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Can FTSE 250 Stocks Beat Brexit Gloom?

Mid-caps have underperformed relative to their large and small-cap peers since the Brexit vote, but are they due a recovery?

Cherry Reynard 26 March, 2019 | 9:51AM

Theresa May Brexit

There was a time when UK funds focused on the mid-cap sector dominated the top of the league tables. Mid-caps were seen as the “sweet spot” for growth: small enough to grow, but big enough to avoid risk. However, since the Brexit vote, FTSE 250 companies have struggled versus their large and small-cap peers. Has the “sweet spot” permanently soured?

In retrospect, it is relatively easy to see why mid-caps have been weak. Mid-caps are more focused on the domestic UK economy. While the companies in the FTSE 100 generate three-quarters of their earnings internationally, mid-caps have only half coming from outside the UK. At the same time, the FTSE 250 has a far higher weight in economically sensitive areas such as consumer goods (14%) and consumer services (12%). This includes high street names such as Dixons Carphone (DC.), JD Sports (JD.) and a number of the housebuilders.

Equally, the slump in the pound has benefited many FTSE 100 companies that report in dollars. The lower exchange rate has flattered the earnings and dividends they pay to shareholders, even if there is little change in the fortunes of the underlying business. At the other end, smaller companies have been able to move under the radar in many cases, operating in niche areas relatively unaffected by the vulnerability of key parts of the UK economy. Mid-caps have been in the eye of the storm.

However, Georgina Brittain, senior portfolio manager for small and mid-cap funds at J.P. Morgan Asset Management points out that today mid-caps sit on historically low valuations relative to both large and small companies. While investors would normally be expected to pay a premium for the higher growth at lower risk available from mid-sized companies, today that premium is considerably lower than it has been in the past: “These are not numbers I’ve seen very often,” Brittain adds.

Dividend Growth Lags in 2018

On income, the picture is more mixed. Mid-caps have historically grown their dividends at a faster pace than large caps, but that wasn’t the case in 2018. The top 100 companies grew their dividends by an average of 4.6% over the year, compared with an increase of 6% from the mid-caps. However, mid-caps paid a lot of one-off special dividends. Strip these out and the top 100 payouts were 9.3% higher, while domestically sensitive mid-cap dividends were just 1.4% ahead. Mid-cap underlying growth lagged the FTSE 100 all year. However, it should be said that this weakness was confined to some key sectors within the mid-caps, notably telecoms, retail and support services.

Brittain is clear that there are plenty of attractive opportunities within the mid-caps, even among the unloved retail sector: “It is easy to be very negative on UK retail, but we own some retailers. It is possible to be in the right place at the right time and grow nicely.” Some retailers have been tainted by association and investors aren’t paying very much should the market turn.

She highlights a disconnect between consumer confidence, which is on its knees, and disposable income, which is at long-term highs. She believes there may be pent up demand should there be any resolution to the Brexit problems: “In the event of any kind of deal, we expect to see consumer confidence ticking up.” She also has holdings in the leisure sector, in areas such as pubs. They have had a perfect storm, she argues, and weathered it. Equally, there are plenty of mid-caps that are not economically sensitive and are generating strong growth. She gives the example of software provider Softcat (SCT).

Consider Micro-Caps

Gervais Williams, manager of the Diverse Income Trust (DIVI), says that investors should consider mid and small caps for diversification purposes as well as on performance grounds. He points out that UK large caps are focused on a handful of sectors, and this is true across the globe: “The issue of correlation is becoming more worrying. European large caps are focused on similar areas to UK large caps. Globalisation has had an impact and increased correlations across the globe.” A large cap-only approach misses certain sectors altogether – the FTSE 100 has just 1% in technology, for example. Williams points out that mid-caps are much broader in scope.

He believes micro-caps could also be a good choice should there be some resolution to the Brexit issue: “Micro-caps are quite a lot cheaper. They are quite overlooked and an area where investors don’t spend a lot of time. Coming after Brexit, the UK has been overlooked. Should that be resolved, there will be renewed interest, particularly because not much is happening in Europe and investors are anxious on Asia. UK may not look not as bad as people thought. They could buy an index, but international earnings dominate. Those that want to participate are likely to move to small or micro-caps.”

There can be no doubt, however, that the Brexit problem still looms over mid and small-cap stocks. Sterling continues to take the strain on the ebb and flow of Brexit. Should the process end in a hard Brexit or ‘no deal’ and sterling devalues, mid-caps are likely to underperform relative to large caps. This may be a short-term phenomenon, but it is difficult for investors to see beyond Brexit as it stands. Should the clouds clear, the sector may be in line for a re-rating.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Diverse Income Trust Ord90.80 GBX-0.66
JD Sports Fashion PLC799.00 GBX2.12
Softcat PLC1,101.00 GBX-0.27

About Author

Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.

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