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Adviser  >  News  >  June 2008  >  Where next for UK mid-caps?

Where next for UK mid-caps?

2007’s credit crunch, and the market turbulence that came with it, brought a halt to a four-year run of stellar returns from the UK’s medium-sized companies. The big question is: Is this now the end of the line for UK mid caps, or is this actually the time to be tapping in to their superior long-term growth potential? We spoke to Andy Brough, manager of the Schroder UK Mid 250 Fund, about his views on the subject and how he has been positioning the fund in response.

2007 was a tough year for mid caps and things have been pretty dire since the beginning of the year. What would you say to people who are thinking about giving up on this area of the market?

Now is not the time to be selling. 2007 was certainly not one of the better years for the fund and the last eight months have not been great for mid caps as a whole. However, we’ve had setbacks of this degree before – and a lot worse – and both the fund and the market have bounced back strongly. Take 2002 for instance. Mid caps fell 25% in 2002, but in 2003 they came back with a return of over 40%. So while things have been more painful recently, that needs to be set in the context of the exceptional returns mid caps have generated over the long term.

Indeed, since November 1999, mid caps have returned an average of 9.0% a year. Put that against the FTSE 100 index, which has returned 2.0% per year, and consider the cumulative impact of that outperformance, and it is clear that mid cap investing is very attractive if you take a long-term view. The fact remains that these are some of the fastest-growing companies in the UK market.

Given the bad news we are hearing about the US and UK economies, though, are you worried about the outlook for earnings in 2008?

Companies are going to face greater challenges in growing profits this year, but we are relatively sanguine that many mid caps can still generate growth. At the moment, the market would have you believe that no-one is buying a car, no-one is going to nightclubs or pubs and that all the people in China have suddenly stopped spending their quickly accumulating wealth. But for all its importance to people in that particular region, the ‘credit crunch’ could be nothing more than a breakfast cereal.

There is an awful lot of fear and uncertainty out there at the moment. However, it is at times like these when you need to take a rational look at the market and assess what is actually happening with the underlying companies. There are many mid cap firms that have exposure to strong long-term growth trends and can, therefore, be largely unaffected by what is happening in the UK or US economies. If you take construction firms like Carillion or Balfour Beatty, for example, what happens in Dubai is probably as important as what is happening here in the domestic economy.

Are you only focusing on mid caps that are exposed to the faster-growing overseas markets then?

Not necessarily, no. We are certainly finding a lot of opportunities in companies that are benefiting from growth trends outside of the UK - like Hunting, a leading global supplier of oil well equipment, and conference organiser ITE Group, which has a dominant position in Russia and the CIS countries. However, we are also picking up shares in a wide range of more UK-focused names, particularly because many have been given such a beating by the market in recent months.

Could you give an example of one of those?

Take FTSE 100 drop-out Daily Mail & General Trust. Having sold it when it joined the large caps last year at £8, we’ve been able to start a new position recently at around £4.50. People are still reading newspapers and to supplement that, the company has invested a lot of money diversifying into the internet and B2B.

Is that one of the more extreme opportunities you’ve been finding?

It has been an extremely attractive buying opportunity, but it’s certainly not an isolated case. In 20 years of managing money, I have seen a number of financial crises and a number of market setbacks. Yet, in all that time, I have never seen such a disconnect between the underlying strength of many UK businesses and what the market is currently willing to pay for their shares. While this is obviously disappointing for returns on a short-term basis, it has given us a great long-term opportunity in terms of picking up companies with beaten up shares but good market positions.

How confident are you about the fund’s potential over the coming year then?

It’s easy to say everything is going to be ok, but we’re fairly optimistic about 2008. The fear that is around at the moment is not going to go away overnight, but the thing that has turned it around on previous occasions has been takeover activity.

Companies tend to know better than anyone what their peers are worth, so when there are a lot of attractive and cheap assets about – as there are now – corporate activity tends to pick up significantly.

As far as the fund is concerned, the types of companies that we look for – unique companies, with healthy balance sheets and dominant market positions – tend to be strong as stand-alone entities, but are also very attractive to their peers. Takeover activity has, therefore, been of real benefit to the portfolio in previous years and we believe that that will also be the case during 2008.

Source for data: Schroders as at 29 February 2008, bid to bid with net income reinvested. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.