Earlier this year AXA Investment Managers launched a mid-caps fund. At the same time the Schroder UK Mid & Small Cap investment trust, made the decision to change its name and mandate to Schroder UK Mid Cap. Both asset managers are convinced of the attractive prospects for this section of the market, which typically comprises companies sized between £100m and £3bn. If history is anything to go by - they should be right. Over the past 10 years the FTSE 250 returned 162.4 per cent compared with 49.5 per cent for the FTSE 100. This outperformance was mirrored by the performance of mid-cap focused funds - if you take a glance at the Investment Management Association's (IMA) UK All Companies fund sector league table the top performers over three and five years include a number of funds with mid-cap in their names.
Storming ahead
While past performance is no indication of future returns, analysts remain convinced that mid-caps will continue their strong run, saying that the FTSE 250 should continue to do better for structural reasons: the companies in this index are less mature than those in the FTSE 100 and hence have better growth prospects.
The FTSE 250 captures companies at a typically strong growth phase: when they are progressing from being small to large. "When a company is in the FTSE 250 you are likely to enjoy very strong capital growth and maybe also dividend growth," says Chris St John, manager of the AXA Framlington UK Mid Cap Fund. "Aggreko, for example, made fantastic returns between being a small-cap and a FTSE 100 stock."
Many mid-caps have been built on solid fundamentals such as pricing power which can help protect against inflation. These companies also tend to boast strong brands and operate in industries with high barriers to entry.
Further, mid-caps' smaller size makes them more likely candidates for takeovers which drives their share price. Over 2005 to 2006, for example, there were around 39 takeovers with companies being bought at significant premia. Mergers and acquisition (M&A) activity looks set to spike up once again: there have been around nine bid approaches year to date in contrast to 11 for the whole of last year. Paul Spencer, fund manager of the Rensburg Mid Cap Growth Trust, reports that while the first six months of 2011 were quiet - activity is picking up.
"Over the next five to 10 years or longer you are better with small and mid-caps than blue chips if you're looking for UK growth," says Mark Dampier, head of research at Hargreaves Lansdown.
That said, it is worth nothing that nearly 50 per cent of FTSE 250 revenues come from outside the UK making these companies less exposed to slow UK growth than small-caps. But some UK exposure is not necessarily a bad thing. "The UK may currently be out of favour, but it is a big economy and at some point people will like it again, at which point the FTSE 250 will be an area where you can exploit this," says Mr St John. "By investing in this index you have complete flexibility - you should be able to make money at most points of the economic cycle."
A good example is Howden Joinery which makes kitchens for builders, a difficult business to be in at present, with rivals such as MFI and Homeform having recently gone into receivership. Mr St John says Howden Joinery runs a good service and is well managed. "Pain allows the strong to get stronger, while this company is very well capitalised and in pick up time should have its place in the sun," he adds. The FTSE 250 changes more than the FTSE 100, so that poor companies fall out but stronger ones rise through. "You are not looking at the same shares to outperform as five years ago," says Paul Spencer, manager of the Rensburg UK Mid Cap Growth Trust. "It is a bit of a moving feast with lots of different shares."
Diversification benefits
A major advantage of the FTSE 250 over the FTSE 100 is its much greater sector diversification. While the large-cap index is dominated by the oil & gas, financials and mining sectors, the spread of investments are much more varied among mid-caps (see chart).
The top 10 shares in the FTSE 250 only account for 12 per cent of the overall index reducing concentration risk. In contrast, the top10 shares in the FTSE 100 account for almost half (48 per cent) of the index. The largest FTSE 250 company, Meggitt, accounts for just over 1 per cent of the index compared with around 7 per cent for the FTSE 100's largest company - HSBC.
"You can create a portfolio which reflects your market outlook without worrying about some sectors," says Mr Spencer. "If I don’t like a sector I can have nothing in it. But when certain FTSE 100 sectors perform poorly this can be a major influence on the whole index."
Compared with small-caps, mid-caps are easier to buy and sell making them theoretically less risky.
Although the FTSE 250 is around its all time high of 12,220 its forward price-earnings ratio (PE) is still relatively low, according to Mr St John. It has generally traded on a PE ratio of between 12 and 16 times over the past 10 years and is at the lower end of this range at the moment, leaving opportunity for further capital growth. During the downturn many companies protected profitability by cutting costs, and during the bounce back even a small rise in turnover led to profit growth.
Some mid-caps are also well placed to benefit from large-cap growth, as they supply these companies. Engineering group Weir, for example, is set to benefit from FTSE 100 miner BHP Billiton's increased spending on shale gas drilling equipment.
"The forecast for FTSE 250 earnings growth is high, driven by both turnover growth and margin expansion, and valuations remain attractive," says Mr St John. "In addition, growing corporate cash balances should lead to an environment in which increases in capital expenditure, dividend growth and M&A becomes increasingly prevalent."
The risks
Of course, mid-caps are not without their risks. They tend to be more volatile than large-caps, and if for example, there is a global downturn or major European debt default the FTSE 250 will be hit, though this should also impact the FTSE 100.
"If defensive stocks rally in the next two years the FTSE 250 could get left behind," says Mr Spencer. But he adds that in times of economic difficulty there are more defensively-orientated stocks in the FTSE 250 such as water companies like Pennon and funeral company Dignity.
The absence of tobacco companies and large pharmaceutical companies also means that dividends and yields are not as good as in the FTSE 100. The FTSE 100's predicted yield for 2011 is 3.6 per cent while for the FTSE 250 it is 3 per cent. But dividend growth rates in these two indices are quite similar, says Mr Spencer, although admittedly there are higher yielding sectors in the FTSE 100.
It is also worth noting that a fund just focused solely on the FTSE 250 is restricted. "Being able to invest in mid-caps and smaller companies gives us so much choice," says Mike Prentis, manager of the Throgmorton Investment Trust. "Mid-caps are well analysed by brokers but at the smaller end you can find stocks maybe covered only by one broker. Not being able to invest in these would be a great disadvantage. There are many great mid-caps, but we bought some of these when they were smaller and kept them."
