributes approximately 18 per cent of this, followed by Europe at 17 per cent, and the remainder is stretched across Australasia, Asia Pacific and emerging markets.
“Some of the best opportunities are in areas where at the moment there’s the most pain,” the manager continued.
“There are some parts of the market that have been absolutely crushed during the past two years and if you look at anything exposed to oil and gas and mining or emerging markets, you see some share prices that are extraordinarily weak.”
“We think that the disparity between the stocks exposed to that area of the market in terms of rating and areas where there’s a high degree of certainty in earnings is really too wide.”
The manager warns that it is vital to adopt a long-term perspective when taking a look at these areas of the market, and says the team is certainly not expecting the underperforming areas to rebound immediately.
He adds that the businesses he is buying in these areas look financially robust and have simply been dragged down in price because of macroeconomic headwinds impacting investor sentiment.
“We feel comfortable that we’re investing in survivors that can last out difficult market conditions for quite a long while. We think that’s where the long-term value in the market is currently residing,” he says.
“There are certainly some areas where there’s very little earnings risk but people are taking on a lot of valuation risk for the security of that deliverance of earnings.”
“If you try to make money, sometimes you have to be a little bit early in investing into areas where there’s pain. I think that’s really what we’re trying to do by taking advantage of a lot of uncertainty and a lot of nervousness. Because of this uncertainty, share prices are presenting some interesting opportunities.”
Over one, three, five and 10 years, the £1.1bn Franklin UK Mid Cap fund has provided a top-decile total return. Its performance has been particularly strong over the last decade, as it has more than doubled the performance of its average peer in the IA UK All Companies sector and outperformed its FTSE 250 benchmark by 80.16 percentage points with a total return of 227.32 per cent.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
The fund has a clean ongoing charges figure of 0.82 per cent.
