FTSE 250: should you invest in the mid cap rally?
With economic confidence returning to the UK this year and new rules permitting AIM shares to be held in ISA wrappers, investors have been more willing to hold riskier investments.
Mid-cap investors in particular have been rewarded, with the FTSE 250 index (made up of the 101st to 350th biggest companies on the stock exchange), hitting an all-time high in August following positive manufacturing data, and continuing to gain ever since.
This is compared to the FTSE 100 index, which has lagged its younger brother, delivering half the gains seen in the 250.
In fact, the November Profit Watch report from investment platform The Share Centre, which analysed the revenues and profitability of the top 350 UK companies, found that mid caps made up a disproportionately large percentage of revenues in the third quarter of this year.
However, experts warn the mid-cap market is starting to look expensive compared to the large cap sector.
The big question for investors is it looking too expensive.
From a valuation point of view, the UK-listed large cap stocks are definitely trading at much lower multiples to those in the FTSE 250 Index, says Jason Hollands, managing director at Bestinvest.
“This is essentially because UK mid caps have a much more domestic earnings profile than the companies in the FTSE 100 index. While companies in the FTSE 100 derive around two thirds of their earnings internationally, including in many cases emerging markets, mid caps typically earn around half theirs in the UK.
“So, as UK recovery fever has gathered momentum, mid-cap stocks have performed well and this has driven valuations towards the top-end of their historic range,” he says.
Although mid-caps are more expensive, Adrian Lowcock, senior investment manager at Hargeaves Lansdown, says they are by no means “stretched”.
He says: “Stock markets have the tendency to take valuations to extremes, either too cheap or too expensive. Mid caps, while a bit pricey, could continue to perform strongly for some time especially if economic growth continues and is translated into earnings growth.
He says the key is for investors to be highly selective when it comes to finding the best value.
“Our analysis shows that high yielding mid-caps are looking more expensive than low yielding mid-cap stocks which are close to fair value.”
Investors should also remember that although valuations may look more attractive in large caps, some of these stocks sit within the commodities space, which means they remain sensitive to any slowdown in growth from emerging markets.
While mid caps may look “pricey”, the outlook for these companies remains positive, as long as the economic recovery remains on track.
With mid-cap firms more closely reliant on the domestic economy than their FTSE 100 peers, they are often a better bellwether for growth than large caps. However, this means these firms are more susceptible to shocks and a slowdown in economic recovery.
Two sectors in the FTSE 250 that look set to do particularly well are retailers, which will benefit from increased consumer confidence, and house builders, which stand to benefit from a pickup in housing transactions.
“No doubt government schemes are boosting house builders, and Help to Buy’s impact should further bolster future results,” says Helal Miah of The Share Centre.
He adds that things are generally improving for a “diverse range of sectors” within the mid-cap market.
With the backdrop of a recovering economy, investors need to decide whether they are willing to pay a premium for mid caps, bearing in mind that experts say this part of the market is still not considered overvalued.
Or are they more cautious over the strength of the UK’s recovery, in which case they may be better placed at the large cap end of the spectrum where they can still benefit from changes to the country’s fortunes.
Adrian Lowcock’s top mid-cap and large-cap fund picks:
One of the advantages of mid cap investing is it is an area where active managers are able to add value through stock selection. For mid cap exposure I would recommend Old Mutual UK Mid Cap. Manager Richard Watts believes the strong share price performance could have further to go. There are of course no guarantees and medium-sized companies can be more volatile than larger, more established companies.
The fund has benefitted over the last 18 months or so from a significant overweight to domestically-focused sectors such as house builders and general retailers. Last year, companies dependent on the struggling UK economy were out of favour but an improvement in UK economic data has led investors to re-appraise their views, and many of these companies have rallied strongly.
Richard Watts believes the UK economy will continue its gradual improvement, boosting employment and household incomes. As a result the fund remains significantly exposed to the retail, house building and other consumer-facing sectors.
For large cap consider, I recommend Lindsell Train UK Equity Income. Nick Train, manager of the fund, looks for businesses that can consistently grow their profits over the long term.
His view is companies that are likely to be trading profitably in 20 years’ time should generate strong long term returns. He believes investors undervalue the importance of dividend income. While this is not an equity income fund, he believes companies that can focus on growing cash flows and dividends will prosper over the long term.
Nick Train believes there is a wonderful collection of consumer companies with strong brands and market positions. Companies supplying global consumer brands such as Unilever, which manufactures Dove soap and PG Tips, and Diageo, producer of Smirnoff and Johnnie Walker whiskey, have proved resilient in recent years. The strong cash flows and robust earnings enjoyed by these companies have driven strong returns.