The past five years have been a mixed time for the UK mid-cap company universe as Brexit and then Covid-19 have led to bouts of market nervousness that have hit domestically-focused stocks particularly hard.
But since March 2020, and notwithstanding blips of market turbulence along the way, UK small and mid-caps have climbed fairly steadily. Although uncertainties remain, concern regarding the financial impact of the pandemic has receded and government support has enabled UK businesses to continue to keep the lights on. Over the past year in particular, successful trials and roll-out of the Covid-19 vaccine, plus a recognition that both small and mid-caps had become substantially undervalued have helped many of these companies to power ahead.
So what further mileage has the mid-cap universe got from this point on and what are the potential risks for investors in this space? Well, looking at risks first, investing in smaller and medium-sized companies can be riskier than investing in their larger counterparts while focusing on a particular country – the UK in this instance - adds a layer of country-specific risk. Nevertheless, as markets strive to achieve post-Covid 19 normality and post-Brexit trade evolves, we would argue that there is potential upside, with strong performance of selective mid-sized UK companies likely to be driven by a number of factors.
First, the UK continues to see a robust economic rebound as consumers spend savings accumulated during lockdown. Indeed, economic recovery has been a lot stronger than expected while unemployment levels have remained lower than feared – even following the end of the government’s furlough scheme. Indeed, in its economic and fiscal outlook published on 27 October 2021, the Office for Budget Responsibility forecast year-on-year GDP growth of 6.5% in 2021 and 6% in 2022, falling back to 2.1% in 2023.
Recent concerns over fuel supplies and rising gas prices caused non-essential spending growth to slow a little (12.9% in September 2021 compared to 15.8% in August 2021 according to Barclays’ UK Consumer Spending Report for September 2021. But with UK households having built up over £150 billion in excess savings, we believe discretionary spending still has much further to go.
Second, greater trading certainty in a post-Brexit world is helping to support earnings prospects. UK corporate earnings are expected to grow 27% in 2021 and 13% in 20221 – and we believe mid-caps that meet our criteria for quality can grow faster than this. Finally, attractive mid-cap valuations are encouraging merger and acquisition activity, which seems to inject further dynamism into the sector.
For all these reasons we are very positive on mid-caps and on consumer discretionary stocks in particular. Half – 50.7% as at 31 October 2021 – of our portfolio is currently allocated to consumer discretionary compared to 26.8% for the benchmark. A number of these companies have performed very well for us during lockdown and continue to do so.
UK media company Future, for example, is currently our biggest holding, accounting for 5.7% of the portfolio as at the end of October 2021. Future is skilled at two essential things: producing content cost-effectively then monetising it effectively. This has allowed it to acquire media content businesses, reduce their costs and harness income streams from their assets very efficiently. The combination of M&A, strong organic growth, margin improvement and high cash conversion has allowed Future to deliver repeated earnings upgrades over the past three to four years.
Miniature wargames maker Games Workshop, our second-largest holding at 4.0% (as of 31 October 2021), has also been growing rapidly, has strong margins (43% operating margin in 2021) and returns all surplus cash to shareholders. Despite recent cost pressures, its top line has still been growing, thanks in part to the relaunch of the Warhammer 40,000 franchise (the most popular miniature wargame in the world). It also has huge intellectual property potential; Games Workshop IP features in major video game releases and it is starting to produce and monetise its own animated video content.
Pets at Home (3.6% of the portfolio as of 31 October 2021) was originally a holding after delivering impressive like-for-like store sales growth, having reset prices to be competitive both offline and online. Other factors have since driven performance. A data-led view of customer lifetime value is enabling the business to target a long duration of sales (food, accessories, vet services and even grooming) over the life of a pet. Its Pets at Home Vet Group joint venture partnerships are set to become highly cash generative. Finally, an increase in the UK pet population during Covid-19 is providing a structurally larger market.
Plenty of uncertainty remains as to how the pandemic endgame will play out with Omicrom’s recent emergence as a ‘variant of concern’ impacting sentiment at the time of writing. Concerns over supply chains, inflation and the prospect of rising interest rates will no doubt continue to have an impact. Our response is to seek out and hold companies that we believe can weather these issues more successfully than their peers, for example by being a key supplier (Watches of Switzerland and Rolex, or JD Sports and Nike, for example). Despite the recent difficult backdrop such stocks have continued to see strong earnings upgrades, with scope for profit margin expansion ahead.
As the UK edges closer to normality post-pandemic and post-Brexit, we expect a further rebound in the economy that should benefit these and other mid-cap holdings in our portfolio. But active, high-conviction stock selection remains key.