Investors should focus on cash-generative companies with strong balance sheets instead of getting drawn into the riskier, “hot” part of the market, according to BMO Global Asset Management’s Tom Wilson.
Wilson, who manages the F&C UK Mid Cap fund, said extreme valuations of large cap companies seen more recently could be tempting to some investors keen to jump on the bandwagon.
However, he said they may be better served by avoiding the large-cap space where valuations look less sustainable in favour of companies lower down the market capitalisation scale with strong balance sheets and solid revenues.
The fund manager claimed there is a tendency by investors to generalise and see mid-caps as very domestic and cyclical. And that the general belief that the FTSE 250 is made up of just retailers, construction companies and restaurant groups shows a lack of understanding of the mid-cap space.
FTSE 250 sector weightings vs FTSE 100
Source: FTSE Russell
Wilson said: “The current environment is tempting some investors into riskier corners of the market, where they perceive there to be better returns.
“In general, I feel that risks are being under-appreciated by market participants, whether it be high levels of debt globally or excessive valuations.
“In addition to the visible risks, it is the unforeseen risks that have the potential to cause permanent capital loss.”
With capital preservation his chief aim, Wilson said he looks for companies with strong balance sheets and the ability to generate cash that are able to “weather any storm”.
As such, Wilson avoids the “hot parts of the market” that look overvalued, preferring long-duration assets that may be out-of-favour and priced at a discount to their inherent value.
“We try to participate in rising markets, outperform a bit and then really preserve capital on down markets,” he explained.
The fund manager tries to stay away of tech or industrials stocks and looks out for the unloved stocks, such as recent addition property company John Laing Group.
While the firm has provided strong returns it is not considered by the manager a particularly “hot” stock.
“John Laing Group is quite unloved, it’s not going to be the next Amazon,” he said. “But most of the times, the most successful businesses are the most boring ones, those that can weather the storm during the bad times and continue doing well during the good times.”
Other defensive, non-cyclical stocks in the mid-cap space include Pennon Group and National Express, said Wilson.
Performance of stocks over 1yr
Source: FE Analytics
“Pennon Group is a British water utility and waste management company that doesn’t have that traditional cyclical profile but a more defensive one, you won’t get surprises,” he explained.
“National Express can do well in down markets when people find train prices expensive so will benefit from smaller peers losing shares in down markets.
“They have many businesses to it and offer services such as school transportation. Kids will continue going to school during an economic downturn.”
Wilson said mid-cap stocks have greater scope for growth as they are less bureaucratic and the decision-making progress is, therefore, more flexible and ensures decisions are actually made.
“If you were Vodafone and you wanted to make decisions you have to go all the way through the company and then all the way down,” he said. “At some point it gets lost and the decision never gets made.”
Furthermore, Wilson said mid caps tend to have an aligned management, a fact that facilitates the decision-making process.
“They tend to have the best management teams, teams with high levels of equity ownership that usually make decisions for the long run,” he added.
The fund manager said companies in the mid-cap space are nimbler and more adaptable, particularly in the face of technological disruption.
Additionally, some mid caps’ high level of specialisation mean that they often dominate the markets they operate in, unlike broader large cap companies, which face greater competition.
Most importantly, however, mid-cap stocks also have greater alpha potential than large caps and is not as well covered by analysts.
He said: “The FTSE 250 is a constantly refreshing index that is continuously getting new ideas coming through as well as new companies.”
Wilson was appointed sole manager of F&C UK Mid-Cap in 2015, and manages the fund alongside head of European equities David Moss. The manager takes a stockpicking approach and aims to provide long-term capital growth and preserve capital in down markets.
The three FE Crown-rated, high-conviction fund holds 25 stocks in the portfolio. The fund’s largest sector weighting is to the financials and industrials sectors, representing 24.2 and 21.5 per cent of the portfolio respectively.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
The fund is a top quartile performer in the IA UK All Companies sector over one three and five years.
Over three years the fund has delivered a 32.33 per cent total return, compared with a 24.48 per cent gain for the FTSE 250 (ex Investment Trusts) benchmark and a 21.48 per cent return for the average sector fund.
The fund has an ongoing charges figure (OCF) of 0.81 per cent.