One of the great advantages of running a dedicated mid-cap fund is that you don't have to follow t...
One of the great advantages of running a dedicated mid-cap fund is that you don't have to follow the herd mentality. All too often, so-called blue-chip fund managers slavishly model themselves on the overall shape of the index.
The problem is the structure of the UK market. It is dominated by just a few stocks and a handful of sectors. For example, the largest 15 stocks account for more than half the market's value. Moreover, by sector there is a level of concentration that brings into question any notion of a sensible spread of risk. Oils, banks, telecoms and pharmaceutical stocks account for more than 60% of the value of the FTSE 100 index. By contrast, the Mid 250 index offers much better diversity. It takes 60 stocks to get to half the index value and the sector spreads are much more even. Investors should therefore question whether these dominating sectors and stocks are what they would choose to invest in or whether their fund managers are just hugging the index for the sake of it.
Once liberated from the chains of the index, the first advantage you experience in mid-cap stocks is access to faster growing companies. The bigger a company gets, the more likely it is to be dominated by external factors such as regulation, competition and the overall level of GDP, which can restrict growth prospects. In contrast, medium sized companies often provide specialist or niche products and services that can grow at well above the rate of larger companies.
Take the dominant sectors in the FTSE 100 mentioned earlier. For oil exposure, medium sized oil and exploration companies offer potentially much more exciting returns than the integrated ones (BP and Shell) because incremental oil discoveries will have a greater impact on the bottom line. Alternative energy also offers higher growth prospects such as distributed power, which is why Turbo Genset looks interesting.
In pharmaceuticals, the larger companies are experiencing slowing earnings growth. Even where potential new blockbuster drugs are expected, they may end up merely replacing the turnover of older drugs coming off patent. By contrast, the mid-cap area offers companies with exciting drug pipelines and good cash flow, which should generate returns far in excess of their larger counterparts. Galen, Bioglan and Shire Pharmaceuticals are good examples.
Telecoms companies are also having a torrid time at the moment as they grapple with rising investment costs and falling prices. Telecom volumes are growing rapidly at the moment, but it's much easier to play this sector via mid-cap companies that supply the telecom operators and have pricing power as well as volume growth.
As for the banks, the prospect of recession means the possibility of bad debts and margin pressures. Investors can avoid this problem by investing in mid-cap financials like Cattles, a company with the ability to grow whether the economy is expanding or not. Another example is Man Group, an asset gatherer with specialist skills in great demand at present.
If you are the sort of investor that prefers to back value stocks, the best hunting ground will be found in the mid-cap index, rather than the FTSE 100. As the graph shows, a savage derating of mid-cap stocks took place between 1997Ã2000, which resulted in mid caps being rated at a 40% discount to the FTSE 100. Since then, mid-caps have started to come back into favour but they still sit on a 20% discount to the FTSE 100, so this rerating may have further to go.
One explanation for the valuation difference between mid-caps and FTSE 100 companies is liquidity. The liquidity driven bull market we have experienced in the last few years, fuelled by massive flows of mutual fund money into equities, tended to favour the larger blue chip companies. But when that liquidity started to dry up, as it has done, fundamentals began to reassert themselves. Bargain hunters have not been slow to recognise this and the spotlight today is very much focused on undervalued mid-cap stocks.
Mid-caps also have advantages over small companies as well as larger ones. One important issue is the relative ease with which fund managers can buy and sell mid-cap stocks compared to small-caps. When a small stock goes out of fashion and you want to sell it, it is often very difficult to find a buyer willing to take it off you, whereas mid-caps are much easier to trade in.
General business practice can also be a problem with small companies. In my experience, by the time a stock is approaching the point of entering the mid-cap index, typically around £350m in size, many of the teething problems that small businesses often experience have been ironed out. The challenges facing small-cap managers include dealing with poor financial controls, lack of compliance with the Cadbury code, weak non-executive directors, inexperienced operating management and a general lack of independent research material.
One other factor worth mentioning is the more sophisticated use of intellectual property in managing businesses. In the past, smaller companies with a good product or service used to go cap-in-hand to a large company for capital, expertise or distribution power, only to have their birthright, their intellectual property, bargained away from them in the negotiating process. This often left the originator with a pitiful proportion of the future rewards.
Fortunately, there is much better understanding today of how to protect intellectual property through patents, copyright and design rights. The general awareness of the importance of intellectual property has been greatly aided by specialist companies that are experts in this field, such as BTG and Scipher, who can ensure the originator captures as much as possible of the potential upside.
Recent examples of hugely successful enterprises that have successfully channelled intellectual property to their advantage are ARM Holdings and Autonomy. They are showing the way forward for mid-cap companies, enabling them to strike better commercial deals and exploit their intellectual property to the maximum.
This is particularly important in the faster changing marketplace in which we all operate today. In fact, there have been a number of good examples recently of quite small companies capitalised at £300m or so who have become FTSE 100 companies in a matter of months, such as Baltimore, and Colt Telecom. This has presented investors with the potential to make 10 times their money in a short period of time.
I can't think of any FTSE 100 companies that are likely to do that today but I believe there are such candidates in the mid-cap sector and I plan to go on exploiting these investment opportunities.
The message is clear: professional and private investors alike should seriously consider holding a mid-cap fund to provide the prospect of higher returns and introduce an element of diversity to their portfolios.
Derek Lygo is director of equities at Dresdner RCM Global Investors
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