UKFeb 6 2017

Positive signs for small and mid caps as 2016 finishes on a high

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Positive signs for small and mid caps as 2016 finishes on a high

Small and mid caps faced a tricky few weeks in the wake of the Brexit vote in June 2016. While the FTSE 100 index recovered swiftly and even reached record highs in the second half of the year, the middle of the spectrum ended 2016 on a positive, if slightly underwhelming note, with the FTSE 250 gaining just 6.7 per cent. 

Data from FE Analytics shows the FTSE Small Cap (ex IT) index fared slightly better with a rise of 12.5 per cent, although both indices underperformed the FTSE 100’s gain of 19.1 per cent. 

Scott McKenzie, manager of the Saracen UK Income fund, notes: “One of the reasons [the FTSE 250] did so badly is it has a different sector make-up to the FTSE 100. Last year oil and mining sectors were very strong and they are mainly in the FTSE 100, whereas there is virtually nothing in the small- and mid-cap [space]. Also, the mid-cap [index] has a lot more UK-exposed businesses – retail is a big sector and leisure – which were badly affected post the Brexit decision.”

The sweeping generalisation of ‘sell mid caps, buy large caps’ smacks of throwing the baby out with the bathwater John Monaghan, Square Mile Investment Consulting & Research

The exchange rate effects of a weaker sterling have also weighed on mid-cap businesses, as Mr McKenzie believes the weaker pound has badly affected domestic industries that import products or materials. “Retail is quite badly affected as it is an importing sector. Oil and mining are US dollar reporters so they’ve had a big benefit from the fall in sterling. Currency has been a huge issue, as well as the Brexit decision,” he says.

However, there are some glimmers of optimism within the mid-cap space. John Monaghan, senior investment research analyst at Square Mile Investment Consulting & Research, points out that despite the market turmoil in the aftermath of the Brexit vote, the FTSE 250 had recovered well by the end of the year. 

“Much of the furore in the summer was clearly around the implications for the UK economy moving outside of the EU, with sentiment shifting away from domestically facing small- and medium-sized companies into their larger, more internationally focused peers,” Mr Monaghan explains. 

“With sterling weakness, the worth of overseas profits became even more valuable. However, the sweeping generalisation of ‘sell mid caps, buy large caps’ smacks of throwing the baby out with the bathwater,” he warns. “There are companies listed on the [FTSE] 250 that conduct a significant level of their business overseas and irrespective of the outlook for the UK economy in a post-Brexit world, there will be both winners and losers among the UK’s domestic stocks.”

Mr McKenzie is also optimistic that 2017 could be a better year for the smaller end of the market spectrum, not least because “there is a lot of ground to make up from last year”. 

An additional factor could be a strengthening of the pound, with the manager suggesting some investors are assuming the currency will continue to weaken further. “When sterling got to 1.20 against the US dollar, that was a low point,” he says. “I would not expect it to be as weak this year as last year. If it strengthens it will be good for some of those sectors such as retail.”

While mid-cap stocks with overseas earnings have performed better, as would be expected, Mr McKenzie suggests the main issue investors will face in 2017 is looking at valuations. “UK [focused company] valuations are lowly valued, for example retailers, while some of the overseas sectors are highly valued,” he says.

“[Investors] have to take a view on the value as well, and [we believe that now] value is definitely in UK-exposed businesses.”

Nyree Stewart is features editor at Investment Adviser