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Investment Trusts

Has Brexit created an opportunity in mid-cap shares?

The Schroder UK Mid Cap plc trust’s investment objective is to invest in mid-cap equities to provide a total return in excess of the FTSE 250 (ex investment companies) index .

23/03/2017

Long-term approach for long-term success

The Schroder UK Mid Cap plc trust’s investment objective is to invest in mid-cap equities to provide a total return in excess of the FTSE 250 (ex investment companies) index1

Lead manager Andy Brough and co-manager Jean Roche have a bottom-up investment strategy, meaning they start by looking closely at the companies they invest in. Brough, who has over 28 years’ investment experience and Roche, more than 16 years’ investment experience, do not focus exclusively on factors such as growth and value potential, but on each company’s individual ability to create value for shareholders. As long-term investors, they will typically hold investments for three to five years. In other words, they are stock pickers.

The Schroder UK Mid Cap Fund plc has delivered strong long-term outperformance since Schroders took responsibility for the management of the trust2 in 2003. Over this period, it ranks first of eleven trusts in the Association of Investment Companies (AIC) UK All Companies sector3.

Performance (%)Schroder UK Mid Cap Fund plc

Q4 2015 - Q4 2016

Q4 2014 - Q4 2015

Q4 2013 - Q4 2014

Q4 2012 - Q4 2013

Q4 2011 - Q4 2012

Net asset value (NAV) total return

2.5

14.4

-2.9

46.9

31.6

Share price total return

-8.2

14.0

-10.5

73.4

36.2

Benchmark total return*

5.1

12.0

2.8

34.9

28.7

Source: Schroders, bid to bid price with net income reinvested, net of the ongoing charges and portfolio costs and, where applicable, performance fees, in GBP, as at 31 December 2016. *In April 2011, the FTSE 250 ex Investment Trusts replaced the FTSE All-Share ex ITs ex FTSE 100 TR. The full track record of the previous index has been kept and chainlinked to the new one +FTSE 250 (ex Investment Trusts) total return.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. 

In 2016, revenue return per share increased by 25.5% in 2016, underpinning a 22.3% increase in the total dividend, to 11.25p – and, since 2007, the dividend has almost tripled from 4.11p4, covered 1.1x by the revenue return per share of 12.33p. The dividend coverage is important as it is used to show how sustainable a dividend is.

So why, then, is the Schroder UK Mid Cap Fund plc share trading on a 18.0% discount to, that is below, its net asset value (NAV), given its long term outperformance and attractive, well-covered dividend?

Buy FTSE 100, Sell FTSE 250 – said everyone

The answer lies partly in the fact that investment in the FTSE 250 is currently out of favour, mainly because of the Brexit vote. The FTSE 250 index lagged large caps in 2016, generating a total return of 8.6%, versus 18.4% from the FTSE 100. Many of the internationally diversified larger companies performed very well as the market reflected the expected beneficial impact of sterling weakness to their overseas earnings following the UK’s decision to exit the EU. However, FTSE 100 dividends grew by 4% on aggregate, distributing 70% of their earnings, while FTSE 250 dividends grew 15%, distributing just 48%!

The FTSE 250 is global too

While it is well understood by most market participants that the FTSE 100 has numerous multi-national resources, healthcare and consumer goods companies, it is less well understood that the mid-cap index also has plenty of overseas exposure, notably in its significant industrials sector (which includes Support Services - see ‘Comparison of FTSE 250 (ex investment companies) index sector distribution with the FTSE 100 at 31 December 2016’, below).

Comparison of FTSE 250 (ex investment companies) Index sector distribution with the FTSE 100 at 31 December 20161

%

1Source: Schroders/Factset

In line with cyclical sectors (where price and demand are closely linked to the state of the economy) more generally, industrials have performed particularly well since late 2016 as the global economic outlook has improved and policymakers placed greater emphasis on fiscal stimulus measures. With approximately 50% of its earnings derived abroad, across all sectors, the FTSE 250 could offer plenty of opportunity to gain overseas exposure. Schroder UK Mid Cap Fund plc in turn, is about 50% exposed to non sterling denominated revenues.

Confidence at home

The team also sees plenty of opportunities amongst the many domestically focused mid caps. Many of these underperformed in the run up to and following the UK’s decision to leave the EU, amid fears about the UK economic outlook, but a number of macro-economic data points have since emerged to suggest markets over-reacted to the “leave” decision. The Bank of England (BoE) upgraded its 2017 UK GDP growth forecast from 0.8% to 1.4% in November 2016, and then to 2.0% this February, reversing the greater part of its post-referendum cut which it made in August. Business confidence is back at levels last seen in 2015, and retail sales continue to show annual growth, albeit the rate is gently slowing. The most recent GfK Consumer Confidence data (January 2017) showed an improvement.

Whether the BoE should take credit for the effects of the decision not having as much impact as originally suspected is a moot point, but the fact that both the FTSE 100 and FTSE 250 are trading above pre-referendum levels – and, have indeed gone on to achieve new all-time highs – suggests the market is now more willing to believe UK economic activity will be only marginally negatively affected by the Brexit process.

Imported inflation could be offset

The team remains alert to the risk that imported inflation (inflation resulting from a rise in the price of imports) may begin to erode the UK consumer’s earnings power, and much of the focus has been on food price inflation and rising prices at the pumps. However, flat mortgage interest costs could be important offsetting factors. Meanwhile, it should be remembered that categories such as clothing and footwear continue to experience deflationary pressures. 

The managers are not complacent about the risks, however, and therefore their style of seeking out companies with strong pricing power, meaning the demand for their products isn’t highly sensitive to its price, is key to outperforming in a rising inflationary environment.

Easy as ABC?

The managers use an “ABC” triangle strategy when selecting stocks for the portfolio.

Pricing power, as mentioned above, is one of the key considerations when categorising companies as either ‘A’, ‘B’ or ‘C’ stocks (see below). ‘A’ companies have a strong business franchise and/or scarcity value, which means they can charge more due to their products being in short supply. They often operate in sectors offering structural growth, are run by high-quality management teams with proven track records and enjoy strong balance sheets. Often, company management themselves have significant ownership of the shares – they might be founders for example (e.g. Supergroup, owner of British clothing and accessories brand Superdry).

The sectors ‘A’ companies operate in are typically concentrated so that the demand for the shares in the constituent companies exceeds the supply of stock, which appreciates in value as investors ascribe a higher rating to the company and its prospects.

The team seeks to concentrate investments in “A” companies.

 

 ‘B’ companies are either undergoing a change of management strategy, benefiting from withdrawal of industry over-capacity, or are likely to see a re-rating or an increase in demand simply because of where we are in the economic cycle.  The balance of supply and demand for these shares shifts over time as companies reduce capacity and shrink the amount of equity on the market by buying back shares. The managers seek to trade shares in “B” companies.

‘C’ companies suffer from industry overcapacity, are in long-term decline, or are failing to provide successful growth opportunities for investors. They might have uncomfortably frequent exceptional charges in their accounts. The supply of shares in these companies will typically exceed demand, leading to downward pressure on share prices. The managers seek to avoid ‘C’ companies. 

Companies may, of course, move between classifications at various stages in their lifecycles and under different management teams. The managers keep in close contact with company management precisely to stay on top of this classification.

A surprisingly strong dividend story

The majority of the fund’s most overweight holdings have seen both profits and dividend upgrades over the course of the past year. At the trust level, revenue return per share increased by 25.5% in 2016, underpinning a 22.3% increase in the total dividend, to 11.25p – and, since 2007, the dividend has almost tripled from 4.11p5. Of course, past performance is not a guide to future performance and may not be repeated.

The managers continue to expect that their portfolio holdings could generate superior long-term returns as they deliver a rising stream of earnings to underpin progressive dividend policies. They believe that the FTSE 250 has more scope to increase shareholder distributions by virtue of its higher dividend cover6 of 1.9 versus just 1.5 timesfor the FTSE 100. The holdings of Schroder UK Mid Cap Fund plc have an impressive median dividend cover of around 2.2x in the financial year to come.

As mentioned above, there was a significant widening of the share price discount to its net asset value in 2016. This was in line with other investment trusts perceived to be UK centric against the backdrop of the referendum result. The trust currently trades at a discount of 18.0%8, despite its significant exposure to overseas earnings, and to high quality UK domestic plays. Investors wishing to increase their exposure to the UK mid cap space may wish to take a closer look at Schroder UK Mid Cap Fund plc.

What are the risks?

  • Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and investors might not get back the amount originally invested.
  • The trust Invests in smaller companies that may be less liquid than larger companies and price swings may therefore be greater than investment trusts that invest in larger companies.
  • The trust will invest solely in the companies of one country or region. This can carry more risk than investments spread over a number of countries or regions.
  • As a result of the fees and finance costs being charged partially to capital, the distributable income of the trust may be higher but there is the potential that performance or capital value may be eroded.
  • The trust may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

Important Information

The views and opinions contained herein are those of Andy Brough and Jean Roche, UK Fund Managers. They may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds and are subject to change. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. For investment advice, speak to your Financial Adviser. If you don't already have an Adviser, you can find one at www.unbiased.co.uk or www.vouchedfor.co.uk.The most up to date Key Features Documents, available at www.schroders.co.uk/investor or on request.Issued in March 2017 by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority. UK11682



1The trust changed its investment objective and name to Schroder UK Mid Cap Fund plc with effect from 26/01/2011. It was previously called Schroder UK Mid & Small Cap Fund plc. In April 2011 the FTSE 250 x Investment Trusts replaced the FTSE All-Share ex ITs ex FTSE 100 TR as the trust’s benchmark.

2 Schroders took responsibility for the management of the trust in May 2003.

3Source: Ranking in Association of Investment Companies (AIC) UK All Companies sector, sourced from Morningstar from 2 May 2003 to 31 December 2016.

4Source: Schroder UK Mid Cap Fund plc, Annual Report and Accounts for the year ended 30 September 2016.

5Source: Schroder UK Mid Cap Fund plc, Annual Report and Accounts for the year ended 30 September 2016.

6The number of times a company’s most recent dividend can be paid out of its annual earnings.

7Source: Thomson Reuters Datastream, 23/12/2016.

8Source: Schroders as at , 21/03/2017.

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Important information: The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Exchange rate changes may cause the value of any overseas investments to rise or fall. Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.