Mind your mid-caps

Earlier this summer, star fund manager Neil Woodford warned Investors Chronicle that mid caps were expensive. "The bull market is five years old and mature," he said. "Valuations have risen substantially, driven by central banks' targeted policy - quantitative easing. We are left with a gap between where share prices are and what fundamentals will support, and the most overvalued area is mid caps." Mr Woodford believes there could be quite a significant correction in overstretched areas.

Read the full interview

When mid-cap share prices were soaring, foreign investors and large-cap managers moved down into these to try and get additional returns. More recently, they have been pulling out of the sector, which has put even more downward pressure on the shares.

For example, Peter Hewitt, manager of IC Top 100 Fund F&C Managed Portfolio (FMPG), has reduced his portfolio's holdings in Schroder UK Mid Cap (SCP) and the mid-cap focused Mercantile Investment Trust (MRC).

"There may be early signs of a change of leadership within the market," he says, "as for the first time since 2011 the FTSE 100 Index, which comprises the very largest companies, has begun to outperform medium- and smaller-sized companies which comprise the FTSE Mid 250 and FTSE Small Company Indices. In response, we have trimmed exposure to specialist mid-cap funds. The mid-caps' decline has further to run and might continue for a while."

The more recent underperformance of mid caps has detracted from the performance of funds that focus on mid caps with good longer-term performance records, such as IC Tip Fidelity Special Values (FSV) investment trust, although this means you can pick it up on a wide discount to its underlying net asset value.

Read our tip on Fidelity Special Values

"The strength of sterling is affecting confidence in earnings projections and putting pressure on valuations, particularly within mid caps with a high degree of overseas earnings," says Gavin Haynes, managing director at Whitechurch Securities. "Up until the start of this year mid caps (and smaller companies) significantly outperformed the UK stock market during the recovery phase. However, following a sustained period of outperformance, the Mid 250 benchmark has been flat year-to-date and lagged the blue chip-focused FTSE 100. Valuations in this area of the stock market no longer appear cheap following the strong recovery and you need to be more selective to find value."

Still a place for mid caps

But Mr Haynes adds that "there are still a large number of dynamic businesses that provide exciting growth opportunities for stock-pickers among medium-sized UK companies".

Mr Lowman adds that although you can pay a bit of a premium for mid caps, they have generally done better than the FTSE 100, and this is where picking the right stocks comes in. "Among UK mid caps there are pockets of value so an active manager can do better than a tracker in this area," he says. "They have the opportunity to find undervalued and underpriced gems."

Mark Martin, manager of Neptune UK Mid Cap Fund (GB00B3D7FD61), says sectors in the mid-cap index that offer good value include healthcare, which is less exposed to the economic cycle and so provides diversification.

But he also argues that the FTSE 250 overall is not expensive, and fairly cheap against the 'FTSE 80' - the 80 smallest companies in the FTSE 100. "The FTSE 250 is not super cheap but it certainly is not expensive," he says. "And given their growth, the FTSE 250 and especially the FTSE SmallCap indices are reasonably well valued (relative to other European and US indices)."

Peter Lowman, chief investment officer at wealth manager Investment Quorum, points out that over any lengthy period of, for example, 10 to 15 years, the FTSE 250 tends to outperform the FTSE 100. "This is because over longer periods mid caps have the potential to grow quickly and the businesses don't necessarily have the complicated corporate structures that large caps do: for example, if they want to reduce corporate spending they can do it faster."

Taking individual calendar years, over the past 10 years the mid-cap index has outperformed the large-cap index in every year but three - 2007, 2008 and 2011.

"The companies in the FTSE 250 are younger and smaller so their growth rates are a lot higher than the FTSE 100," explains Mr Mitchell. "Although yields are generally higher on large-cap companies in terms of dividend growth, the FTSE 250 is on a par with the FTSE 100."

Also, the FTSE 250 is on a price-earnings ratio (PE) of 15.4 times against 14 times for the FTSE 100 and 15.9 times for the 'FTSE 80', but 2014 earnings growth expectations are 4 per cent for the FTSE 250 against 2.3 per cent for the FTSE 100 and 1.2 per cent for the 'FTSE 80'.

Because the FTSE 250 has come down a bit it is better value than it was, adds Juliet Schooling-Latter, research director at discount broker Chelsea Financial Services. "Despite the strong run it is not a bad time to be in there because there is a wider variety of sectors and companies," she adds. "And an active manager can select within this and pick the ones that are not overvalued."

FTSE 250 sectors offer different exposures to their equivalent in the FTSE 100. For example, while you may find a lot of large banks in the latter index, in the FTSE 250 you get companies such as asset managers. Consumer services also account for a significant portion of this index and, according to Mr Lowman, when the economy starts to grow they should do well.

Derek Mitchell, manager of Royal London UK Mid Cap Growth Fund (GB00B4V70S51), also points out that there is a broader spread of industries and no single sector dominates, unlike in the FTSE 100 where sectors such as oil, mining and banks account for substantial proportions.

Mid caps can also be boosted because they are subject to mergers and acquisitions (M&A), and Mr Martin believes the appetite for this is increasing. "Given the rise in markets, M&A has lagged in recent months and years," he says. "M&A deals occur in clusters - and are starting to warm up now. History suggests more scope for more M&A in coming years."

Mid caps should also continue to benefit from the UK recovery.

Liquidity risks

Risks to mid caps and the funds that invest in them include liquidity (the ability to buy and sell shares), and their volatility, which is greater than the FTSE 100. Because the shares in this index can be subject to M&A, their share prices can be ramped up by talk of this, but then lose the premium if the acquisition does not come to fruition.

In the near future, as central banks - including the Bank of England - tighten monetary policy, there could be market volatility, and a rise in UK interest rates could have a detrimental effect on domestic-focused cyclical shares.

Because the FTSE 250 is more exposed to the domestic UK economy, if the recovery does not continue it could do worse than the FTSE 100. But the FTSE 250 also contains a number of exporters that are vulnerable to a strong pound.

Best mid-cap funds

Ms Schooling-Latter says that mid-cap funds are more suitable for investors with a reasonably diversified portfolio, and a medium- to high-risk appetite. "If you have a globally diversified portfolio you could have up to 5 per cent in UK mid-cap funds," she says.

Mr Lowman suggests that a medium risk investor could allocate around 8 to 9 per cent of their assets to UK mid and small caps (out of an allocation of 30 per cent to the UK), while a more adventurous investor could put 12 to 15 per cent into these. At the moment they could have more of that allocation in mid caps because they are more liquid than small caps.

Mr Lowman and Ms Schooling like Franklin Templeton UK Mid-Cap Fund (GB00B6ZVYF25) which is one of the best performers in the Investment Management Association (IMA) UK All Companies sector over three and five years.

They also like Neptune UK Mid Cap (GB00B3D7FD61). "We like the way its manager runs money because he has a very good strategy for downside, and has proved it," says Mr Lowman.

"He is a safe pair of hands and in the current environment you want to look for someone who has their eye on downside protection," adds Ms Schooling-Latter.

Neptune UK Mid Cap is the fourth best-performing fund out of more than 230 over five years, best over three and among the top 25 per cent over one year.

Mr Haynes likes Old Mutual UK Mid Cap (GB00B1XG7999), which is also one of our IC Top 100 Funds. It is one of the best-performing funds in the IMA UK All Companies sector over three and five years, although its performance has been hit over one year, taking it down into the fourth quartile.

Passive investors could look to db x-trackers FTSE 250 UCITS ETF DR (XMCX), a fully physically replicated exchange traded fund that tracks the FTSE 250 Total Return Index and is a member of the IC's Top 50 ETFs.

Mr Lowman adds that mid caps are not suitable for very risk-averse investors, while cautious investors should look to an all-cap fund such as Schroder UK Opportunities (GB0031092728), which allocates across the market capitalisation spectrum, and is among the top performing UK All Companies Funds over three and five years.

The fund's manager, Julie Dean, also runs the Schroder UK Growth (SDU) investment trust which trades at a discount of nearly 7 per cent - much wider than its 12-month average of around 3.5 per cent.

Read our tip on Schroder UK Growth

Read our interview with Julie Dean

But Mr Lowman adds that if you have the risk appetite to invest in small- and mid-cap funds you will get better performance over time from funds focused on these.

Performance of recommended funds

Source: Morningstar, as at 21 August 2014

Some funds with mid cap in the name have a significant allocation to small caps - for example Neptune UK Mid Cap, which has 46.5 per cent of its assets in this area. And many small-cap funds offer significant exposure to mid caps, in some cases as much as 70 per cent or more.

Read our report on this

A good example is IC Top 100 Fund Henderson Smaller Companies (HSL), which has a strong performance record, beating the Numis Smaller Companies ex investment companies Index and its sector average over three and five years. It is on a discount of more than 15 per cent, wider than its 12-month average of about 13 per cent.

Read our interview with its manager

"It is really important that you look under the bonnet of a fund before you invest in it," says Ms Schooling. "The size of a fund can indicate this, because if it is large it will be pushed up the market-cap scale. A manager who has the flexibility to go up and down the market-cap scale is better, therefore a fund that is not too big. Small-cap funds which can go into mid caps and vice versa are the best option."

Performance of mid-cap focused investment trusts

Source: Morningstar as at 25 August 2014