By Daniel Grote of Citywire

As the FTSE 250 hits highs, ‘mid-cap’ stocks begin to close gap on blue-chips and small companies that has emerged since Brexit vote.

As the FTSE 250 hits all-time highs, ‘mid-cap’ stocks are beginning to close the gap that has emerged with blue-chips and smaller companies following the Brexit vote.

The medium-sized company index reached the milestone last week, before setting a further six all-time closing highs, although that impressive run is set to be broken today, as markets have dipped.

That run has helped to claw back some of the ground lost to the FTSE 100 and Small Cap indices in the rally that has taken hold following the EU referendum.

Since the vote, the FTSE 100 has notched up a series of all-time highs, rising 14.8%, while the Small Cap index has performed even better, up 16.8%. But mid-cap stocks have lagged this rally, up just 8.2% even with this month’s milestones.

The main reason mid-caps have played catch-up to larger companies is the impact of the pound’s heavy fall following the Brexit vote.

As much as 80% of the FTSE 100’s turnover comes from overseas earnings, meaning they benefited from the pound’s slide. However, the companies that make up the FTSE 250 do not have such a heavy bias towards overseas earnings.

Citywire AA-rated Richard Watts, manager of the Old Mutual UK Mid Cap fund, said there was a 50/50 split between UK and overseas earnings in the FTSE 250.

‘There is somewhere in the region of 30% more exposure to overseas earnings in the FTSE 100 than in mid-caps so currency is more favourable to FTSE 100 companies,’ he said.

Watts added that the FTSE 100 was also boosted by the outperformance of mining and oil stocks last year, pushing the index ahead of mid-caps.
‘Part of the reason that mid-caps outperformed the FTSE 100 in 2015 was the underperformance of oil and mining stocks and we have seen a reversal of that trend in 2016,’ he said. ‘Mining and oil performance is strong and the FTSE 100 has a greater weight of these stocks.’

Strategic winners

Holly Cassell, assistant manager of the Neptune UK Mid Cap fund, said when it came to currency it was important to look at the companies that would benefit from a real boost to their underlying trading, not just improvement off the back of exchange rates.

She said the FTSE 100 was made up of lots of companies that would benefit just from the ‘translational impact’ of currency movements without growing their businesses – what is known as ‘financial winners’.

‘Where we think the most exciting opportunities lie is in “strategic winners” – that is those mid-caps which were indiscriminately sold off following the Brexit vote but experience a double whammy benefit from the weak pound,’ she said.

These companies generate revenues in foreign currency but pay costs in sterling meaning they benefit from a margin uplift.

Cassell gave the example of bank note printer De La Rue (DLAR), which ‘has a global customer base but for which the UK is a designated centre of excellence for its banknote printing business’.

Small cap lag

With the pound’s 16% fall against the dollar since the Brexit vote it’s no surprise that mid-cap stocks lagged their more internationally-focused blue chip counterparts but they also fell behind supposedly more domestic small cap stocks.

Watts said small caps ‘in theory’ had more exposure to the UK than mid-cap companies so the impact of Brexit and the sterling downgrade should have been bigger.

‘Small cap companies by their nature, because they’re small, are growth stocks and the market last year did not have a problem with UK-facing stocks if they were structural growers,’ he said.

It was UK cyclical stocks – companies affected by the ebb and flow of the economy – that were hardest hit by Brexit, as fear for the British economy abounded.

‘UK domestic cyclicals bore the brunt: housebuilders, challenger banks and retailers,’ said Watts. ‘Those stocks in particular represent a large part of the mid-cap market….cyclicals brought down the mid-cap index whereas UK-facing growth stocks performed quite well and those sit in the small cap index.’

Mid-cap opportunities

Mid-caps might be facing difficult but Watts said there were still opportunities. His fund underperformed post-Brexit as he said it was ‘not positioned for leave’ but was buoyed by the continued strong performance of plastics engineer RPC Group (RPC), online takeaway service JustEat (JE), and online fashion retailer Boohoo (BOOH).

‘We used the opportunity of significant share price weakness in housebuilders and challenger banks to add to our positions and buy them,’ he added.

‘What we did not want to do was increase exposure to the UK and we sold our UK retail exposure. [Housebuilders and challenger banks] offer more attractive rewards than retailers. The fall in performance [of the former] was very aggressive and the falls in retail were not, even though they have exposure to the weak pound. There is lots of earnings risk in retail that is not reflected in the share price.’

Watts added that the worst could be over for mid-caps, as long as sterling remains stable. ‘The direction of mid-caps from here will be to do with currency,’ he said. ‘If sterling finds a level in the £1.20s over the long term then the pound is now cheap… if currency stabilises there is not a lot in it in terms of FTSE 100 versus mid-caps.’

Mergers and acquisitions could also provide a boost to the mid-cap market as US business look to exploit the weak pound to snap up UK companies.

Cassell said deals in the mid-cap space were down last year but ‘we expect to see this trend revenue in 2017, particularly if sterling remains depressed’

This article is independently written by Citywire and not subject to editorial oversight by Blackrock