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Our views 04 March 2022

Why are mid caps underperforming?

5 min read

The FTSE 250 ex IT's underperformance against its larger cousins has been stark, with the index down over 10% since January. It has underperformed the FTSE 100 by 11.4% YTD and by 16.3% over 12 months on a total return basis. 

Historically the index has been regarded as a rich picking ground for high growth, quality companies with more of a tilt towards domestic companies and a lower weighting in the energy, commodities and financials sectors. This explains some of the premium valuation relative to the FTSE All-Share. The constant refresh of the universe due to Initial Public Offerings (IPOs), merger and acquisition (M&A) activity and promotion or demotion of companies into and out of the index has made this market segment a fertile hunting ground for portfolio managers. Furthermore, the inefficiency in stock market pricing has been exaggerated by the fall in analyst coverage since MiFD II.

Over the long term, investing in UK mid caps has been an astute asset allocation call within the UK market with the FTSE 250 ex IT rising by c. 125% over the last 10 years outperforming the FTSE All-Share (+87%) over this period. However, inflation and the resulting increase in the discount rates has cast uncertainty over potential future growth aspirations. This has led to a sharp de-rating of those higher value, quality name such as Genus, Aveva, and Games Workshop, with some companies down by more than 20% YTD. At the same time, with concerns about the health of the UK consumer, the index has suffered from its high exposure to consumer discretionary stocks as well as its lower weighting in commodity/energy stocks (as commodity prices surge) and the large banks that are generally seen as beneficiaries of rising interest rates. Finally, the market’s latest move into safe havens like big pharma and consumer staples has favoured the FTSE 100.

Our mid-cap Growth strategy has a bias towards quality stocks, with strong balance sheets that have the right key fundamental attributes, combined with a secular market growth opportunity to sustainably grow into large caps. Consequently, the fund has suffered disproportionally during the current market rotation after a strong 2021. Our portfolio tends to have a higher PE relative to the index reflecting its superior characteristics in terms of earnings growth, profitability, return on equity and lower gearing at the stock level (as expressed by net debt / EBITDA). However, the current earnings season has reinforced the benefit of our focus on the key fundamental attributes. As a result, portfolio companies should be best placed to preserve pricing power and use innovation to improve productive efficiencies and/or reduce their cost bases accordingly. So far, we have not seen any material change in earnings guidance and indeed there remains upside earnings opportunities for many in 2022. Our focus on cash flow and balance sheet optionality means that the solvency of our portfolio holdings should be less impacted by the sharp increase in credit spreads and higher interest rates. Furthermore, they remain well positioned to self-finance growth capital expenditure throughout the cycle. Given the strong long-term growth prospects of the asset class which are less linked to macro factors like commodities and bond yields, we believe that the market will eventually return to focusing on fundamentals and reward ‘Growth at a Reasonable Price’ investors.

 

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.

The Royal London UK Smaller Companies Fund and Royal London UK Mid Cap Growth Fund are sub-funds of Royal London Equity Funds ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000807. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.