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Sector Focus: Mid-caps lead the way for UK equity funds

After a strong period for equities, it is little surprise to find mid-cap and high alpha portfolios leading three-year performance in the UK All Companies sector.

Top of the pile – more than doubling the 35 per cent peer group average over the period to mid November – is Neptune UK Mid-cap, and manager Mark Martin is confident his favoured sector can continue to outperform.

“The UK domestic recovery is gaining traction, as recent GDP growth figures of 0.8 per cent for the third quarter suggest,” he says. “As the FTSE 250 has greater exposure to the UK economy than the FTSE 100, this recovery is particularly encouraging.”

Martin also cites lower political risk for mid-caps, not suffering potential headwinds from regulation of energy companies, for example. 

He says: “Some mid-cap companies actually benefit from political and regulatory tailwinds such as the Help to Buy scheme – like Carpetright and paving firm Marshalls.

“Within the FTSE 250, absolute valuations remain reasonable by historical standards. It is at a stock specific level, however, that deep value can still be found.”

Neptune UK Mid-cap continues its balanced, three pronged investment strategy, with allocations in recovery, structural growth and turnaround stocks.

Martin says this is designed to reduce volatility and maximise risk-adjusted performance over the business cycle and this attitude to risk is important given the strength of UK mid-caps since 2012. 

“Our tolerance has fallen as valuations have risen,” he says. “In 2009/10, valuations were very low, which enabled the portfolio to adopt a greater tolerance for risk. Today, however, we are not in the same valuation landscape and as such have a lower tolerance for pure cyclicalilty.”

Healthcare remains a key weighting in the portfolio and Martin is avoiding sectors where profit margins are at all-time highs.

The Cazenove UK Opportunities fund is just slightly behind on performance and Schroders’ acquisition of manager Julie Dean and colleagues has gone a long way to addressing the loss of Richard Buxton to Old Mutual.

Dean is a business cycle investor and with consumer cyclicals continuing their marked outperformance, she is maintaining a focus on industrial cyclicals, which are not discounting as much of a recovery just yet.

She says: “We have continued to add to industrial cyclicals, particularly Melrose and Premier Farnell, which should benefit from any sustainable economic upturn.

“Over recent months, we also further reduced our underweight exposure to the mining sector, taking a new position in Glencore Xstrata. We remain cognisant of the risks that any further slowdown in China presents to this sector, but feel valuations and market positioning now provide some support for share prices. The more recent return to pre-crisis correlations between the dollar and commodity prices also suggest that global demand for commodities may be returning to a more normal pattern.” 

In financials, Dean continues to favour insurance and other financials sectors where she said companies should benefit from rising bond yields and equity markets.

Elsewhere, the Old Mutual Dynamic Equity fund has also significantly outperformed the sector over three years, with current overweights in software, support services, life insurance, banks and housebuilders.

Manager Luke Kerr keeps a broad balance between structural growth, companies with strong total return characteristics and special situations but noted a material shift earlier this year, reducing international and augmenting domestic exposure.

Kerr says: “Having been overweight in the capital goods sectors, the fund is now meaningfully underweight, reflecting high valuations relative to history and more muted trading prospects for these predominantly international-facing firms.

“In terms of UK consumer exposure, we increased the overweight position in housebuilders, moved overweight travel and leisure and moderated the underweight in retailers. Elsewhere, we have built material exposure to US residential and non-residential construction activity via holdings in [companies such as] Ashtead and Keller and remain overweight in IT software where we continue to hold niche businesses with strong growth prospects.”

Against a mixed, albeit improving macro backdrop, Kerr says conditions vary greatly by company and strong stock selection has therefore become even more important in delivering outperformance.

Mid-caps have maintained a strong run over recent years and Franklin UK Mid-cap manager Paul Spencer continues to highlight the FTSE 250’s diversity as a key advantage over the FTSE 100.

He says: “Nervousness has been creating short-term volatility in equity markets at a time when earnings forecasts for UK-listed stocks have turned negative once again and when equity supply is rising quickly to meet demand.

“The level of stock issuance, in the primary and secondary markets has stepped up sharply in recent weeks and risks causing a bout of market indigestion. We reiterate our commitment to make volatility work for us by putting cash to work in quality names.”

These have included Spirent and Thomas Cook while Spencer has disposed of long-standing and successful holdings in Berkeley Group and Hiscox recent.

Overall, his portfolio is overweight industrial goods and services and oil and gas and underweight basic materials, media, retail and utilities.

Of the smaller funds among the outperformers, Cavendish Opportunities passed its 25th anniversary earlier this year, with manager Paul Mumford maintaining his contra-cyclical approach throughout the portfolio’s life.

His preference is to seek out companies where a small development can make a substantial, or even transformational, change, meaning he tends to avoid holdings in oil and pharmaceutical giants.

He says: “My mandate gives me a great deal of flexibility and while the focus is still on smaller companies, I can move into the mid and larger-cap stocks when these represent better value.

RBS and Lloyds Bank are a classic case of stocks offering excellent returns as they recover, so why avoid them if you can take a small interest in a diversified portfolio?”

In recent months, Mumford has taken profits in Tesco and Rio Tinto, making room for companies offering better prospects such as Randgold Resources.

He says: “Stocks have had a good rise through the year and there could be consolidation in the short term although the market rating is still below its long-term average.”

 
Top 5 and bottom 5 UK All Companies funds 
   
Top
 
Name
3yr
Neptune UK Mid Cap 
89.25
Cazenove The Capital 
88.36
Cazenove UK Opportunities 
85
Invesco Perpetual UK Aggressive 
83.24
Ecclesiastical UK Equity Growth 
77.86
   
Bottom
 
Name
3yr
Manek Growth 
-35.44
MFM Bowland 
2.02
Henderson UK Alpha 
3.63
Ignis UK Focus 
5.21
MFM Slater Recovery 
8.51
   
 
Figures are based on total returns over the three years to 27/11/13
   
Source: FE Trustnet  

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