Franklin Templeton: Why now for UK mid caps?

Key takeaways:

1. UK mid caps have recently underperformed but key characteristics exist that make the FTSE 250 an attractive proposition.
2. When mid caps outperform they have historically done so significantly.
3. UK assets are undervalued but certain areas of the UK market are more expensive than others.
4. The macro environment remains supportive which has led to positive earnings surprises.
5. After a peak in interest rates the FTSE 250 has historically outperformed the UK market.
6. Throughout bull runs, mid cap companies have outperformed large cap businesses.

After a period of underperformance for UK mid cap stocks, we believe that investors should be reminded of some of the key characteristics that make the FTSE 250 a particularly attractive space at the present time.

When mid-caps outperform, they really outperform

Over the long run, mid cap businesses have outperformed their large cap counterparts as indicated by the cumulative returns of the FTSE 100 vs FTSE 250 (ex IT) for the last 20 calendar years.

The data shows that the FTSE 250 outperformed the FTSE 100 in 13 of those 20 years, 65% of periods. Performance was equal in 5% of periods, and the FTSE 100 outperformed the FTSE 250 in 30% of periods.

The significance of the outperformance however must not be overlooked, 35% of the time the FTSE 250 outperformed the FTSE 100 by over 15% on an absolute basis. This compares to the FTSE 100 outperforming the FTSE 250 by over 15% on an absolute basis, which only occurred 5% of the time.

To put the recent underperformance into perspective, this is one of the largest periods of FTSE250 underperformance, surpassing the 2007/08 Global Financial Crisis sell down.

Figure 1: FTSE performance

Source: FE Analytics, 31st December.

The UK is cheap, but not everywhere…

Many investors are aware of the valuation story within the UK at present but very few have considered the distribution of value across the capitalisation spectrum.

A forward P/E ratio compares a company’s share price to its expected earnings over the next year and is frequently used as a relative valuation measure. On a forward P/E basis, companies rated <11x P/E are materially above their average of the last decade. Conversely, businesses rated between 11-21x earnings have been trending lower and are now materially below their average of the last decade (figure 2). The 12 month forward P/E of the FTSE 250 index is 11x next year’s earnings, this is at the bottom end of the long term range and is over a 20% discount to the long term average of 14x.

This suggests that quality value and sensibly priced growth stocks are an attractive area of return for UK mid caps, and that other areas of the market which include deeper value names are looking expensive relative to history,

Also, the dividend yield of the index is nearly at parity with the FTSE 100, at c.4%, which is broadly recognised for its propensity to deliver attractive income (figure 3).

Both of these measure indicate that a significant degree of value remains in the FTSE 250. This has been recognised by broader financial markets, which have seen £14bn worth of bids for UK companies since the beginning of the year.

Figure 2: Leading P/E by valuation band (UK)

Source: Panmure, 31 March 2023.

Figure 3: FTSE 250 versus FTSE 100 dividend yield relative

Source: Berenberg, 30 April 2023.

Positive surprises for macroeconomists and domestic firms alike

Macro data has generally been stronger than expected over the last 12 months and economists suggest that peak interest rates are at least in sight. Consumer spending has also proved resilient as the £200bn saved during the pandemic provided a healthy buffer through a period of rising prices.

A strong labour market, continued wage growth, political stability, and a relative moderation of energy prices have all contributed to the evasion of a technical recession within the UK. This has fed through to UK earnings revisions – company’s upgrading their outlook -, which have greatly improved since the ‘peak-pessimism’ sentiment of Q4 2022 (figure 4).

Figure 4: UK earnings revisions have improved from 2022 lows albeit they are only closer to neutral and lagging large caps marginally

Source: Barclays, 30 April 2023.

Outperformance after peak rates

If economists are correct about interest rates peaking shortly then this may bode well for the FTSE 250. The index has historically delivered relative outperformance compared to the broader UK market in the periods immediately following a peak in interest rates (figure 5).

Figure 5: Historic FTSE 250 cumulative returns in the periods immediately following a peak in interest rates

Source: Bloomberg as at 30/04/2023.

Mid caps have historically outperformed in bull runs

It is difficult to call the bottom of the market, however present UK mid cap valuations are near trough-level multiples. No investor can consistently predict the future with any accuracy, but during the last two bull runs (2003-2007 and 2009-2019) the mid cap index has significantly outpaced the UK market (figures 6 and 7).

Figure 6: 01/04/2009 – 31/12/2019

Source: FE fund info 2023, 01.04.2009-31.12.2019.

Figure 7: 28/02/2003 – 30/11/2007

Source: FE fund info 2023, 28.02.2003-30.11.2007.

WHAT ARE THE RISKS?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile. Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.