Many mid cap companies within the FTSE250 Index are market leaders in their industries, offer exposure to both domestic and global demand, have large cash resources and enjoy genuine pricing power – crucial during an inflationary period. These enduring qualities ensure there is always opportunity for stock-picking investors.
The attraction of this asset class is best illustrated by the returns generated. Over the ten years to the end of 2010, the FTSE 250 Index has outperformed the FTSE 100 Index by an average of 5.7% each year. Over 25 years, the outperformance record is similarly strong, despite a number of domestic and global economic contractions over this time horizon.
As well as providing impressive returns relative to the FTSE100, the FTSE250 also offers higher stock and sector diversification when compared to the blue chip Index. For example, the largest single stock weighting in the FTSE 100 (at 31/03/11) was 9.2% (Royal Dutch Shell). In the FTSE 250 Index, Tate & Lyle, the largest holding, represented just 1.4%. Similarly, the top ten FTSE100 companies made up a highly concentrated 49.4% of their Index, while the FTSE 250’s top ten represented a far more modest 12.6%.
Capital gains
Investors in this asset class have the opportunity to have exposure to companies in the most exciting stage of their development. Typically, this is a period where earnings growth is high and the liquidity of the underlying shares is increasing. As a result, there is potential to achieve impressive capital gains.
In addition, companies with exceptional capital discipline can also offer dividend growth. One example is Aggreko, the global leader in the rental of power and temperature control equipment. In 2002, Aggreko was close to the bottom of the FTSE250 Index, with a market capitalisation of £250m. By 2009, Aggreko had entered the FTSE 100 Index. During this time, the company developed its business significantly, generating both capital and dividend growth to the benefit of shareholders.
Despite rising by 133.8% from its November 2008 low to 30 April 2011, the opportunity for further progression in mid caps may be more significant than you think. Over the past 20 years, the FTSE 250 Index has generally traded on a one year forward price/earnings (“P/E”) valuation range of 12–16 times. Currently, the Index is at the low end of this range, leaving plenty of scope for further progress.
The extreme nature of the banking crisis resulted in widespread balance sheet debt reduction. Consequently, corporate net debt as a percentage of earnings is low, giving company management significant capital flexibility. Company directors are now in a position to exploit this balance sheet strength by either funding organic growth, increasing dividend payments, buying back shares or making earnings enhancing acquisitions.
Corporate activity
With corporate balance sheets generally strong, and mid cap valuations attractive, the scene is set for an increase in corporate activity. During 2010, takeover activity rose considerably in our mid cap universe, with the departure of 11 companies, including such stalwarts as Chloride, SSL and Dana Petroleum. This is a theme we expect to continue.
Although the corporate background is favourable, short-term investor risk aversion has been increased by various events recently, including the tragic Japanese earthquake and tsunami, unrest in North Africa and sovereign debt turmoil in the Eurozone. Meanwhile, at the stock level, like-for-like comparisons will be more challenging in 2011 and, as such, earnings upgrades will be harder to achieve.
However, the best mid caps should still see significant earnings progression, driven by top-line growth and margin expansion, provided that they possess pricing power in this inflationary environment. At present, we favour companies with exposure to international markets as these are likely to provide better medium-term profit growth opportunities than those available to domestically-focused companies, however, we are cognisant of long term opportunities which may arise once the UK economic recovery accelerates.
