Finding Value and Opportunity in UK Mid Caps By Richard Watts

There are some good reasons to know all about mid cap stocks

So far in 2019 there has been a reversal of the Q4 market situation. The Fed has halted monetary tightening and there’s been a strong recovery in US stocks that has benefited small and mid caps in the UK. In addition, although the Brexit end game remains unforecastable at the time of writing, we see more likelihood of a favourable agreement that should be positive for UK stocks.

Since the start of Q4 2018, we moved from underweight to neutral in UK domestic cyclicals, and they have rebounded quite strongly – this has been good for the portfolio. We did this by adding to holdings in builders Barratt Developments and Taylor Wimpey, and we initiated a holding in Persimmon. In addition, we added to our position in real-estate company Workspace.

We funded this increased position in domestic cyclicals by reducing exposure to international cyclicals. We didn’t want to introduce more economically sensitive stocks into the portfolio in the current low-growth economic environment, so we took international cyclicality down and domestic cyclicality up. Given the relative cheapness of UK domestic cyclicals, we shifted our focus there.

The fund continues to be tilted toward structural growth stocks as that is the nature of the mid cap market. We believe the low-growth, loose-monetary-policy world should favour structural growth stocks such as Fever-Tree, Blue Prism and boohoo. We have topped up our holdings in boohoo. These structural growth stocks have rebounded from their declines in 4Q, which has been positive for performance over the early part of 2019.

UK assets have been unloved and investors are underweight the UK market, especially international investors. This reflects the Brexit uncertainty and the potential for a Corbyn-led government. International earners have outperformed UK domestic-facing stocks by 70% since 2016, the year of the Brexit referendum.1

As a result, the FTSE 250 is trading on less  than a 0.5 P/E point premium versus the more defensive and international FTSE 100, where historically that premium has been 1-2 P/E points.2 Normally, the mid cap index trades at a discount to FTSE 100 only in times of financial stress, such as the 2008 financial crisis, after the 2016 referendum and when there is an expectation of recession.3

Excluding the impact of Brexit uncertainty, the underlying UK economy is in good shape. The risk of recession is low, employment and wage growth are strong and inflation is below target.

We believe that in the case of a soft Brexit or no Brexit, UK stocks would rerate and mid caps would rerate meaningfully vs large caps, helped by stronger sterling. We would expect any such rerating to be led by UK domestic cyclicals, which could potentially have high single-digit rates of mid cap earnings growth.

That would be a pretty powerful return. More delay on Brexit, while it wouldn’t be a positive catalyst, probably doesn’t carry downside risk. Crashing out without a deal would be viewed as negative by the market and therefore wouldn’t be good for UK equities, but we think the chance of this is remote.

In summary, UK mid cap equities are undervalued, even after the 1Q rebound from 4Q, in our view. A Brexit solution that the market views as favourable could potentially bring significant upside. We believe the fund’s exposure to fast-growing companies such as boohoo and Fever-Tree and to cheap UK domestic cyclicals provides good positioning to take advantage of any potential opportunities this year.

1 Merian Global Investors, as at March 2019

2 Bloomberg, as at 4/1/2019

3 Bloomberg, as at 4/1/2019

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