Are UK mid caps still a prime hunting ground for stock pickers?

A slew of recent takeover bids for FTSE 250-listed companies, including digital payments firm Network International, oilfield services provider John Wood Group and veterinary medicine specialist Dechra Pharmaceuticals, has shone a light on the attractions of UK mid-cap companies – for some buyers, at least.

All three of these were targeted by overseas private equity firms, perhaps keen to snap up these British assets before the pound – which has appreciated by around 18% versus the US dollar since last September’s low point – gets any stronger.

Jean Roche, who co-manages Schroder’s open- and closed-ended UK mid-cap funds, says the FTSE 250 index represents “what the UK does best” – including high-growth niches such as technology-enabled industrial firms, specialist retail and defence. Excluding investment companies, there are in fact only about 170 companies in the index, with a broadly 50/50 split between domestic and international revenues. This is starkly different from the FTSE 100 index, where the great majority of revenues are from overseas – which can clearly be beneficial when the UK economy is struggling, but less so in a recovery, and also calls into question whether the largest London-listed companies really deserve to be characterised as ‘UK plc’.

Historically – and particularly prior to the Brexit referendum in 2016 – an allocation to mid caps was pretty much essential for any UK investor in search of outperformance. Yet over the past five years, the FTSE 250 index’s total return has lagged that of the FTSE 100 index by around 20 percentage points, and over 10 years the large-cap index is even further ahead, having opened up a performance gap in 2016 that widened significantly after the start of the Covid-19 pandemic in 2020.

As shown in the table, the average UK mid-cap fund (across both open-ended funds, which include a number of index trackers, and investment trusts) has returned exactly zero over the past five years. However, Roche – whose funds are the top performers over both one and three years, with the Schroder UK Mid Cap investment trust also topping the group over five years – says the scene is set for a period of strong mid-cap performance, with earnings growth for FTSE 250 companies forecast to outstrip the FTSE 100, S&P 500 and Eurostoxx 600 averages over the coming year. She outlines improving (although still negative) consumer confidence, upgrades to GDP forecasts and better business confidence as factors underlying this expected improvement.

Although the macro backdrop may be improving, the FTSE 250 is fundamentally a stock picker’s market – as can be seen in the wide dispersion of returns in the table, from +3.5% to -19.5% over one year, +47.3% to -7.8% over three years, and +21.2% to -27.4% over five years. “All we have to do is pick the best 50 stocks out of the 170 available – what could be more simple?”, Roche jokes. She maintains a strict sell discipline, always selling out of a stock on promotion to the FTSE 100, in order to keep the strategy pure. However, the manager does not find the mid-cap universe overly limiting: “We know it as the Heineken index, as it is constantly being refreshed,” she says.

So while the recent takeover announcements – including Micro Focus, Ted Baker and Brewin Dolphin – may change the names of the stocks in the FTSE 250, investors who wish to follow the lead of the overseas private equity buyers can remain confident that mid-cap fund managers will still have an adequately sized pool in which to fish for differentiated investment opportunities.

See also: April not the cruellest month for UK companies 

Photo credit: www.chrisboland.com