Royal London’s UK mid-cap growth fund recently registered its fifth anniversary as one of the best-performing vehicles in the UK all companies sector.
Current manager Derek Mitchell has been at the helm since 2009, replacing Leigh Himsworth, and is positive on equities despite the current mid-cycle slowdown.
He builds the portfolio from the top down, developing a macro framework from researching and meeting companies and then buying stocks best-placed to perform in the prevailing environment.
This is clear from the big portfolio shifts in recent years, with the fund cutting safety-first sectors such as utilities, pharmaceuticals and food producers as soon as the rate of economic decline slowed in 2008 and quickly moving to a pro-cyclical stance.
Additions largely focused on the industrial space in areas such as engineers and support services and this call benefited performance as cyclicals led the market through most of 2009 and 2010.
“Most cyclical stocks rise during a recovery phase so our job was to find the strongest companies, such as IMI and Weir Group, which both moved up to the FTSE by dint of stellar performance.”
Such promotions have reduced the fund’s cyclical bias to some extent and Mitchell has also been trimming positions as the initial recovery stage runs out of steam.
He has taken profits in companies such as chemical firm Victrex and industrial engineer Fenner.
He says: “Despite out-performing large caps of late, mid-caps have not been immune to the poor newsflow and what we are witnessing is a mid-cycle slowdown, with volatility to reflect this.
“However, the broader spread of businesses found within the mid-cap index has limited the extent of under-performance relative to the less diverse FTSE 100, which is highly concentrated in the poorly performing banks and mining sectors.
“I have been gradually reducing industrial cyclical exposure to mitigate against slowing economic growth, while adding to other sectors such as aerospace and defence, travel and leisure, financial services and IT software.”
With that in mind, he notes recent performance-drivers have been diverse, including buy-to-let lender Paragon, oil services provider Cape, consumer electronics company AZ Materials and cash & carry operator Booker.
Mitchell remains positive on mid-caps in general, largely because of activity to cut costs in 2008/09, when consensus suggested the world was heading back into a 1930s-style recession.
“Things turned around very quickly, leaving many companies with cash on their balance sheets, allowing them to pay down debt and sort out pension funds. Many are now looking at how to use the remaining cash, with robustly financed companies either paying dividends or exploring M&A opportunities.”
Mitchell sees this as a big positive for the overall equity market, providing a cushion against any short-term risk.
“Further market weakness could lead the pace of M&A activity to increase, potentially providing further support for mid-cap stocks as they are more likely to be acquired than acquire,” he says.
“We have actually been disappointed by M&A so far, with many UK plcs still cautious in the aftermath of the credit crunch. But several international players are flush with cash and we expect deals in industrials, for example, where companies such as Invensys could be taken out.”
Another key theme for Mitchell is overseas earnings, particularly with the rate of UK growth at less than half that of the world as a whole and one-third of emerging markets.
“With the UK consumer all but disappearing, we are focusing on stocks with con-siderable overseas exposure and moves to outsource production overseas have already seen many British firms move away from low-growth economies,” he says.
Mid-caps are generally seen as more of a domestic play but Mitchell says around 50 per cent of their earnings now comes from abroad, against 70 per cent from the FTSE 100.
Outside industrials, the manager also notes Ashstead Group as among his top performers, with the generator rental company largely exposed to the US market.
Mitchell says US firms are gradually moving away from buying this equipment towards renting and the company emerged from the downturn in a strong position.
Babcock is another favoured name and the outsourcing stock is expected to prosper as the UK Government increasingly beats the austerity drum next year.