The mid-cap area of the UK market has been the darling among investors for a while, with the FTSE 250 significantly outperforming the FTSE 100 and FTSE Small Cap indices over one, three, five and 10 years.
Performance of indices over 10yrs
Source: FE Analytics
In an article published yesterday, FE Trustnet found that a composite of the 11 UK mid-caps funds that are benchmarked against the FTSE 250 more than doubled the performance of the IA UK All Companies sector average over three and five years, with the likes of Franklin UK Mid Cap, 
Neptune UK Mid Cap and Old Mutual UK Dynamic Equity delivering stellar long-term performances.
What FE Trustnet noticed though when speaking to our panel of investment professionals is that many of them are bearish or cautious on the UK mid-cap space generally at the moment. This is understandable, given that buying into an area of the market which has already delivered significant gains could present a greater risk of losing capital.
FE Alpha Manager Paul Spencer (pictured), who runs Franklin UK Mid Cap, even said earlier this week that he is tilting his portfolio away from the UK towards overseas markets as a result of stretched UK mid-cap valuations.
“The UK consumer appears to have a rising level of discretionary spending at the moment, but that’s reflected in share prices,” he told FE Trustnet earlier this week.
“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.”
Martin Bamford, managing director at Informed Choice and chartered financial planner, told FE Trustnet yesterday that he agreed with Spencer, and warned that the mid-cap market looks fully-valued after holding up well during recent bouts of volatility.
Performance of indices over 1yr
Source: FE Analytics
“We would not actively seek to allocate client money to UK mid-caps, although we still believe some allocation via mainstream UK equity funds remains important for long-term investors,” he said.
Some investors, on the other hand, would argue that the FTSE 250 will continue to perform well as it is largely domestic-facing and is therefore benefitting from an improving UK economic backdrop.
However, Alex Crooke, manager of the £801m Bankers Investment Trust, is currently reducing his exposure to UK domestic-facing companies and is instead finding better value opportunities in European and Japanese equities.
“The UK economy is behaving well but there are some challenges – you have the minimum wage rising and that is going to be more challenging for corporate profits. I think that will be difficult for margins - sector by sector you can certainly see some challenges in some areas,” he pointed out.
“We sold out of Wetherspoons a week or two ago because of this. Also, the UK is trading very well as an economy. Can it get any better? Over the short term, I’m not sure.”
He says that expectations for Europe and Japan’s economies are comparatively low, and argues that earnings revisions on GDP numbers have been picking up in Europe.
“It’s not for every company of course – you’ve got to work out which ones are exporters and domestic so you still need to stock-pick, but economic activity is picking up and European earnings levels are still very depressed – that’s my point. If you’re buying at these depressed earnings levels that are as low as 12/13x, I would rather have that and the potential that these stocks could recover because you’ve got activity picking up.”
In contrast, Thomas Moore, who runs the five crown-rated SLI UK Equity Income Unconstrained fund, currently has a heavy weighting towards the FTSE 250 of almost 50 per cent, which is more than double that of the FTSE All Share.
He says that while P/E ratios and valuations are high across the UK market, there are still plenty of attractive opportunities available so long as a selective approach is taken.
In fact, he believes that the mid-cap space is far safer than cheaply-valued large-caps for income investors in particular, as a result of unsafe balance sheets and low levels of dividend cover among many blue-chips.
Dividend cover of indices over 20yrs
Source: Standard Life Investments
“This is a signal of potential dividend cuts in the FTSE 100. You can see the light blue line [in the above graph] is pointing almost vertically south at the moment, and that shows the market is seeing this rather intense downgrade in earnings leading to a reduction in dividend cover,” he explained.
“In other words, companies are attempting to maintain and preserve their dividends at the moment. However the tide is going out and unfortunately that is leaving some companies rather exposed.”
“As more and more companies find that their dividend cover [ratio of earnings per share and dividends per share] is heading towards 1x and some are even heading through 1x like BP, Shell, GlaxoSmithKline and many others, these companies are going to be asked all sorts of tough questions in the boardroom and by their shareholders about how sustainable these dividends really are, and that’s already having a big impact on share prices.”
The counter argument against buying into domestic-facing mid-caps rather than global-facing blue-chips though is the impending Brexit referendum, which is likely to spark market volatility.
Dan Boardman-Weston, portfolio manager at BRI Wealth Management, doesn’t have any fund exposure at all in the mid-cap area of the UK market for this reason, as well as the limited number of value plays in the FTSE 250 index.
“We feel that for many (not all) companies, valuations and earnings expectations are too high. With the volatile markets that we are experiencing, we’d prefer to have a margin of safety when it comes to valuations and earnings,” he said.
“To generalise, the mid-cap market is more insulated to global economic worries as a lot of the companies are domestically biased. Though this in itself could potentially create a problem with the forthcoming EU referendum.”
