Good time to buy over-sold UK ‘mid caps’ before they rebound

UK equity fund managers Alex Wright and Jean Roche believe ‘mid cap’ and smaller company shares have suffered an ‘excessive de-rating’ this year that should pave the way for a recovery once stock markets stabilise.

UK equity fund managers Alex Wright and Jean Roche believe ‘mid cap’ and smaller company shares have suffered an ‘excessive de-rating’ this year that should pave the way for a rebound once stock markets stabilise.

Wright, lead manager of Fidelity Special Values (FSV ) investment trust and Fidelity UK Special Situations fund, and Roche, manager of Schroder UK Mid Cap (SCP ) investment trust, have struggled as their preferred hunting ground of opportunities outside the FTSE 100 has de-rated on fears of inflation and recession. The ‘mid cap’ FTSE 250 index has plunged nearly 21% this year, while the Numis Smaller Companies benchmark has fallen 18.5% compared to the more resilient 4% decline in the large company FTSE 100.

The UK blue-chip index has fared better during the aggressive rotation away from growth stocks because its weighting in oil and commodity stocks has benefited from the surge in energy prices and cost inflation, while defensive sectors, such as utilities and consumer staples, and cheaper ‘value’ areas like tobacco and financials have also done well.

Downturn priced in 

In an update this month, Wright (above), who runs his funds with co-manager Jonathan Winton, struck a bullish tone, saying market sentiment had recently become overly pessimistic and pointing to the attractive opportunities among cyclical mid and small caps that have ‘significantly derated’.

Wright, who will have overseen Special Values for 10 years in September, and who invests in a mix of large, mid and small-cap stocks, has fleshed out exposure to financials, industrials and consumer discretionary companies. 

The net asset value (NAV) of the £968m closed-ended fund has fallen 7.5% this year, behind the 4.6% decline in the FTSE All Share index. As investor sentiment has worsened, the shares have dropped nearly 12%, to stand on a 4% discount below NAV.

‘The funds’ structural bias to small and mid-caps and sector exposure (underweight oil and gas and mining, and overweight consumer discretionary) have proved a headwind,’ he admitted.

However, Wright was convinced that while the short-term economic outlook was challenging as central banks combat inflation and recession risks, a downturn is already priced into share prices.

‘We believe sentiment has recently become overly pessimistic. Cyclicals and mid and small caps, for example, have significantly derated reflecting excessively negative outlooks, which is presenting us with attractive opportunities,’ Wright said.

Wright topped up positions including Barclays (BARC) and Irish bank AIB (AIBG) following Russia’s invasion of Ukraine when share prices crashed.

He added to support services group Serco (SRP) and tobacco firm Imperial Brands (IMB), which have made good returns since. He made a partial switch out of Shell (SHEL) into Austria-listed oil and gas group OMV

Although UK stock market returns have been depressed in recent years, Special Values has outperformed the domestic market, helped by a 15% diversification to stocks in Europe and the US. Over 10 years, its 223% total shareholder return has proved much better than the 94.6% from the FTSE All-Share.

Roche barometer

In half-year results this week for the £230m Schroder UK Mid Cap trust, which Roche (above) has run with Andy Brough for nearly six years, the managers were cautiously optimistic given their sector’s historically cheap valuation levels and the Lloyds Bank business barometer’s 5% increase in May. This reflected an improvement in corporate confidence since February lows, despite the challenge from inflation.

Net asset value fell 11.4% in the six months to 31 March, slightly worse than the FTSE 250’s decline of 9%, with shares in the trust diving 18% to trail at a 15% discount to NAV. The shares have continued to decline since, falling 14% over three months, with the discount widening to 18% against a one-year average of 12% while offering a 3.2% dividend yield.

Like Special Values, the UK Mid Cap trust has delivered modest returns over three and five years but has nevertheless beaten the benchmark. Over 10 years a 170.5% shareholder returns is clearly ahead of the 113.5% from the mid cap index.

 

Roche (pictured above) and Brough made several changes to the portfolio over the half-year period, taking up positions in the property sector with Savills (SVS) and Sirius Real Estate (SRE), and adding to critical power solutions provider XP Power (XPP), shipping services company Clarkson (CKN) and mining equipment provider Weir (WEIR).  

‘There is no doubt we have seen a dip in consumer confidence more recently. It remains to be seen how this pans out over the rest of the year. Interestingly, UK corporates appear to be a lot more confident with the Lloyds business barometer showing a marked improvement in May,’ they wrote.

Industrials now constitute 34% of total assets, which is almost 13% above the index, according to the latest factsheet from May, followed by consumer discretionary, which makes up 20.5%. Top positions include Man Group (EMG), Spectris (SXS) and Diploma (DPLM), which make up 13.5% of total assets.

 

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