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Cap fight

Matt Goodburn gauges debate on whether to invest in mid caps or large caps

Size matters but do you want to go for big or medium in the current investment climate? Mid-caps have outperformed their blue- chip counterparts consistently for the past three years, helping to propel mid-cap funds, including Schroders’ mid 250 and Old Mutual UK select mid-cap, to the top of the performance charts.

But with mid-caps harder hit in the recent market sell-off, many investors are wondering whether FTSE 100 or FTSE 250 stocks offer the best opportunities.

Credit Suisse multi-manager co-head Gary Potter believes that calculating whether large caps are better value than mid-caps is down to where you believe we are in the economic cycle.

He says: “From today’s mid-caps, you get the large caps of the future so I believe you need some mid-cap exposure.”

Potter believes that purely from a valuation point of view, large caps look reasonable at present. He believes that over the next few months, the potential for economic slowdown will help result in large caps outperforming.

“On pure profit to earnings ratios, bigger companies do look better value than they have for some time. Mid-cap growth companies tend to operate better in strong economies. Right now, large caps offer better risk return characteristics because they are paying less in valuations and they tend to have strong balance sheets,” he says.

Potter believes, however, that such a premise is over-simplistic because there are many examples in the mid-cap area of vibrant businesses growing faster than their large-cap counterparts.

Investec blue-chip fund manager Christine Baalham believes that the investment case for large caps v small caps is not simply a case of picking one over the other and sees merit in both areas.

She says: “It is certainly true that mid-cap stocks have had a fantastic run since the market bottomed in 2003, buoyed by a high level of corporate activity and strong earnings’ growth. In contrast, the biggest stocks in the index have suffered from large-scale institutional selling as pension funds have lowered equity weightings and active fund managers have increasingly moved towards unconstrained mandates.”

Baalham believes that despite the recent correction in the market, valuations of mid-caps are currently less attractive than their blue-chip counterparts.

“Even accounting for the recent pullback, the valuations of mid-caps have been pushed to historically unattractive levels relative to the FTSE 100. The FTSE 250 index trades on over 16 times earnings compared with only 12 times for the FTSE 100 and while some of this differential can be accounted for by sector weightings, not all of it can,” she says.

Baalham says large-cap balance sheets are currently less geared compared with mid caps and, combined with the current strong cashflow generation, this points to healthy company capital management. “This is leading to an increasing use of share buybacks and special dividends to return excess capital to shareholders, a sign of good capital management,” she says.

Threadneedle mid 250 fund manager Simon Haines believes plenty of growth opportunity remains in the mid-cap sector for stock-pickers prepared to weed out the success stories.

Haines looks for structural growth stories within the FTSE 250, especially where the company occupies a specific niche in the market.

He sees value in mid-cap leisure stocks as well as oil exploration and bus and rail stocks, which offer the promise of steady and predicable cashflow, but he is avoiding industrial cyclical stocks and stocks which have a big amount of dollar exposure.

Haines says mid-caps are starting to bounce back. He says: “Overall, in the last rolling quarter, mid-caps have underperformed the FTSE 100 by around 4 per cent.”

Haines believes this has happened partly because the industry has evolved, with more retail investment houses and hedge funds launching high-alpha products as investor appetite for risk had increased dramatically up to the fallback in May.

He says: “There is now a lot more tracking money surrounded by high alpha mandates. These managers are looking through mid-caps for high-alpha income stories, as are hedge fund managers. Consequently, the mid-cap valuations have been pushed up to a premium on the FTSE 100 stocks.”

Haines believes the way to keep unlocking mid-cap value is for managers to be more selective in their stockpicking. “It is harder now but the star companies are still there,” he says.

Zurich fund development director Peter Davis believes the nature of the potential economic slowdown will determine how the two sectors continue to perform.

Davis believes that picking one over the other to outperform is almost impossible because there are good and bad companies in both sectors.

He says: “Mid caps have outperformed large caps for a number of years but in the last three months, they have slightly underperformed them although this does not mean that there is market sentiment against mid caps.”

Davis believes that both are necessary for building a balanced and effective portfolio. He says: “We would look for a bit more concentration in mid-caps when building a portfolio but would want mid, large and a small amount of small cap exposure also.”


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