Jupiter: The unique appeal of UK mid caps

Jupiter’s Richard Watts, Co-Head of Strategy, UK Small and Mid Caps, argues that shares in UK mid-sized companies are particularly well-positioned for a post-pandemic economic recovery and worthy of consideration as a stand-alone allocation for UK equity investors.

UK mid cap stocks are a little bit different than shares of smaller or larger companies.
For one thing, the FTSE 250 mid cap index has delivered faster earnings growth than the indices of UK large or small caps. The mid cap index also is more domestically focused than the FTSE 100 large cap index: FTSE 250 companies generate around half their revenue in the UK versus FTSE 100 companies, which make around 80% of sales overseas. Mid caps also have fewer earnings disappointments than smaller company stocks.

These distinctions leave the mid cap index particularly well placed for a post-lockdown economic recovery in Britain and worthy of a standalone allocation by UK equity investors, says Richard Watts, who is portfolio manager of the Jupiter UK Mid Cap Fund in addition to his role as Co-Head of Strategy for the UK Small and Mid Cap Equities desk.

Stronger earnings growth from mid caps

Past performance is not a guide to future performance. The value of investments can go down as well as up and is not guaranteed. 

Source: Peel Hunt, Thomson Reuters DataStream, as at 15.01.21.

The broader macroeconomic backdrop is favourable for UK equities. Contributing to this improved outlook is the Covid 19 vaccine rollout and falling infection rates, Britain’s recent trade agreement with the EU, the high rate of consumer savings built up during lockdown and continued central bank and government support for the economy. Bank of England Governor Andrew Bailey has said the UK economy should return to pre-Covid activity levels by the end of the year.

One sign of market vitality has been robust activity this year in initial public offerings and mergers and acquisitions, which has added dynamism to the FTSE 250 in the form of additions to and deletions from the index. Gains in Sterling this year versus the dollar and euro is another tailwind, as the FTSE 250 is positively correlated to Sterling strength, in part because it reduces costs of imported supplies.

The dispersion of performance and dynamism in the FTSE 250 index makes it ideal for an active manager to add value through stock selection, Richard says, adding that the fund has beaten the index in 14 of the last 17 years. FTSE 250 companies are less well covered by equity analysts than those of the FTSE 100, which also provides stock-picking opportunities for Jupiter’s well-resourced UK Small and Mid Cap desk, Richard says.

Stronger earnings growth from mid caps

Past performance is not a guide to future performance. The value of investments can go down as well as up and is not guaranteed.

Source: Factset, as at 31.12.20. *2004 to 2020.

The positioning of the Jupiter Mid Cap Fund is nuanced. It remains overweight structural growth companies such as online retailers as these companies have proven to be strong performers over time. ASOS and Boohoo, for example, remain well positioned for post-lockdown with favourable earnings outlooks and valuations, Richard says.

The fund has been complementing the overweight tilt to these disruptive structural growth companies with exposure to well-managed, conservatively financed, less expensive, more economically sensitive businesses, to ensure the fund is positioned for the recovery. These include homebuilders, travel companies and financials.

The fund trades at a price to earnings (P/E) multiple of around 18 times versus 17 times for the index, with the premium reflecting the fund’s overweight positioning to structural growth companies.

Richard sees a compelling opportunity for earnings momentum to drive a rerating of midcaps. FTSE 250 company earnings have been suppressed by the Covid lockdown, and there is no reason why they cannot revert to the historic rate of profit growth, he says.

The first chart (above) shows the recent sharp fall in earnings expectations for the mid cap index relative to the large cap index. This short-term fall in earnings expectations is important and reflects that the mid cap index is more exposed to economically sensitive stocks, Richard says.

The economic data is clear, with the Citi economic surprise index for the U.K. in positive territory for several months, which means incoming economic data is better than consensus expectations, and so we should expect GDP upgrades, Richard says. The recent Services PMI data was also strongly above expectations, for example.

So, the data is consistent with improving economic activity, which should drive strong earnings upgrades for economically sensitive mid cap stocks, Richard said. Since there has been a sharp fall recently in mid cap earnings expectations relative to large cap, we should expect this earnings rebound to be relatively strong, he said. Whilst the mid cap index is trading at a 3-point P/E premium to the FTSE 100, it is because the market is trying to price in the strong likelihood of earnings upgrades for mid cap stocks, he said.

Richard said that in his experience these things are never fully priced in, and what is likely to happen is that stocks respond positively to earnings upgrades and their share prices push on. In short, at the aggregate index level, the FTSE 250 index will hold a premium valuation multiple on higher earnings numbers, which will drive continued outperformance of the mid cap index relative to the large cap index, he said.

Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.

Fund specific risks:

• Investment risk – there is no guarantee that the Fund will achieve its objective. A capital loss of some or all of the amount invested may occur.
• Geographic concentration risk – a fall in the UK market may have a significant impact on the value of the Fund because it primarily invests in this market.
• Company shares (i.e. equities) risk – the value of Company shares (i.e. equities) and similar investments may go down as well as up in response to the performance of individual companies and can be affected by daily stock market movements and general market conditions. Other influential factors include political, economic news, company earnings and significant corporate events.
• Concentration risk (number of investments) – the Fund may at times hold a smaller number of investments, and therefore a fall in the value of a single investment may have a greater impact on the Fund’s value than if it held a larger number of investments.
• Liquidity risk – some investments including those in unlisted companies may be hard to value or sell at a desired time and price. In extreme circumstances this may affect the Fund’s ability to meet redemption requests upon demand.
• Currency risk – the Fund can be exposed to different currencies. The value of your shares may rise and fall as a result of exchange rate movements.
• Derivative risk – the Fund may use derivatives to reduce costs and/or the overall risk of the Fund (i.e. Efficient Portfolio Management (EPM)). Derivatives involve a level of risk, however, for EPM they should not increase the overall riskiness of the Fund. Derivatives also involve counterparty risk where the institutions acting as counterparty to derivatives may not meet their contractual obligations.

For a more detailed explanation of risks, please refer to the “Risk Factors” section of the prospectus

Important Information: This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. This document is for informational purposes only and is not investment advice. Past performance is no guide to the future. Every effort is made to ensure the accuracy of any information. 27287