Despite the recent underperformance of UK large-caps, investors should be wary of returning to this area of the market in the search for bargains as there is still room for domestically focused small and mid-caps to run further, according to Neptune’s Mark Martin and Franklin Templeton’s Paul Spencer.
UK small and mid-caps have enjoyed a strong rally over recent years with the FTSE Small Cap rising 70.44 per cent over the past five years and the FTSE 250 posting an 81.03 per cent total return. The FTSE 100 has gained just 35.04 per cent over this time.
Performance of indices over 5yrs
Source: FE Analytics
Of course, the long-term outperformance of small and mid-caps is nothing new given the strong growth potential, but corresponding higher risk, found in those parts of the market.
However, they have proven to be particularly resilient during recent months as investor sentiment has been buffeted by Chinese economic growth fears, low commodity prices and uncertainty over the timing of interest rate rises.
Over the past six months the FTSE 100 has fallen 6.18 per cent, driven by drops in mining companies and those reliant on emerging markets for their fortunes. The FTSE 250, on the other hand, has lost just 0.55 per cent while the FTSE Small Cap has eked out a 0.63 per cent gain.
In a recent investor update, Whitechurch Securities noted that some UK equity managers have been tempted back into bombed-out areas of the market: “From a contrarian perspective, we are beginning to see bargain hunting fund managers dip their toes into energy and mining stocks, based on hefty yields and management commitment to severe cost cutting to help restore profitability in a more difficult climate.”
Our data shows that 100 funds from the IA UK All Companies sector have more than the FTSE All Share’s 4.88 per cent in the basic materials sector while 51 are overweight oil & gas companies. Some 37 funds are overweight both of these sectors, relative to the FTSE All Share.
Those returning to these two sectors – which are dominated by large-cap companies – have reaped the rewards over the past month, which is a very short time frame on which to judge an equity investment. While the FTSE All Share has rallied 7.58 per cent, the basic materials sector is up 11.21 per cent and the oil & gas sector has surged 13.09 per cent.
Performance of indices over 1 month
Source: FE Analytics
Not all are convinced, however. FE Alpha Manager Mark Martin, manager of the £725.4m Neptune UK Mid Cap and £40.7m Neptune UK Opportunities funds, says investors should take a cautious approach when considering large-caps given how much of the index is made up of companies that are far from being out of the woods.
“While there are a number of optically cheap companies at the higher end of the market, the FTSE 100 has far greater dependence on emerging markets and higher oil prices, both of which I’m currently wary of having too much exposure to.”
Within his Neptune UK Opportunities fund, which takes a multi-cap approach to investing, the manager is overweight the smaller end of the UK market – especially small-caps, which he sees are offering investors “the best value overall”.
12-month forward P/E of FTSE All Share
Source: Neptune, DataStream and Liberum Capital
Martin remains positive on the outlook for the UK economy, despite the recent publication of disappointing growth numbers, but points that other investors share his optimism and that this is reflected in valuations of big parts of the market.
“There is a lot to be optimistic about the UK at the moment. We’ve had a sustained return to real wage growth in recent months, GDP is at pre crisis levels and both consumers and corporates are exhibiting increased confidence in the recovery,” he said.
“These bull points are largely reflected in broad market valuations, however, with 12-month forward P/E ratios above historical averages. The best value in the broad market, therefore, is to be found at a company specific level.”
“The possible exception to this is the FTSE Small Cap index – particularly the lower end, with many companies trading at a marked discount to the rest of the market. The multi-cap focus of this fund allows me to take advantage of these opportunities, which are even less researched than mid-caps.”
Franklin Templeton’s Spencer agrees that areas outside of the FTSE 100 still look attractive in spite of their strong run over recent years. He particularly favours UK mid-caps.
“The range of industries and exposures offered by mid-cap companies persuades us that this remains an attractive place to hunt out bargains, particularly at the moment,” he said.
“And there are a number of wider financial and economic factors at play that reinforce our convictions. For example, with many balance sheets that appear to be in robust shape and private equity apparently awash with cash, we believe the mid-cap space is ripe for an acceleration in merger and acquisition [M&A] activity, which seems to have stalled in recent years.”
M&A as percentage of index market cap
Source: Franklin Templeton and Liberum Capital
Spencer – who is lead manager of the Franklin UK Mid Cap fund and co-manages Franklin UK Managers' Focus and Franklin UK Smaller Companies – also argues that investors should avoid thinking in terms of “large-caps versus mid-caps’ and consider them as complementary to each other within a portfolio.
“Mid-cap investing, for example, offers an alternative to the occasional concentrations of exposure that can come with large-cap investments. So while banking, oil and gas, pharmaceuticals, tobacco, life insurance and mining together account for 53 per cent of the large-cap-focused FTSE 100 index, they comprise just 6 per cent of the FTSE 250 index,” he said.
“On the other hand, there are about 30 discrete sectors represented in the FTSE 250 index. For example, the Industry Classification Benchmark heading ‘support services’, which makes up around 12 per cent of the FTSE 250 index, encompasses businesses involved in outsourcing, packaging, building supplies, distribution and recruitment—all activities we would consider as discrete sectors.
“Similarly ‘financial services’ would include insurance, real estate, wealth management, specialist lending and a few challenger banks. Under the ‘travel and leisure’ umbrella are pubs, leisure, dining out, bus and rail, and gambling stocks.”
In a coming article, FE Trustnet will ask the experts which funds they favour for exposure to the small and mid-cap parts of the UK stock market.
