UK equities: What’s the market missing in the mid-cap area?

We examine the potential opportunities emerging as the performance of UK large and mid-cap stocks diverges.

Key points

• UK mid caps have underperformed UK large caps over the year to date, partly because the latter are perceived to be more defensive.
• We believe the risks faced by some mid-cap companies have been over-discounted relative to large caps.
• For long-term investors willing to do their own in-depth research, the mid-cap area is an interesting hunting ground for stock ideas.

We have seen some extreme market moves so far in 2022, and particularly so in relation to UK mid caps. Over the year to date, the FTSE 250 Index has declined by 13.1% on a total-return basis, underperforming the FTSE 100 Index by 16.4%¹. This is an enormous move over a period of less than six months. So, what is going on and what is the outlook? Are UK mid caps to be avoided given this volatility, or does this present an opportunity?

Mid caps have underperformed large caps in part owing to the lack of mid-cap companies exposed to energy and mining, which make up over a quarter of the FTSE 100 Index¹and have been strong this year on the back of spiking commodity prices. In addition, large caps are perceived as more defensive, meaning that at times of heightened geopolitical and economic uncertainty such as we are currently experiencing, they tend to outperform their smaller peers despite their business performance not necessarily being superior during turbulent times.

With a longer-term horizon, however, over 10 and 20 years the FTSE 250 Index has outperformed the FTSE 100 Index by 2.1% and 3.4% respectively on an annualised basis,¹ including the underperformance year to date. As stock pickers with a long-term horizon and willing to do our own in-depth research, we see UK mid caps as an interesting hunting ground for stock ideas. The lack of analyst coverage of names in the mid-cap area can lead to the market misunderstanding companies or not fully appreciating their superior growth prospects relative to large-cap names over the medium term. The recent sell-off has only amplified this, and we believe some stocks have been incorrectly grouped into areas of perceived vulnerability.

In our opinion, pet supplies retailer Pets at Home is an example of this. While fears have grown around a weaker consumer and rising cost pressures, an environment which is certainly hurting many retailers, our research suggests Pets at Home has earnings resilience. One third of the company’s growth target is based on maintaining share in the market (and so relies on market growth), and two thirds is based on taking market share. In relation to this latter target, Pets at Home’s initiatives are focused on getting the consumer to spend more money with it versus other retailers, for example by persuading customers to spend more on pet essentials or use Pets at Home for vet and grooming services. At the same time, Pets at Home has demonstrated that its typical customer is stickier than most, with 90% of 5,000 surveyed customers saying they had no intention to reduce expenditure on pet care, with one third considering switching to own-brand food.²

Pets at Home’s expansive own-brand food range, which in fact generates more cash profits compared to branded pet food, gives us further confidence that if the UK experiences a recession, Pets at Home should be relatively well insulated. Similarly, the firm’s omnichannel model has helped it mitigate cost inflation relative to its online peers, with the ability to save through rent roll reductions as well as utilising its store footprint as pickup and delivery sites to enhance its distribution network.

Luxury watch retailer Watches of Switzerland is another example where we believe the market has misunderstood the real driver of the company’s growth, putting too much emphasis on the risks associated with the strength of luxury demand and the subdued Chinese consumer. Prior to the Covid-19 pandemic in 2020, travel retail made up 27.5% of the company’s sales but this fell to 5.3% during the pandemic, with demand almost entirely diverted to other open domestic channels. So any reopening in China, and subsequent uplift in demand, should only add to the growth potential.

Today, the investment case depends on Watches of Switzerland replicating the success of its rollout in the UK to the US, where the market is twice the size of the UK by value but 2.3 times smaller on a per-capita sales basis, in part owing to the lack of investment and strong retail presence. Watches of Switzerland has a unique relationship with Rolex and other top luxury watch brands, and its well-invested store base and strong marketing proposition has consistently seen it win greater allocation versus the small independents, a trend that we believe can continue.

In summary, we firmly believe that the UK mid-cap area is an interesting hunting ground for businesses with both long-term growth potential and resilience, even if the UK faces a protracted challenging period ahead from a macroeconomic and geopolitical perspective.

Sources:

1. Bloomberg as at 06/06/22
2. Pets at Home, monthly customer survey, May 2022, incorporating cost of living and inflationary impacts.

Authors

Georgina Gregory

Portfolio manager, Global Opportunities team