The more UK-focused ‘mid-caps’ of the FTSE 250 have performed very well in the past decade or so, in contrast to the more international FTSE 100 companies, rewarding investors with returns of 306% between December 2008 and May 2017.

But following the surprise Brexit vote in last year’s EU referendum, the UK stock market witnessed a sharp sell-off along with the value of the pound. High street retailers, airlines and housebuilders – found among the mid-caps – were particularly hard hit, while internationally-facing companies – found among the large caps – fared well on the back of the falling pound.

While the FTSE 250 has largely regained lost ground, for Mark Martin, manager of the Neptune UK Mid Cap fund, the sharp sell-off of the FTSE 250 in favour of the blue chip index by panicked investors presented him with exciting opportunities.

He says: “This was music to my ears. There were forced sellers who owned FTSE 250 companies and a lot of fund managers who have done extremely well  over their careers by being overweight mid-caps, but they saw Brexit and panicked, thinking they have to sell all their FTSE 250 exposure.”

As such, he said there is value in mid-caps and it is a mistake for investors not to have any exposure, while everyone else seems to be “piling into momentum” of the blue chip index.

However, while he does hold selected housebuilders within his concentrated portfolio of c. 30 stocks, Martin says the valuations are “very elevated” and he remains cautious on their outlook.

He cites the eight-figure pay packages of CEO housebuilders “free-riding on government stimulus packages” as one of the reasons. He says: “Income funds love housebuilders as they pay back money to shareholders and special dividends which is great for fat cat PLCs but not great for UK PLC, which desperately needs money to build new houses. There’s increasingly inequality in the market and CEOs are benefiting inappropriately.”

Martin adds that income funds are buying housebuilding shares “en masse” so turning to these to find yields seems a “no brainer”.

“But, even if valuations are low, housebuilders are risky particularly for income funds as they tend to be held by people who are more risk averse, probably older, by those who probably own their own houses and have equity. If I was one of those people I would not be thanking my income fund manager for doubling up my bet by having housing equity and investing my money in housebuilders. It’s risky and fragile.”

Martin adds: “Everyone talks about bricks and mortar being a safe investment, they have a pension based in bricks and mortar, but I don’t think it’s a safe investment at the moment.”

He would need to see a material move back in valuations in order to add to his holdings of housebuilders. “We’d need to see quite a lot of change to go overweight into the sector. The housing market is illiquid and driven by momentum and we are seeing some signs in London and the South East that momentum’s coming out of market”.

The manager’s mid-cap strategy

Along with deputy fund manager, Holly Cassell, the fund is made up of holdings with a low correlation to the domestic economy. Martin explains: “If you’re in midcaps, they’re more domestically-focused so you want to hedge out that domestic exposure by increasing exposure to the non-domestic parts of the index of which there are quite a lot.

“We try to focus our exposure in the FTSE 250 towards companies that are exporting so they’re benefiting from the translation of overseas profits into sterling. But we also seek those exporters that have a lot of UK costs so they have transactional benefits too.”

The fund manager who joined Neptune in 2008 says that a lot of people in the market have been buying Diageo or Glaxosmithkline because of their overseas exposure, but if they have a lot of overseas costs, they benefit just from translational exposure, but not transactional exposure.

“Companies like De La Rue and Venture have substantial overseas earnings so benefit from translational costs but they also have disproportionate UK costs so given the depreciating currency, there’s a double money benefit. People buying Diageo for translational exposure is fair enough but you really want to be buying one that has both such as De La Rue and Venture.”

Sausage skin manufacturer Devro makes up a near 10% weighting in the Neptune UK Mid Cap fund (its top 10 holding). While Martin’s says it’s niche, he’s particularly excited about the prospect for the firm.

“Devro has just finished a period of significant capital expenditure, it has translational exposure, and while its zero-free cash flow doesn’t look good, we know that its cap ex period has just come to an end. It’s built two new factories and has four other factories around the world. Its major competitor was Spain’s Viscofan and for years, Devro has complained that it can’t compete, purely because of the euro. Overnight with Brexit, Devro made hard-earned marginal gains and with its operationally-geared business model, it will feel the benefit for years.”

His fund is overweight industrials (nearly 35%) as there are a lot of exporters there and he also looks for M&A potential within industrials in particular. Defence is also a picked sub sector because of the Donald Trump effect.

“If we experience geopolitical tension, it will likely be negative for global growth and stock markets, but defence would be good hedge against any potential weakness,” he concludes.

Are investors better off in a multi-cap strategy?

Darius McDermott, managing director of Chelsea Financial Services, says most investors are better-off having a multi-cap UK equity fund as a core holding and adding to mid and small caps specifically as and when their portfolio grows and diversifies.

“There is no disputing the fact that mid-caps have done very well in the past decade or so and investors have been rewarded – good medium-sized companies are, after all, the large cap stocks of the future. It is a more volatile area of the market though and good fund managers and stock-picking skills are vital.”

He says there are no particular stocks or sectors he has high conviction in: “There were some cheap opportunities immediately after Brexit but the market doesn’t look great value now. Stock-picking will be key from here on in – there are no clear winners just yet. In terms of funds my two favourites are Neptune UK Mid Cap and Franklin UK Mid Cap. Both have excellent managers with good long-term track records,” he says.