Mid-cap stocks: an investment sweet spot
The 25th March 1996 is the day that the AIM All-Share index was launched with a starting level of 1,000. The AIM index is up 10% since then but the FTSE 250 Index of mid-cap stocks is up 378%. Over the same period the FTSE 100 is up 104% and the FTSE Small-Cap Index is up 178%.
In recent decades the mid-cap space has provided the best pond for UK investors to fish in. This contrasts with academic research that highlights the out-performance of small cap stocks. The question now for investors is whether the drivers of this out-performance remain in place.
Key drivers of out-performance include a scope for growth, focused business models and good corporate governance. An additional factor has been the attractive sector exposure of FTSE 250 companies.
Source: SharePad. *Performance excluding dividends.
Investors are often attracted to the allure of small cap stocks given the scope for out-sized returns. However, small cap stocks tend to be riskier than mid-cap stocks and stock selection is critical.
There are often a few small-cap high flyers that deliver the bulk of the returns while other small cap companies fall by the wayside. It is also notable that the FTSE Small cap Index below has seen a number of significant draw-downs.
The Nifty FTSE 250 index: a strong and smooth ride
Source: Google finance.
FTSE Small Cap Index: a bumpy ride
Source: Google Finance.
FTSE 250 out-performance drivers
Scope for growth – Mid-cap stocks range in value from £600 million to £5 billion and therefore have scope for further growth. This contrasts with the mature companies in the FTSE 100.
The property listing website Rightmove (RMV) provides a good example. Much of its extraordinary growth happened while it was a member of the FTSE 250. The business is now in the FTSE 100 and is the dominant player in its market.
Investors found their happy with Rightmove
Rightmove (RMV) grew rapidly while it was in the FTSE 250
Evidence of the maturity of FTSE 100 stocks comes from the dividend payout ratio. A number of FTSE 100 companies pay out the bulk of their earnings while FTSE 250 companies generally reinvest in growth.
Mature companies and sectors are at risk of new competition and often experience declining returns. This has been the case for the UK supermarket sector and also for apparel retailers.
Sufficient size – To reach around a £600 million market value a business needs to have a reasonable level of sales and will usually be profitable. This helps to eliminate much of the lower quality companies at the bottom end of the market.
When a company is valued at over £600m it will also usually have a track record and should have been given a run over by auditors and investors. There are also economies of scale in areas such as human resources.
Focused businesses – Mid-cap companies are often focused businesses with strong market positions. Examples include JD Sports (JD.), Spirax-Sarco (SPX), Renishaw (RSW), Aveva (AVV) and Auto Trader (AUTO).
By contrast, the pharmaceutical giant GlaxoSmithKline (GSK) has become a sprawling business. It is no surprise that GSK has failed to deliver strong returns for investors in recent years.
Diversification – The FTSE 100 is dominated by a few companies and a few sectors. By contrast, the FTSE 250 is much better diversified and so is able to offset a setback in any one sector or company.
Notable setbacks in the FTSE 100 include BP’s (BP.) Deepwater Horizon oil spill in the Gulf of Mexico. The UK banking sector also experienced significant losses during the global financial crisis.
Investment Trust exposure – The FTSE 250 includes the bulk of the large investment trusts listed in the UK. With these vehicles typically deploying financial leverage they have scope to outperform over the long-term.
Corporate governance – All companies in the FTSE 250 index are premium listed on the main market. This means that they follow the highest levels of corporate governance and have a reasonable amount of liquidity.
Some premium listed companies fail to qualify for the FTSE 250 because their shares may not have a sufficient free float. There are also standard listed companies on the main market, which follow weaker corporate governance rules.
The AIM market is an additional category of share listing and the corporate governance levels are lower than the main market. It is not a coincidence that the AIM market has seen more than its fair share of disasters.
Sector exposure – The FTSE 100 is driven by what are arguably lower quality sectors. They include banks, oil and gas, mining, mature retailers and mature pharmaceutical groups.
The largest FTSE 250 companies, by contrast, are in a range of sectors such as software, medical equipment and industrial machinery. The top 20 FTSE 250 companies by market value include one resource group and no banks.
Ten largest companies in each index
Three investment case studies: Shell, HSBC and Spirax-Sarco
Looking at the two largest companies in the FTSE 100 index and their share price performance in recent decades has been lacklustre. They both have a high dividend payout ratio but should still have been able to grow earnings.
FTSE 100 group Shell (RDSB) since 2000
Source: Google Finance.
FTSE 100 group HSBC’s (HSBA) shares have made little long-term progress
Source: Google Finance.
Turning to the FSTE 250 and a number of the largest companies in the index are dropouts from the FTSE 100. This means that their long-term share price performance will not have driven the FTSE 250.
The largest FTSE 250 company that is not a FTSE 100 dropout is the engineering group Spirax-Sarco (SPX). The company has proven to be an excellent compounder for investors with the shares up more than ten times since 2004.
Spirax-Sarco is the “first for steam solutions” – did you know that?
A FTSE 250 driver: Spirax-Sarco Engineering
Source: Google Finance.
Mid-cap stocks: advantages for investors
The mid-cap space has some attractive structural features. It offers more choice than the FTSE 100 and at the same time, liquidity is better than you will find with small-cap stocks.
The FTSE Small-Cap Index does have 290 companies but only 222 are worth more than £200 million. Additionally, some of its larger components are illiquid and hard to trade in such as the real estate group Daejan (DJAN).
UK mid-cap stocks market cap range: £5bn to £600m
When the question of what a mid-cap stock comes forward the answer might be: how long is a piece of string. In the UK the FTSE 250 is considered to be a mid-cap index and consists of the next 250 largest companies below the FTSE 100.
The FTSE 250 at the top end has a couple of companies that are valued at over £5 billion and at the lower end they are valued at close to £600 million. This is therefore effectively the current valuation range of mid-cap companies in the UK.
Time to also consider AIM stocks?
The AIM market has 41 companies that are currently valued between £5 billion and £600 million. AIM does get a bad rap but many of the largest companies now appear to be reasonable quality.
AIM has been through two booms and busts with the first during the dot com boom and the second the resources boom. The market finished lower in the bust following the two booms with the AIM index hitting a low of 373 in 2009.
AIM All-Share Index since launch: will a third bull market deliver long-term returns?
Source: Google Finance.
The largest companies on AIM today are generally profitable and in many cases benefit from secular growth drivers. The largest group is the online clothing retailer ASOS (ASC) and Fevertree (FEVR) is in second place.
The litigation-funding group Burford Capital (BUR) is in third place and then the Chinese biotech group Hutchinson China Meditech (HTCH) is in fourth place. While both companies are esoteric they appear to have strong prospects.
The fifth largest company on AIM is the biotech group Abcam (ABC) and then the online clothing group Boohoo (BOO) is in sixth place. The robotic software group Blue Prism (PRSM) in seventh place does tend to elicit mixed views from investors.
Ten largest companies on AIM: only two are loss making
A number of fund managers have avoided the AIM market but have recently come to regret it. This doesn’t mean that the AIM market isn’t in a bubble but the quality of the largest companies on AIM does appear to have improved.
For example, Abcam (ABC) is a high quality life sciences company on AIM; its lease adjusted ROCE excluding goodwill is currently 27% and the operating margin is close to 30%. The group has been able to reinvest earnings to further grow the business.
Abcam is a success story that has been under the radar for many
Excluding AIM would mean missing out on growth stories like Abcam
Source: Google Finance.
Mid-cap funds: passive and active
For investors interested in funds, one option is to buy a FTSE 250 ETF such as the Vanguard FTSE 250 UCITS ETF (VMID). This excludes the AIM market, which clearly has potential advantages and disadvantages.
Another option is to find active funds that focus on the mid-market such as Investment Trusts. One example is the Mercantile Investment Trust (MRC), which appears to mainly invest in FTSE 250 companies.
The Investment Trust’s benchmark is the FTSE All-Share index excluding FTSE 100 companies and investment companies. At the end of January 2018, the fund was 80% exposed to FTSE mid-sized companies while 3.4% was in AIM.
Mercantile Investment Trust is up 580% since 25 March 1996 versus the 378% increase for the FTSE 250 index. The recent performance has also been good with the fund outperforming over a 1 year, 3 year and 5 year period.
Mercantile Investment Trust performance: steady results
Source: Mercantile Investment Trust factsheet.
There is a wealth of other funds to choose from including other Investment Trusts and open-ended funds. A number of funds have outperformed Mercantile in large part by taking larger positions in AIM shares that have performed well.
Mid-cap stocks: around 300 to choose from
Selecting mid-cap stocks is not an onerous task with 41 AIM stocks to choose from and 250 companies in the FTSE 250 index. However, there tends to be more media coverage of blue-chips and small-cap stocks.
Blue chips often make it into the news given their size and the impact that any large changes have on UK jobs and investment returns. Small-caps make it into the news because they can be exciting and fast-moving.
This suggests that the mid-cap space may be somewhat overlooked by the media and investors. The three largest FTSE 250 groups – Wood Group (WG.), Spirax-Sarco (SPX) and Phoenix Group (PHNX) – are hardly household names.
The largest companies on AIM do have a higher profile and have delivered strong shareholder returns. However, some of the companies may still be overlooked given their somewhat esoteric business models i.e. Burford Capital (BUR).
It can also be worth classifying mid-cap stocks in terms of how they have fallen into the market cap category. Some dropped out of the FTSE 100, some are recent IPOs and others were previously small-cap companies.
Summary: don’t miss out on mid-caps!
Investment returns are greatly improved if investors start by finding the most attractive pond to fish in. Mid-cap stocks in the UK have outperformed the FTSE 100 and also the Small-Cap index since March 1996.
The drivers of this out-performance are likely to remain in place given the sector breakdown of the FTSE 100. It may be another story in the US where the largest listed companies are primarily from the fast growing technology sector.