Is the FTSE 250 overlooked and misunderstood?
At a time when pessimism towards UK equities is entrenched investors are overlooking the diversity and resilience of mid cap companies.
Unstructured Learning Time
It may be the less well known of the FTSE indices but the FTSE 250 is the authoritative measure of UK-quoted mid cap companies. Often referred to as the market’s “second tier” it is the next most established tranche of companies quoted on the London Stock Exchange outside of the FTSE 100.
The revenues of the FTSE 250 are more evenly split between overseas and domestic sources than is commonly understood. As a consequence, investors in mid caps could potentially benefit from both a pick-up in the global economy, and highly depressed sentiment towards the UK market, which is currently viewed by international investors as one of the least favoured asset classes.
Entrenched pessimism towards UK equities
Pessimism towards UK equities is entrenched against an uncertain economic and political backdrop ahead of Brexit, and has surpassed levels seen in the wake of the global financial crisis, according to the Bank of America Merrill Lynch’s latest survey of global asset allocators’ weighting in the country (see below).
This level of negativity is at odds with the news we are hearing from mid cap companies whose earnings have exceeded market expectations more times than not over the past two years. (Past performance is not a guide to future performance and may not be repeated)
This isn’t to say there aren’t some highly challenged mid cap sectors and companies, as the seemingly never-ending litany of woe from the traditional bricks and mortar retailers reminds us, for example. However, we believe the backdrop is not as poor as the wider investment community perceives it, and certainly not when you consider the many high-quality companies in the space which continue to thrive despite the headwinds they face.
The market is becoming more discerning – heavily punishing companies which disappoint – but this could be to the stockpicker’s benefit.
Mid cap companies tend to be more dynamic than large caps, and this is one of their key advantages at a time of great structural change. As the evolution of the internet and e-commerce is disrupting many traditional business models, mid caps tend to be small enough to adapt, and sufficiently young to have avoided many of the legacy issues afflicting sector incumbents at present.
The most successful mid cap companies have not only taken share from larger peers but, more importantly, forged ahead into overseas markets. Many of the larger FTSE 250 constituents are global leaders in their chosen specialist areas, and the index’s significant weighting in internationally diversified industrials partly explains why half of its revenues come from overseas (see below).
Despite this, the market continues to see the FTSE 250 as “domestic”. This misperception was perhaps best highlighted by the feverish reaction of investors following the unexpected EU referendum result in June 2016 when the index ended the day 7.2% lower, the biggest one-day drop in its history to date.
Overseas trade buyers seeing the opportunity?
If overseas financial observers of UK equities remain resolutely negative, the same can’t be said of trade buyers, as evidenced by the steady flow of inbound merger and acquisition activity in the past year. The recovery in sterling from its post-referendum lows seems to have left the appetite for quality UK companies undimmed.
In the FTSE 250 we’ve seen engineering and project management business WS Atkins acquired by a Canadian peer, property investor Kennedy Wilson Europe Real Estate purchased by its US parent and South Africa’s FirstRand complete the acquisition of UK challenger bank Aldermore.
More recently, trading software supplier Fidessa has become the subject of a potential bidding war and NEX Group has agreed the terms of a bid from US futures exchange CME Group.
UK economic growth has slowed since the referendum result (although not as much as expected) and consensus is forecasting sub 2% GDP growth over the next couple of years as Brexit and political uncertainty continue to weigh on business decisions. Business investment slowed in the run-up to the referendum and collapsed in its wake, even contracting through most of 2016. In contrast, capital expenditure by FTSE 250 companies has expanded.
Many of the best FTSE 250 companies are future-proofing themselves as they reinvest part of a growing stream of earnings into their businesses (at the same time as paying a progressive stream of dividends to shareholders). There has been a serial improvement in earning revisions1 over the past two years (as you can see from the green line on the chart below), during which time the index has delivered double-digit returns for sterling investors.
The FTSE 100 performed better in 2016, as investors discounted the benefit of a weaker sterling to its majority overseas earnings, but the FTSE 250 has outshone it since April 2017, resuming the long-term trend of outperformance, which has seen the index return 510% over the past 20 years versus 134% from the FTSE 100 (total returns 31/03/1998 – 30/03/2018, source: FactSet).
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. Past Performance is not a guide to future performance and may not be repeated
If sentiment toward UK equities has continued to plumb new depths, the same can’t be said of the currency which has staged a recovery since the autumn of 2017. Sterling has rebounded against a backdrop of better-than-expected macroeconomic data, the decision by the Bank of England in November to reverse its 25 basis point post-referendum rate cut, and progress with Brexit negotiations.
Should sterling hold onto its gains there might be some light at the end of the tunnel for the UK consumer, which has had to contend with a foreign-exchange driven inflation spike. It may be that this spike peaked at the end of last year and, against the backdrop of a buoyant jobs market (and more recently some signs that wages are picking up) the rate of generalised price increases in the economy may begin to more closely resemble wage inflation during 2018.
Some consumer micro markets are showing a marked improvement in revenue and margin trends, and the recent “surprisingly positive” statement from sofa retailer DFS Furniture (albeit not a FTSE 250 company), for example, may be testament to this. The chief executive officer of FTSE 100 retailer Next, Simon Wolfson, has also given the impression of pressures easing in the consumer market.
Market environment favours stockpicking
The outlook for the corporate sector seems less clear, and investors may wish to focus on the companies which have the power to pass on rising costs by increasing prices to end customers, without impacting volumes. It would be sensible to also avoid those with too much debt. If some of these very challenged companies do surpass lowly expectations, the rewards could be great, but so too could the risks of failure, as underlined by some pretty cataclysmic share price performances.
Given the growing divergence between the best and worst-performing shares it is perhaps no surprise that some UK active stockpickers had a much improved year in 2017. Our feeling is that we’re in a new market environment in which mid caps could offer great opportunities for the highly selective investor.
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.
Smaller companies may be less liquid than larger companies and price swings may therefore be greater.
Investing solely in the companies or one country or region can carry more risk than investments spread over a number of countries or regions.
1. An earnings revision occurs when an analyst amends their forecast for a company’s future earnings, either revising higher (upgrade) or lower (downgrade)↩