Mid caps – structural advantage, or a lucky streak?
UK mid-cap equities have outperformed their more illustrious larger peers over a long period, Schroder UK Mid Cap Fund Manager Rosemary Baynard looks at whether that outperformance can continue and if so what will be the fundamental drivers.
The UK mid cap sector has been a fertile hunting ground for investors in recent years. Not only have companies exhibited strong growth, the sector has been consistently refreshed by a wave of IPOs, which has allowed investors to participate in some of the UK’s newest and most dynamic companies. Merger and acquisition activity has also been supportive of valuations. But does this argue for a longer-term overweight position in the sector? And should investors be deterred by current valuations?
Outperformance is not a short-term phenomenon: UK mid caps have outperformed large and small caps over the past three decades - the FTSE 250 index has returned 515% from July 1987 to date, compared to 141% from the FTSE 100 and 103% from the FTSE Small Cap index (see table). Over this period there have been five bull markets and in all but one the FTSE 250 outperformed the FTSE 100, including the most recent upward phase since 2009, during which time mid caps have returned 192% versus 68% from large caps.
Source: Thomson Reuters Datastream. Based on capital returns only. Data to close of 24 August 2015.
The challenge is to determine whether this outperformance is structural or cyclical. For example, it might be unfair to point out that mid-caps have outperformed during the recent stock market rout as the FTSE 100 has been weighed down by its mining and commodities exposure, as these are cyclical problems. Equally, it might be unfair to judge the relative performance of the two indices at times when the FTSE 100 was dragged lower by the poor performance of the banking sector but as mid-cap investors, we believe that the outperformance of this part of the market is more than simply a cyclical phenomenon.
Mid-cap advocates often talk of them being in the ‘sweet spot’ for growth. Certainly it is predominantly, although not universally, true that small and mid-cap companies tend to be in the growth phase of their development. Many larger companies will already have passed that phase, and be experiencing greater competition and/or pricing pressure. There is also the straightforward maths that a larger company needs to sell millions more products than a smaller company to move the dial meaningfully on its revenues.
Mid caps will often occupy higher margin market niches. Competition has not yet stolen a march on their products and services. They can readily tap new markets. They may still retain many of the qualities that serve smaller companies so well such as management with a substantial stake who are engaged and invested in the business, but are more established and do not carry the same risks. They may have better access to capital, for example, and may offer more secure dividends.
This is not simply theory. Mid-cap companies have grown their earnings faster than other parts of the market over the long term. According to the Morningstar Historic Earnings Growth metric (which is calculated by averaging the previous four year’s growth rate for each stock in the index) mid-caps show superior earnings growth in the UK, US and Europe. The metric shows that the long term earnings growth of FTSE 100 stocks is -6.5%, while the FTSE 250 has exhibited 4.7% growth over the same period. More recently, this has been conspicuous in trading uprates and dividend rises for mid-cap companies.
However, all these are qualities common to the mid-cap sector in aggregate, but there are also a number of qualities that make mid-caps a more attractive hunting ground for active managers. They tend to be less well researched especially the many unique companies with no quoted peer group comparators. This means that there tends to be greater mispricing in mid-caps and companies may deviate significantly from fair value. This creates opportunities for active managers, such as ourselves. The Schroder UK Mid-Cap fund plc aims to bring these opportunities together in a single portfolio.
Pricing power is a particularly important part of the process on the fund. We believe this is a significant long-term driver of profits growth and therefore share price returns. We find this pricing power appears to be more prevalent in the mid cap sector, where more domestic names may enjoy local monopolies or local network effects and avoid the full force of international competition. Equally, M&A has been consistently supportive. The mid-cap universe is a very attractive hunting ground for larger companies looking for growth, especially international players looking for a foothold in Europe. This year has seen bids for mid caps from Europe, the U.S. and Japan. Mid-cap companies are well-established, have been through the start-up phase and entered the growth phase, which makes them less risky for larger companies to acquire. This is an important driver of returns in the sector and has contributed meaningfully to the long-term performance of the Schroder UK Mid-Cap Fund plc.
Of course, the sector still has its pitfalls. The recent National Living Wage proposal will be a cost pressure for some. Equally, the sector can be vulnerable to bouts of ‘irrational exuberance’ as exciting, but possibly over-valued, companies come to market. This was especially true during the tech boom of 1999-2000.
There is a long-term opportunity in mid-caps and an active approach, such as that used on the Schroder UK Mid-Cap fund plc. can maximise that opportunity. A relative lack of attention from larger investors creates opportunities for mid-cap specialists to add value through stock selection.
The Schroder UK Mid Cap Fund Plc targets investment opportunities in medium-sized UK companies with the aim of providing a total return in excess of the FTSE 250 (ex-Investment Companies) Index. It has delivered a strong long-term performance record since Schroders took over management in 2003. Lead manager Rosemary Banyard, a long-standing and highly-experienced member of the Schroders' UK equity team, prioritises pricing power, believing that it is a significant driver of long-term share price growth over time. The fund uses a stock picking strategy with no pre-determined style bias and focuses on each company’s individual ability to create value for shareholders. The approach is applicable in all investment environments and can generate attractive returns in varied market conditions.
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