UK mid-cap stocks had been given a mixed outlook heading into 2017, yet despite their lacklustre performance last year several industry professionals have highlighted some attractively-valued investment opportunities in the sector.
Funds that invest in FTSE 250 stocks have been immensely popular over the years, particularly among growth-focused investors with long-term time horizons.
Over the past decade, the FTSE 250 index has returned 116.05 per cent, compared to the FTSE 100 and FTSE Small Cap indices’ respective returns of 67.98 and 73.06 per cent.
Performance of indices over 10yrs
Source: FE Analytics
In 2016, however, the mid-cap index returned less than half that of the blue-chip and small-cap indices at 6.66 per cent. This has been mostly attributed to the ‘leave’ majority vote in June’s EU referendum and the subsequent slump in sterling. The result led many investors to shy away from domestic-facing stocks and move their money into larger firms with global revenues reaping the benefits of the downward currency movement.
In fact, 2016 was the first year in more than a decade that the FTSE 250 underperformed both the FTSE 100 and FTSE Small Cap indices as uncertainty surrounding Brexit negotiations mounted.
However, the fortunes of UK mid-caps appear to be reversing following a mass market rotation from growth into value stocks during the latter half of the year. During the past two months, the FTSE 250 has comfortably outperformed the FTSE 100 with a return of 17.91 per cent.
Is this the start of a fundamental change in market behaviour or should investors still be wary of buying into the market area?
Alex Moore, research analyst at Rathbones, says the UK economy held up reasonably well last year despite Brexit fears, meaning mid-caps could now look attractive to investors on valuation grounds.
“The companies tend to be under-researched, so can offer an interesting opportunity set with higher growth potential. However, much depends on an investor’s appetite for risk, as the sector can be volatile and usually requires a longer time horizon,” he said.
“Similar to their large-cap equivalents, funds in the mid-cap universe will have varying styles and philosophies without one necessarily being better than the other.
“Given that mid- and small-caps are generally under-researched compared to large-caps, we prefer managers like [Neptune manager] Mark Martin who have a track record of successfully investing through various market environments and can demonstrate good stock selection.”
FE Alpha Manager Martin’s four crown-rated Neptune UK Mid Cap fund has made it comfortably onto the list of top 20 performers in the IA UK All Companies sector over three years and is one of the top 10 performers over five. Since launch, it has more than doubled its average peer with a total return of 351.98 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
The fund has sat in the top or second quartile every year over this time frame apart from in 2016, when it fell into the bottom quartile.
Adrian Lowcock, investment director at Architas, said: “This fund tends to take quite punchy positions in stocks. When making their decisions the focus is very much on incorporating the macro economic outlook.
“Performance can be quite lumpy and poor stock selection can have a significant impact on returns.”
Broadly speaking, Lowcock says the outlook for UK mid-caps is very mixed as we head into 2017.
“At the moment with sentiment positive and markets focusing on the pros of a Trump presidency, mid-caps are rising. The rebounding oil price and commodity prices are helping basic material stocks, particularly in energy,” he explained.
“But Brexit is looming on the horizon and whilst consumer confidence held up well and the UK economy continued to grow in the last six months of the year, we could easily see an impact on this as Brexit becomes a reality.”
The investment director says the return of inflation will have a mixed effect on mid-caps. For instance, he is wary on sectors such as retail which could struggle as prices rise.
Instead, he believes cyclical mid-caps such as recruiters, infrastructure and challenger banks could be better options given the current backdrop.
“Within the industrial space the focus needs to be on quality in value and a preference for international earnings,” he added.
A mid-cap fund that Lowcock particularly likes is Old Mutual UK Mid Cap, which has been managed by FE Alpha Manager Richard Watts since the end of 2008.
Over this time frame, the fund has returned 730.31 per cent compared to its FTSE 250 (ex IT) benchmark and sector average’s respective returns of 418.79 and 163.75 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
The £2.2bn fund aims to provide long-term growth through a concentrated portfolio of 43 holdings, which currently includes the likes of Paysafe Group, online clothing retailer Boohoo.com and Just Eat.
As with Neptune UK Mid Cap though, the fund found itself in the bottom quartile in 2016 despite performing well during most other years since its launch (it must be noted that the fund struggled during the bear markets of 2008 and 2011 when it fell into the third and fourth quartile respectively).
“Richard Watts is a dynamic mid-cap manager and has the skills for this space,” Lowcock said. “He is good at recognising value stocks and doesn’t mind holding growth companies, when others might consider them too expensive. He will pay for good quality growth.”
Mike Deverell, partner and investment manager at Equilibrium, says it pays to be cautious when it comes to mid-caps this year, given their dependency on the UK economy and the uncertainty over Brexit.
That said, he points out that much of the referendum has already been priced into UK mid-caps, given their underperformance relative to UK large-caps over the last year or so.
“In general terms, medium and smaller companies tend to see greater earnings growth than large companies and so I would still suggest having some exposure this to area,” Deverell said.
“We don’t tend to invest in specialist mid-cap funds, but prefer true multi-cap funds which can invest in small, medium and large as they see fit.
“We also invest in some specialise small-cap funds, like the Marlborough Special Situations fund, which can also go up into the mid-cap space. In general, we prefer small caps to mid-caps as although they are more UK exposed they are typically cheaper and growing quicker.”