UK mid-caps – far from middle of the road

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No matter what their size, the past few years have been tricky for UK companies. First Brexit, then the Covid-19 pandemic – two headwinds that saw many investors leave the UK equities market for more certain climes. Now though, with an acceptable Brexit conclusion and a potential vaccine-led recovery, we believe UK equities, mid-caps in particular, have much to offer investors.

Here we highlight the positive dynamics at play in the UK mid-cap market. We also discuss why investors may want to take another look at this far-from-middling asset class.

Nimble, agile and growing – even in a crisis

The Covid crisis has undoubtedly taken its toll on UK companies, with sectors like travel, hospitality and retail hit particularly hard by lockdown restrictions. But at the same time, there have been inspiring examples of small- and mid-cap companies thriving and growing, even in this uncertain environment.

Much of this is down to mid-caps often being more nimble than larger companies. Many have multiple levers for growth and are able to offer new opportunities, such as additional products and services, or expansion into other geographies. We’ve seen the best management teams adapting quickly to changing demand, renewing their strategic focus and planning ahead. We expect these agile, quality mid-cap businesses to only grow stronger during the recovery.

Leading the way but undervalued

Which brings us on to another point – that small and medium-sized companies tend to lead market recoveries, when investors have a more risk-on appetite. For example, a period of notable small- and mid-cap outperformance followed the global financial crisis. Now, with the successful vaccine programme in the UK providing an escape hatch from the crisis, we expect a similar pattern ahead. Pent-up demand should boost economic activity when restrictions ease and mid-cap companies are likely to be in the recovery’s vanguard.

What’s perhaps more interesting, and less well understood, are the changes in the relative valuation of these stocks. Despite their optimistic outlook, UK mid-caps currently trade at a significant discount to larger peers, even though their growth prospects are often greater. Very few large-cap companies, for example, can continue to grow at attractive rates over the long term in the way small and medium-sized firms can. Often the biggest companies face saturated markets with limited potential to grow. This provides opportunity for nimble medium and smaller competitors to make inroads, but their valuations don’t reflect this opportunity. The current valuation gap could, therefore, provide investors with an attractive entry point into mid-caps.

Many UK mid-cap companies have displayed remarkable resilience and ingenuity during the pandemic.

Distracted by a ‘dash for trash’

The market isn’t currently focusing on ‘quality’ companies. Instead, we’ve seen investors make a ‘dash for trash’ as they seek out value recovery names, often those companies most disrupted by Covid-related lockdowns. This has made for a challenging few months for our ‘quality growth momentum’ investment process. However, history suggests that these ‘dash for trash’ rallies usually only last for around six months.

As such, we believe it’s more crucial than ever to maintain a keen focus on the highest-quality businesses. Sadly, many of the currently attractive value companies will not return to levels of revenue they saw pre-Covid. Balance sheets are challenged, they’ve lost market share (often to better-quality businesses) and many lack strong leadership teams. As they wean themselves off the government’s Covid-related financial support, these businesses may start to struggle again. Interestingly, the pandemic has accelerated change that, for many sectors and companies, was already underway – the weak getting weaker and the strong getting stronger.

At Aberdeen Standard Investments, we maintain our focus on quality growth companies that we believe can perform well over the long term. We think that the market will settle away from the current value rotation. After that, we expect investors to once again reward businesses that can deliver sustainable growth, have good ESG (environmental, social and governance) credentials and enjoy earnings upgrades. We’re also investing in businesses that have strong balance sheets, which will allow them to invest and acquire. These characteristics should help them strengthen their market positions and expand their businesses.

Final thoughts …

Many UK mid-cap companies have displayed remarkable resilience and ingenuity during the pandemic. This is a reminder that many of these innovative and nimble companies can flex their business models and grow, even in challenging conditions.

Given these attractive characteristics, and with UK equities at an attractive inflection point, investors may want to consider a long-term strategic allocation to UK mid-cap stocks as part of their broader investment portfolio.


View Article – published by Aberdeen Standard Investments on 26th March 2021