Mid caps stocks have outperformed their large cap counterparts by just over 107% (source Bloomberg 15th April 2011) over the last 10 years so what is it that has driven this outperformance?
The mid cap universe is made up of a mixture of companies - the ex-FTSE 100 companies that often provide excellent value opportunities as they fall out of favour with large cap investors and ex-Small Cap stocks that have excellent growth prospects. The J.P.Morgan Mid Cap Investment Trust exploits both of these opportunity sets, seeking out companies offering the best of value and growth.
Investors are currently focussed on the macro problems around the world in the wake of the financial crisis and the subsequent stress that public finances are under. Also of concern is a fear of increased inflation and most recently the unrest in the Middle East and it’s impact on the oil price. The ramifications of the current unrest will be felt globally. Oil prices have already risen in response to the disruption to supply. Continued uncertainty or more political change in the region could produce a further spike in the oil price which would act as a headwind to the fragile global economic recovery, we therefore expect markets to be volatile in 2011.
In the UK the consumer is facing a difficult year as public sector cuts and tax increases are implemented and the threat of inflation has increased the likelihood of interest rates rising this year. Food prices, vehicle tax and insurance, rail fares and petrol prices have all been rising strongly since 2009 and the offsetting deflationary influence of falling mortgage interest payments and clothing prices have now started to reverse.
Of course some inflation helps to make the debt burden more manageable and makes real assets such as equities more attractive. In fact UK companies have been benefiting in many cases from being able to pass on raw material price increases to their customers but have not been experiencing wage inflation as there is plenty of spare capacity in the economy. This has helped profit margins to recover strongly and together with the stockmarket equity issuance in 2009 means that, generally, small and mid sized quoted company balance sheets have been repaired. As order books and sales have grown there is a real sense of companies having recovered confidence and that they are returning to business as usual. This is being reflected in an increase in capital expenditure from the minimal levels of the last two years. Despite the strong recovery of the last two years, stockmarket valuations in terms of yield and price to earnings ratios still remain below the medium term average. Forecast dividend growth of 9% for the FTSE250 (source Altium Secs 18/04/11), ahead of the 8.6% forecast for the FTSE All Share (same source) while valuations remain undemanding at these levels with a forward price/earnings ratio of 12.1 times (same source) and earnings forecast to grow at 14.5% next year (same source).
As confidence returns we expect corporate activity to increase and that the targets will be strong well managed companies with substantial market shares or assets; just the sort of companies we invest in and which are plentiful in the mid sized market. This is borne out by the fact that there was significant merger and acquisition activities in the sector last year, as companies took advantage of their own financial strength to acquire earnings accretive competitors. We believe that this is a theme that will continue throughout 2011.
Increasing inflation and higher taxes in the UK perhaps represent one of the biggest threats to the mid cap sector. As a result we have positioned the portfolio so that we are underweight those sectors which are most exposed to inflation type risk and government cutbacks, such as retailers, construction and support services. Instead we have been focussing the portfolio on sectors such as basic materials, the gold miners particularly, water companies, which offer an inflation hedge and we have also increased our exposure to the non-life insurance sector, where we believe global events mean that insurance rates will rise going forward.
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