It’s no secret that UK mid and small-caps have been through the wringer in the past five years, courtesy of Brexit and the Covid pandemic. Therefore, I was pleasantly surprised to read that both indices had recently approached all-time highs*.
In any normal situation, now would probably be the time to think about cashing in – but on this occasion it feels like there is plenty more progress to be made as the economy begins to return to some semblance of normality.
We are long-term investors and, as such, we always believe the greater opportunities will come in the small and mid-cap space. History shows the extra risk taken in this area is often rewarded, and I do not see why it would be any different in this case.
Numbers don’t lie
The numbers reaffirm the resiliency. Since the lows of March 2020, the FTSE 250 has risen more than 75%, while the FTSE Small-Cap has risen 111%*. However, it is also interesting that over five years (which fully covers the Brexit overhang) both indices have comfortably beaten the FTSE All Share**.
I would even say both UK mid and small-caps do not look particularly expensive given the UK recovery is still lagging compared to other parts of the world.
Don’t forget that the market has just started to open up. That’s interesting for mid-caps in particular as the FTSE 250 has had a number of companies that have faced significant challenges due to Covid – the likes of airlines, travel companies, restaurants and pub chains. Some sectors have already bounced post the vaccine announcement, but others could still make big gains once the economy re-opens fully.
What’s behind this resiliency?
Aberdeen Standard points to the ability of mid-caps to be more adaptable or simply nimbler that their larger peers. They can have different levers for growth and opportunities, such as additional products and services, or expansion into other geographies***. There have been plenty of examples of management doing precisely that in the past 12 months.
It’s a similar argument for small-caps in terms of resiliency. We’ve now moved into an environment where mergers and acquisitions – an important part of the small-cap space when it comes to making profits – could well pick up as the combination of low interest rates and a weaker pound peaks the interests of potential buyers.
Another important factor to remember is that Covid has also changed consumer behaviour – which has created significant dispersion in performance across industries and sectors. I recently read a note from Blackrock Throgmorton Trust portfolio manager Dan Whitestone, who believes there are two major trends set to dominate at stock and industry level. The first is digital transformation, but the second one caught my eye – the idea of “Corporate Darwinism” – essentially the strong getting stronger.
Whitestone says this is “unfolding across many industries as the differentiated and financially strong take market share at an accelerated rate from the weak and solidify their market leading positions”. Whitestone goes on to cite the likes of retail, veterinary services, electrical component distribution and building materials as a few examples****.
Tapping into the re-opening
We are now at an interesting point for markets – and UK small and mid-cap businesses are no exception. The past six months have been all about recovery plays, but with markets re-opening (as opposed to recovering) we could see a number of quality companies in this bracket reaffirming their positions as financial support is turned off.
Those looking to tap into the mid-cap market may like the Axa Framlington UK Mid Cap fund, managed by Chris St John. The fund targets UK companies that are benefiting from structural tailwinds. Chris will look for companies that are high quality (both financially and in terms of their management teams) that can show sustained profitability, and that exhibit future growth potential. Another is Marlborough Multi-Cap Growth fund, which currently has more than a third of its portfolio in UK mid-caps^.
In terms of access to UK smaller companies, investor may like the Liontrust UK Smaller Companies fund, which targets companies which meet three specific criteria: intellectual property, strong distribution channels and/or significant recurring business.
Another to consider is TB Amati UK Smaller Companies. It focuses on structural growth businesses that the managers believe can add value in the under-researched small and mid-cap part of the market.
*Source: Stifel – UK Mid and Small-Caps – April 2021
**Source: FE fundinfo, total returns in sterling, 22 April 2016 to 22 April 2021
***Source: Aberdeen Standard – UK Mid-Caps – Far from the middle of the road
****Source: BlackRock – 2021 Outlook: UK Small-Cap Equities
^Source: fund factsheet, March 2021
