Fishing in a lively pond
For Freud it was ‘id’. For investors, should it be ‘mid’? Yes. Mid caps are under-researched and under-owned, which makes them fertile ground for stockpickers. The availability of information in this area of the market is poor. So there is good potential to benefit from identifying positive change in companies that the market has yet to recognise.
You could make the same point about small caps. But what mid caps offer, and small caps don’t, is liquidity. That means we can take meaningful positions, and turn our paper performance into hard cash.
We are not interested in the mid cap asset class per se, and only see it as a reservoir of stock-picking opportunities. Picking mid cap stocks at random gives you a less than 50% chance to outperform (see chart), but the top performers - the outliers - are predominantly mid cap. We have outperformed, independent of the asset class, purely through stock-picking, using our framework of quality, value, growth and change.
We look for stocks with strong finances, which are cheaper and grow faster than the market and which, above all, are experiencing some form of positive change, such as EPS upgrades or director buying. These factors have been shown by academic research to lead to a higher chance of outperformance. By evaluating companies on this basis, we focus on the facts, rather than the ‘stories’ which can generate so much noise in the markets.
Many have been surprised by the outperformance of the European mid caps as an asset class this year, and wonder whether it can continue. My explanation of this year’s outperformance is that mid caps are a peripheral asset just like any other (junk bonds, emerging market bonds and equities, commodities, fine art, etc). The performance of peripheral assets such as mid caps depends on risk appetite, which has been exceptionally strong, due to very stimulative liquidity.
So mid caps can only continue to outperform if risk appetite improves further. But junk spreads, for example, are just over 2% above high quality bonds. If they improve any further, there will hardly be any distinction left between junk and quality. The market would effectively be saying that there is no risk left in the world, which is a very risky position to take.
And liquidity will not always stay this stimulative. The Federal Reserve is tightening, while another crucial source of liquidity is at risk. Asian central banks have been lending their trade surplus to the US government, rather than to their own economies. This lowers US treasury interest rates, and therefore encourages capital to flow to peripheral assets (eg Asian equities). But the problem with this circular transaction is that the Asians earn a low rate of interest, leaving the high returns to the international investor. Although there are reasons for this arrangement (Asian central banks are effectively outsourcing capital allocation to the international investor), one can expect it to come under pressure because of its imbalanced return profile.
In short, the price of peripheral assets such as mid caps is high, just as the liquidity taps are being turned off. Does this worry us? No. On the contrary, we welcome it. The obverse side of easy liquidity is that it has depressed volatility to historic lows. If there is no volatility, all stocks perform the same way, which makes it hard to add value through stock-picking. As liquidity becomes less stimulative, volatility will increase, and with it stock-picking opportunity – the whole point of investing in mid caps in the first place.
Some of our most successful investments recently have been individual mid cap stocks which will actually benefit from the trends which might make the mid cap asset class underperform. We purchased a 3% position in Collins Stewart in September 2004 at £3.88. Collins combines a small company brokerage operation with an inter-dealer broking (IDB) business. IDBs are liquidity platforms through which banks can trade products such as bonds or credit swaps. They are effectively stock exchanges for over-the-counter (OTC) products. This business had been highly fragmented, but Collins, together with competitor ICAP, have been buying the smaller players (we actually bought Collins when it was acquiring competitor Prebon). What we established, after meeting management, was that there is great operational gearing in these businesses: you could transact twice as many trades on the same trading platform. This meant Collins could cut virtually all of Prebon’s fixed costs. After this saving, Collins had added 50% to its profit before tax, on a p/e of 6x. What’s more, there are virtually no capital requirements in this business, so all those profits can be paid out as a dividend.
The cherry on the cake is that an IDB’s top line is driven by volatility. So the factors which might make mid caps underperform as an asset class are actually very stimulative to Collins’ top line.
Why could you find such an attractive play on volatility in mid cap of all places? Precisely because of the inefficiency in this space. So few analysts covered Collins that you could buy it on a market capitalisation of less than £1bn, and get an IDB which could pay £110m of dividends, with the brokerage thrown in for free. How did we spot this opportunity? Rather than focus on the colorful past of CEO Terry Smith, or the perceived strategic challenge of electronic trading to Collins (‘the story’), we focused on the potential for an 11% yield (value), and EPS upgrades (positive change) – that is, the facts.
We have also invested successfully in exchanges such as Euronext and LSE, but Collins was particularly sweet. It rose 19% in August to over £6, after announcing that it had received takeover approaches. We run our winners at Martin Currie, and continue to hold Collins, anticipating further upside.
We continue to find exciting stocks in all areas of the market. We sold Norwegian reverse vending machine company Tomra for a 40% gain in September, our fourth double digit return in this stock since launching the discipline in June 2002. The market was prejudiced due to past disappointments born of excessively optimistic expectations (again, ‘the story’). We saw a stock on an ex-growth multiple (value) with significant new opportunities (growth) and a new management cutting costs and delivering EPS upgrades (change).
PGS, the Norwegian seismic company, trades on a p/e of 9x, and is getting upgrades as oil companies begin again to invest in exploration. And they will continue to do so, whether oil is at $70 or $55. SGS, the Swiss inspection and testing company, has returned 32% since we bought it in December 2004. Most analysts preferred UK competitor Intertek, due to its greater exposure to Asian textiles (‘the story’). Our analysis showed significant operational gearing in a company with a rapidly growing top line, leading to growth and EPS upgrades. The company benefits from rising global trade, but is not at the mercy of the volatile price fluctuations one finds in other companies exposed to the same theme (for example, shipping).
What do all these stocks have in common? They are under-researched because they are mid caps. We face the future with confidence, because all we need to prosper is for markets to be inefficient. Wherever that inefficiency lies, we expect to take advantage of it - without prejudice - by picking stocks based on quality, value, growth and change.
Eric Woehrling is co-manager of Martin Currie GF Pan-European Mid-cap Fund, based in Edinburgh