Mid-caps: Time to take the middle road
Medium-sized companies enjoyed a relatively strong year across many markets in 2015. This is also true over the long term, where mid-caps tend to outperform larger firms.
At a glance
• Mid-caps tend to perform better than large-caps but are less risky than small-caps.
• The expected European economic recovery could benefit mid-cap stocks.
• Mid-caps may not perform that well this year, however.
Paul Spencer and his colleagues at Franklin Templeton have also carried out a more in-depth, year-on-year comparison between the FTSE 100 with its large-cap contingent and the FTSE 250 with its army of under £10bn (€13.9bn) market cap companies. They found that the FTSE 250 outperformed its big brother in seven of the past 10 years.
Richard Watts, who manages the Old Mutual Global Investors UK mid-cap fund, points out that one of the obvious reasons for mid-caps outperforming, apart from their better track record at innovating than their larger cousins, is that their earnings performance is generally better.
“As far as I am concerned there are two reasons that keep mid-caps ahead of large-caps at most points in the business cycle. The first is earnings. If you look at historical earnings over any reasonable time frame they consistently grow earnings 4-5% faster than large-caps.”
There is no surprise about mid-cap outperformance on the earnings front. As Watts notes, it is a lot easier to achieve a higher rate of growth on a smaller figure, so the maths works for the smaller company.
The second structural reason why Watts is happy to invest in mid-caps is that it is a much more dynamic area than large-caps. Companies come and go a lot more rapidly, which gives managers more scope to find winners and losers. Identifying losers is particular important for those like Kuldip Shergill, who runs the Euro mid-cap strategy at Cheyne Capital, which is happy to have a relatively balanced universe of long and short positions.
A third reason that Watts gives for investing in mid-caps is that they are less risky than their smaller peers. They are simply not as fragile, which makes them better able to endure market shocks. “The combination of earnings growth and the favourable risk profile over small-caps is key for me,” he says.
Watts argues that outperforming managers who are not running dedicated mid-cap funds generally find that even if they are running a global fund, their outperformance comes from the exposure they have given themselves to mid-caps.
Shergill argues that a good reason for preferring European mid-cap stocks in 2016 is that they are an ideal way of playing domestic themes. Their greater exposure to domestic markets means that many of them are well placed to take advantage of a European recovery.
“If you look at consensus earnings expectations for 2016, mid-caps are offering 7-8% earnings growth versus 4-5% for the larger index. So you have outperformance potential right there,” he says.
“What we see historically is that investors tend to look to mid-cap stocks during the recovery or expansion phase of an economic cycle. This, I would argue, is exactly where domestic Europe is poised at the present time.”
Shergill says he tries to keep investment ideas as simple as possible. “As an example of the way I play the mid-cap space, earnings for many domestic Italian companies have not recovered since the financial crisis, such as for Italian media. So we would look for mid-cap companies with significant exposure to this recovering domestic Italian theme, looking for a potential rebound in not only advertising in Italy but also for the wider Italian economy as a whole,” he says. Although the Italian economy only grew slowly in 2016 the mid-cap sector enjoyed strong returns.
One of the factors Shergill looks out for in the mid-cap universe is sustainable earnings growth. “Companies with structural growth characteristics do not cease growing overnight, unless some external event happens. If we can find a company with 20% earnings growth that is attractively valued, then you can be reasonably confident that that will give you a 20% price gain over the next 12 months,” he says. “Similarly we also dedicate a significant part of the portfolio to seek out companies that we believe will report earnings materially different to consensus expectations.”
“For our short book we like structural decliners. These are companies in sectors that perhaps have overcapacity or constant regulatory headwinds and where it is very hard to grow profits and cash flow consistently. Shorting them makes sense over the medium term,” he notes.
“My view is that the mid-cap space will remain attractive in 2016, but there is no doubt that conditions are difficult, particularly with the monetary policy change the Federal Reserve is implementing in the US, raising rates while Europe and Japan are cutting them. To generate alpha we are going to have to be an even better stockpicker than we were in 2015,” he notes.
James Sym, fund manager for Schroders’ European Income Alpha fund, which invests across large and mid-cap stocks, is, if anything, even more cautious about the prospects for outperformance in 2016. “You have to recognise that this last year has been a great year for active managers. But some of the themes that gave a tailwind to active stock-picking funds in 2015 in both the mid and large-cap spaces, are unlikely to carry into 2016,” he says.
Active funds are about 200 basis points higher than their benchmarks, on average, and for the average to be that high is remarkable. But Sym points out that simply being out of commodities or light on commodities would have been worth about 300 basis points against the benchmark, so that was an easy alpha win.
“One of the difficulties is that you can’t find undervalued growth stocks in the current market. Growth has been difficult, so any company showing growth potential immediately gets revised upwards,” Sym notes. Growth potential is being valued only 5% less than it was at the height of the dot com boom, which is not a statistic to fill a fund manager with confidence.
One good play as far as oil stocks are concerned, is to look for companies that have had a huge hit on margins through the boom period. “It sounds paradoxical, but margins really tightened as the oil price rose, because supplier prices on rigs, labour, services and ships went higher and higher. A stable oil price will provide room for margin improvement, we think, so in large-cap we are overweight oil stocks, although that is a much more difficult play in the mid-cap space. You probably don’t want to be in E&P [exploration and production] companies at this point,” he says.