Medium sized companies, also referred to as mid-caps have delivered cracking returns in the last five years, outperforming large companies in the UK by a wide margin. Mid-caps you are no doubt aware are typically represented by the FTSE 250 index. In 2013 commentators suggested valuations of medium sized companies were high after the strong rally and I have avoided recommending mid-cap funds preferring smaller companies. (As an aside I remain positive on the latter with the UK economy recovering well. Smaller companies historically outperform larger companies during the recovery and growth phases but underperform during recessions. Further the lack of research and analyst coverage means good stock-picking fund managers can unearth mispriced gems). However I have recently had a rethink on medium sized companies following comments and information from fund managers, F&C and Neptune Investment Management and I can now see a place for mid-cap funds in portfolios. There are several key arguments that I find compelling:
Fundamentals Are Good
Michael Ulrich, manager of the F&C UK Mid-Cap fund argues evidence in the last 20 years shows mid-caps have grown faster than larger companies, they are more nimble and adaptable and their size does not limit growth. However they are large enough to be dominant in niche markets with a competitive edge difficult to challenge. The new thought for me was that successful companies in the FTSE 250 index eventually get promoted to the FTSE 100 in advance of them getting too big to sustain good growth rates or become too expensive. At the same time the index is refreshed by exciting smaller companies getting promoted from the small cap index.
Mid-Caps Complement Larger Stocks
Another reason to consider medium sized companies is that FTSE 250 companies tend to be more focused on the domestic or consumer economy whilst FTSE 100 companies are global companies with strong overseas earnings. This means the sector weightings in the two indices are different. For example oil majors, miners, banks, telecoms and pharmaceuticals tend to dominate the FTSE 100 index whilst house-builders, industrials and financial services companies are more likely to be found in the FTSE 250. As a result stocks in the two indices are complementary and for many investors the addition of a mid-cap fund will add diversity to a portfolio those UK equity funds are dominated by FTSE 100 companies or indeed a few mega-caps such as Royal Dutch Shell, Vodafone, GlaxoSmithKline and HSBC.
Mergers & Acquisitions
Neptune Investment Management who also run a mid-cap fund argue that mergers and acquisition activity that has been muted in recent years is set to increase and mid-caps could be attractive targets with their strong earnings growth.
Valuations Are Misunderstood
We noted returns on the FTSE 250 have far outstripped those of the FTSE 100 in the last five years, raising concerns about mid-cap valuations. However F&C argue the observation that mid-caps are expensive compared to FTSE 100 companies hides an important point. The relatively poor performance of the FTSE 100 is due to a few mega-cap stocks that dominate it. The top 20 stocks of the FTSE 100 comprise about 60% of the benchmark by weight. If you compare the FTSE 250 to the FTSE 100 excluding the top 20 stocks, you find that mid-caps do not look expensive. Mega-caps struggle to grow because of their sheer size – they struggle under a weight of bureaucracy and in the case of the oil majors and pharmaceuticals they are running fast just to maintain their current level of profitability.
In conclusion I see some good reasons to expect the rally in mid-caps to continue.
This blog is intended as a general market commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.