Five reasons why UK mid-caps could be the big winners from here

I’m sure most people have heard of middle child syndrome. It is the belief that middle children are excluded, ignored, or even outright neglected because of their birth order.

The theory is that the oldest child is the authoritarian, burdened with the highest expectations, while the youngest is the spoilt baby who never rises above their siblings. Then there is the one in the middle – he or she is even-tempered but has trouble fitting in due to being sandwiched between the younger and older siblings.

It’s an argument which can be extrapolated over to the investment world in recent times. Large growth companies have stolen the headlines (think of the FAANGs or Magnificent Seven) due to their unprecedented levels of growth, while smaller companies have proven themselves to be exceptionally resilient.

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The story is no different in the UK, where FTSE 100 companies are known for their global revenues and strong dividend features, while for long-term investors, UK small-caps have been the gift that keeps on giving from a performance perspective.

Then there are the mid-sized firms. They have traditionally offered the best of both worlds but things have broken down in recent years amid Brexit, Covid and general economic uncertainty.

Figures dating back to 1955 show UK mid-caps have delivered an average real return of 7.8% annually*. That mix of global leaders and burgeoning businesses has meant they also typically outperformed the FTSE 100, producing an average annual return of 8.3% vs. 4.8% in the past 25 years**. But the past five and 10-year figures show a reversal in fortunes, with the FTSE 100 producing stronger returns.

That reversal has posed questions about this segment of the market. The rise of passive investments (which have a heavy focus on larger companies) have played a part in this reversal – as has the growing desire to have exposure to the US tech behemoths driving the market.

Another major concern is that both defined benefit pension funds and insurance firms have continued to de-equitise from UK PLC. Around 40% were held in UK equities in 2000; it is now closer to 4%***. This number is far lower than many of the UK’s international peers.

We’ve also seen a continued fall in foreign investment, as love for UK equities has waned across the market, since the Brexit vote in 2016. However, there is hope on the horizon for UK mid-caps.

Five reasons why investors can be confident

1. Leading out of a challenging period

Mid and small-cap companies tend to be hit hardest when markets enter challenging periods, however they also lead the recovery on the way out. This is highlighted by the fact that UK mid-caps have historically outperformed the broader market following the first cut in interest rates, paving the way for sustained growth over several years. Between 1990 and 2023, mid-caps have typically returned 24.2% over the next three years following an initial rate cut (vs. 7.1% for the wider market)*. As economic momentum gathers pace, mid-cap stocks are well positioned to become market leaders.

2. Earnings per share look attractive

The FTSE 250 now looks incredibly cheap versus its own history. The price to earnings (PE) ratio, or Price to Earnings Multiple, is the ratio of share price of a stock to its earnings per share. PE ratio is one of the most popular valuation metrics of stocks. It provides an indication of whether a stock, at its current market price, is expensive or cheap. It currently stands at 12.9x for the FTSE 250 index (well below the long-term average of 19.7x)**. To put this into context, the S&P 500 (where the large tech and AI-driven companies sit) stands at 22.6x. The anomaly is that over 25 years the FTSE 250 has delivered better earnings per share growth than the S&P 500 (6.4 vs. 6.3%)** – indicating this is a great long-term opportunity.

3. Pension outflows have bottomed and there is hope for an upturn

One of the biggest challenges has been the unloved nature of UK equities. However, there are positive forward looking because there is simply not much further for this exposure to fall, with the pain mostly felt in the mid and small-cap space. Importantly, there is cross-party support to inject money into the UK market through initiatives like the British ISA and ambitions to mandate more money into UK equities through pension schemes.

4. Yields are attractive on the FTSE 250 making it a true income option

The de-rating of mid-caps means the yields are a lot more attractive than they have been historically. As of writing, the dividend yield on the FTSE 100 is 3.57%, while the FTSE 250 is slightly lower on 3.2%****. This gives investors more companies to consider (less concentration risk from the names in the FTSE 100) as well as the potential for greater capital growth from these mid-cap businesses.

5. Buybacks and M&A activity

Buybacks – companies buying their own shares – are also on the up, an indicator that the boards of these companies think their shares are currently cheap. As for mergers & acquisitions (M&A), these have also risen. Last year there were 40 public market M&A transactions of more than £100m, with an aggregate value of £21bn. All of them were for mid and small-cap companies – with the average premium to the current share price at 51%^.

Where to invest

If you believe UK PLC is unloved, it is hard to ignore mid-caps as a starting place. They have been hit hard but retain strong growth characteristics, with many companies continuing to have strong balance sheets.

Pure growth investors may want to consider the IFSL Marlborough Multi-Cap Growth fund. Managed by Richard Hallett, the portfolio - which has almost quarter of its assets in mid-caps^^ - typically holds between 40-50 stocks, with a one-in, one-out limit and each stock taking a maximum of 4% of the portfolio. Another to consider is Liontrust Special Situations, which has almost 30% in mid-caps^^.

Those looking for an income angle might consider the Rathbone Income fund, managed by Carl Stick, which has 20% in mid-caps and currently yields 4.5%^^. For those looking for a sustainable yield, in both senses of the word, they might consider the Janus Henderson UK Responsible Income fund. The fund has historically held a mid-cap bias and yields 3.9%^^.

*Source: Martin Currie, Are UK Mid-Caps set to shine?
**Source: Schroders, 26 June 2024
***Source: Jupiter, What’s new in UK Mid Cap?, 11 June 2024
****Source: Dividenddata.co.uk, July 2024
^Source: abrdn, 27 May 2024
^^Source: fund factsheet, 31 May 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.