UK equities
06 Nov 2020 | By Richard Watts

The Dynamic and Diverse Universe of UK Midcaps

UK mid caps are a dynamic part of the market offering a tremendous range of stock picking. Richard Watts, Head of Strategy, UK Small & Mid Cap, explains how the deep and wide mid cap universe can offer opportunity amid challenges such as Covid-19 and Brexit as he also looks forward to 2021.

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Does 2020 feel like it has gone by quickly, or slowly? For many of us it probably feels like a strange mixture of the two, but for the world’s business environment there’s no doubt: the year has gone by at supersonic speed.

One of the clearest impacts of the Covid-19 pandemic has been the dramatic acceleration of the digitalisation of the global economy. Of course, this is a long-term structural shift that has been ongoing for some time, but the sudden disruption to working practices have seen several years of progress happen in just a few months. As so many people now spend a larger portion of their lives working, shopping and being entertained online, ‘new world’ economy sectors have very rapidly displaced ‘old world’ ways of doing business.

 

‘New world’ stocks are well represented among UK mid caps

This impact can be seen in a wide array of sectors, including ecommerce, media, information technology, business services and fintech. The UK mid cap universe has a diverse range of dynamic companies that are able to capitalise upon these accelerating trends, a pool of opportunities that widens further if you include equivalently-sized companies listed on AIM.

Those include global players too, including industrial stocks operating in high growth areas such as electronics and precision measurement. Software is another area that is well represented in the midcap space, both for business applications and gaming. These are all areas that we already saw as attractive before the pandemic and we took advantage of the market rout in March, when basically everything sold off, to back that conviction further.

 

Opportunities remain in ‘old world’ sectors

But what about the other side of the story? The rapid digitalisation of the economy over the past few months has hastened the demise of sectors that were already in long-term structural decline. That’s why, despite the ultra-low valuations, we think it’s important to be very selective about bargain hunting for value stock in this environment – but that doesn’t mean opportunities can’t be found.

Covid-19 has also taken a heavy toll on sectors that aren’t facing structural barriers. Housebuilders and airlines are prime examples, both these sectors have struggled a lot this year but we fundamentally do not see them as doomed business models. Quite the opposite: they are essential and at no risk of being replaced with some sort of ‘digital’ equivalent. True they may need to adapt, particularly the airlines, but the strongest among them will undoubtedly thrive into the future.

The obvious next question, then, is what might be the catalyst for such stocks to re-rate? I would expect an economic recovery in 2021, and the data will look less bad as it comes off a lower base. Many beaten-up stocks in challenged but fundamentally sound industries should perform strongly in that environment – it’s an area where we’ve been looking to increase exposure.

 

The key issues for UK equity investors

As we head towards the end of this year, I see a couple of important considerations right now for UK equity investors looking to position their portfolios for 2021. The first is Brexit. A lot still remains possible, even a few weeks before the transition period is due to end, but my own view remains that the most likely outcome is some sort of trade deal with the European Union. Perhaps just a bare bones deal, but a deal nonetheless, and that’s all that is required to remove the cloud of ‘Brexit uncertainty’ that has been hanging over the UK market since the 2016 referendum.

The other issue, of course, is what might happen with Covid next year. None of us can be sure how it will play out, but the news flow on vaccines does seem to be trending in an encouraging direction. From a purely economic standpoint, whatever vaccines do get approved don’t even need to be perfect right away, they just need to be good enough to stop the exponential spread of the virus, allowing governments and business to get on top of the situation and a far greater degree of normality to return. Even without a vaccine, we’ve already seen how the medical profession has learned a lot about how to effectively treat the virus over the past few months.

An acceptable Brexit outcome and light at the end of tunnel for the pandemic could all be big positive catalysts for the UK market. On another level, I’m optimistic that 2021 could bring a reinvigoration of the IPO market in the UK, which has slowed down a lot in the last 5-6 years but is already showing tentative signs of picking up. For all these reasons I think next year has the potential to hit a sweet spot for the UK equity market, and as a result I feel very constructive on UK mid caps.

 

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