Watching Rocky films is a guilty pleasure of mine. I’ve seen the first four loads of times (the ones after that are a bit rubbish). I can’t help getting sucked in by the idea of a small-time boxer from a working-class background who makes it on the big stage.
Poor old Rocky never had it easy. Apollo Creed, Clubber Lang and Ivan Drago all gave him a good beating – but Rocky always managed to outlast these challenges and flourish.
UK mid-caps have endured a similar story in recent years, having had to tackle a difficult domestic economy, rising rates and geopolitical challenges. This year has been far from straightforward for these companies amid fears of higher tariffs, inflation and slower growth.
We’ve also seen the new government’s first budget introduce additional costs, like higher National Insurance and an increased living wage.
But there are reasons to suggest this could be a good time for investors to strike. Right now the FTSE 250 index is carrying a forward dividend yield of 3.48%, higher than the FTSE 100 (3.24%), which is an extremely rare occurrence.
The index is also trading on a forward one-year price-to-earnings ratio (P/E) of just 11.7x – a significant discount to its long-term average of 14x; meanwhile forward earnings per share (EPS) growth is forecast at 8%.
Historically, the FTSE 250 has outperformed the FTSE 100 in periods of strong economic growth, reflecting its greater exposure to the domestic UK economy. Indeed, the FTSE 250 has comfortably outperformed the FTSE 100 over the past 20 years (175.5% vs. 71.3%).
What has held these domestically-focused stocks back – the explained versus the unexplained?
Allianz UK Listed Opportunities manager Richard Knight currently has 75% of his portfolio in the FTSE 250. He believes part of the challenge for mid-caps is not only that rates have been higher for longer, but also that the market has not been as resilient as he hoped.
For example, the UK consumer, which accounts for 60% of GDP, remains a key economic driver. UK households built up an envious £350bn in savings during Covid but Knight says, unlike the US, consumers on these shores have tended not to spend the money in their pockets.
Knight says there are positives for the UK economy, such as relatively good GDP growth and an underlevered private sector. He says the problems come back to UK government debt, which he feels can be managed.
Ultimately it comes back to sentiment for UK equities, with those further down the market capitalisation suffering the most. With pension funds putting between 2% and 4% into UK equities, the demand for these companies is likely to be led by overseas businesses. If things can’t get any worse and valuations remain at the bottom something has to give.
AXA Framlington UK Mid Cap manager Chris St John says well over 50% of UK mid-caps are also buying their shares back. This is accretive to growth and liquidity and an indicator of just how undervalued the market is. He says company management teams have gone through a cycle of despair and are now proactively acting in the best interests of shareholders.
This is manifesting itself in proactive behaviours aimed directly at increasing the return on invested capital by explicitly selling off or restructuring underperforming business units and reallocating into higher-returning areas.
For example, Currys has sold its Greek business, thereby de-risking its balance sheet and allowing management to invest with equity holders and not debt holders in mind.
He says: “UK equity markets are cheap and this is being exploited by both corporate and private equity houses as they take over an increasing number of UK-listed businesses. Not only do we expect this to continue, but we expect the takeover premia to remain elevated. Just Group, for example, recently received a bid from Brookfield at a circa 70% premium, while JTC is currently in the sights of more than one private equity acquirer.”
A positive future regardless of any visible catalyst
St John believes the market is now well-positioned to provide a total shareholder return of over 12% over the next 12 months, even if the index does not re-rate. Should we see stable or falling inflation and rates – in tandem with economic stability – he says returns of 40-50% are possible in the next two years alone.
Knight says there are plenty of examples of companies on valuations which simply make no sense. He cites plastic and fibre products provider Essentra as an example.
He says: “It used to be a conglomerate years ago before selling off parts of the business offering the likes of filters, paper and packaging. Volumes are down 20% from 2019 but the business has gained market share. PMIs [Purchasing Managers' Index] in Europe have just turned positive (above 50) but Essentra’s share price has still fallen (it is down 20% year-to-date).
“It is trading on 13-14x – most industrials are trading on high teens – but people are missing that profits can triple from where they are now based on slightly increasing their volumes and just hitting the margins they used to make in 2018-2019. No one realises it was a conglomerate – it is a company with a £300m market cap that could easily be £1bn in a few years.”
I’ve often noted that mid-caps (like middle child syndrome) can often be ignored in favour of their bigger and smaller peers – but there is no doubt there is incredible value in this market at the moment.
Other managers are taking note, with the likes of VT Tyndall Unconstrained UK Income, Schroder Income Growth and IFSL Marlborough Special Situations all having strong exposure to this segment of the market.
To me, UK mid-caps are like a stretched piece of elastic ready to snap – either performance jumps or private equity companies will swoop on the attractive valuations found across a breadth of industries.
Darius McDermott is managing director of FundCalibre and Chelsea Financial Services. The views expressed above should not be taken as investment advice.