Stronger dividend cover, lower levels of gearing and the potential for M&A are just some of the reasons why investors should be snapping up UK mid-caps rather than blue-chips, according to Mark Martin (pictured) and Holly Cassell. 
The FE Alpha Manager and assistant manager, who run the Neptune UK Opportunities fund as well as the four crown-rated Neptune UK Mid Cap fund, say that stretched valuations at the larger end of the cap spectrum is another reason why investors should be looking at mid and small-caps now to reap both valuation and company-specific benefits.
The duo’s UK Opps fund is benchmarked against the FTSE All Share index and currently has 55.8 per cent in FTSE 250 stocks, 27.9 per cent in UK small caps and just 13 per cent in FTSE 100 holdings, while its benchmark has an approximate 80 per cent weighting to blue-chips alone.
Neptune UK Opps is also positioned so its exposure to UK revenue is overweight versus its benchmark, which the team partially attributes to its mid-cap exposure.
“The second [reason] is that we have a real preference for the domestic non-cyclicals, so these are companies that have been caught in the sell-off because they have 100 per cent UK revenues but actually, their revenue streams are really underpinned by stable, non-discretionary drivers,” Cassell explained.
“A good example of a company here is Mears Group, the social housing and care provider, or Telecom Plus, which is a multi-utility company.”
The management duo’s significant mid-cap overweight is somewhat of a contrarian call given the performance of UK mid-caps year-to-date. Many investors sold out of the market area in the run-up to the EU referendum as they are more domestic-facing than stocks further up the cap spectrum.
Performance of indices in 2016
Source: FE Analytics
Given the subsequent weakness of sterling, the global-facing FTSE 100 index has produced its strongest returns so far this year while it has had the opposite effect on many small and mid-cap stocks.
However, Martin and Cassell aren’t the only managers to see opportunities in the unloved market area. In an article published earlier this month, FE Alpha Manager David Coombs told FE Trustnet that many areas of the UK mid-cap market have been oversold and now represent attractive buying opportunities in today’s post-Brexit environment.
“Because we held the overseas earners, we thought we’d add to our positions. Unfortunately, we couldn’t because they all stayed up so we didn’t have those bargains,” he explained.
“What we ended up buying was the Brexit stocks that got hit even harder. We thought we’d be buying the overseas earners and we ended up buying the domestic earners as they were so sold off. We weren’t massively aggressive with this though because clearly there is a lack of visibility.”
Martin, who also runs the four crown-rated Neptune UK Mid Cap fund, says that today’s investing environment lends itself to both funds outperforming, particularly given their track records during flat or falling markets.
Neptune UK Mid Cap, for instance, boasts the highest Sharpe ratio (which measures risk-adjusted returns) in its entire sector over five years. It has also managed to produce top-quartile returns on an annualised basis during six out of the seven years since it was launched to the end of 2015.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
“We’re really excited about performance going forwards,” Martin said. “We do really focus on the long term, but I just want to touch briefly on some short-term performance because we do think the outlook for companies and indeed funds has changed post-Brexit. This uncertainty that has been created won’t be going away any time soon.”
“The mid cap fund performed its peers and benchmark since Brexit. UK Opps has performed broadly in line with its peers post-Brexit.”
“We actually think there are some really exciting opportunities for alpha where some of the mid-cap companies that both funds hold, the babies have been thrown out with the bath water and some very good companies have been sold off in the rush for the exit in the mid-cap index by a lot of IA All Companies managers who have been surprised by their overweights in mid-cap.”
There are a number of reasons why Martin and Cassell believe that now is a particularly good time to be buying further down the cap spectrum.
When looking at the current forward price earnings ratios for the FTSE 100, FTSE 250 and FTSE Small Cap indices, the duo point out that the FTSE 100 looks very expensive relative to history dating back to 2005, while the FTSE 250 and FTSE Small Cap indices are relatively cheap versus their historical range.
12-month forward P/E vs historical range from 2005
Source: Neptune Investment Management
They add that it is a common misconception that mid-caps are higher risk than large-caps, given that the market area has comparatively lower gearing in aggregate while also offering a higher dividend cover on average.
“Given the fund flows we’ve seen towards income funds in recent times, that search for yield is really important and, if those FTSE 100 dividends start to look like they might be at risk, it means that income managers might have to start looking further down the cap spectrum, providing a degree of support for the FTSE 250,” Cassell explained.
Another factor that could bolster the performance of mid-caps as we head through the year, according to the Martin and Cassell, is the prospect for additional M&A in the market area.
According to Neptune’s data, the FTSE 100 has seen a historically high number of deals announced year-to-date, one of the most recent being Japanese company SoftBank’s acquisition of FTSE giant ARM Holdings earlier this month.
“The FTSE Small Cap index has also seen quite a bit of M&A activity. However, despite traditionally being the real major source of M&A activity, the FTSE 250 has lagged so far this year,” Cassell continued.
“Now the Brexit referendum has passed and we believe there is a degree more certainty in the market than there was in the run-up to the referendum, we expect deal activity to really pick up.”
The assistant manager points out that the weakening of sterling has also provided an additional tailwind for M&A, given that foreign companies will be able to purchase firms at more attractive valuations.
Further examples of overseas companies acquiring UK companies include South African firm Steinhoff’s purchase of Poundland and US firm AMC Theatre’s acquisition of Odeon Cinemas.
“There is a lot of potential for outperformance from M&A – although we never invest in companies purely because of M&A, I do think there is potential for significant M&A to come,” Martin added.
“Purely from an organic perspective, I think lots of companies we hold are set to benefit from the post-Brexit world in which we now live.”
Since its launched in December 2008, Neptune UK Mid Cap has outperformed its sector average and benchmark by 200.49 and 75.37 percentage points respectively with a total return of 332.48 per cent.
Neptune UK Opportunities, which has had Martin at the helm since February 2015, has underperformed its sector average and benchmark over the manager’s tenure.
