Beyond Bulls & Bears

Equity

Shining the Spotlight on Domestic Mid-Cap Stocks, Despite Brexit Uncertainty

Appetite for UK mid-capitalisation stocks has suffered as investors try to digest the impact of various Brexit scenarios. However, Franklin UK Equity Team’s Paul Spencer thinks uncertainty about the UK’s future could present opportunities for long-term investors through the widening valuation gap between UK stocks and overseas shares. He highlights some potential drivers behind UK mid-cap stocks.

It’s understandable that UK mid-capitalisation (mid-cap) stocks might have fallen out of favour with some investors, as Brexit creates the potential for heightened risks to economic growth and prosperity. However, we think it is prime time to dig a little deeper into some investment themes we’ve seen at play within the UK mid-cap market. Mid-cap stocks offer exposure to structurally expanding markets that we think could be insulated from wider economic uncertainties.

To this end, we have sought to gain domestic exposure in three themes that we believe should drive the mid-cap space: an older, wealthier UK population, the shortage in UK housing and the recovery in global industrial production.

  • As the number of affluent UK pensioners rise, we expect to see increased demand for retirement living accommodation and aftercare, home emergency services, self-pay private hospital care and wealth-management solutions.
  • Equally, there is undoubtedly a shortage of appropriate housing in the United Kingdom, which we think could benefit areas that are likely to provide long-term support to rectify the state of the housing sector. A combination of robust homeowner demand, a competitive mortgage market and supportive government policy should provide longer-term support to those involved in residential construction, including housebuilders, building-material manufacturers and merchants.
  • Lastly, we think exposure to overseas markets is unlikely to provide a panacea to all investment uncertainties, especially given the potential negative impact of protectionism on free trade. That said, we still look favourably on companies exposed to rising global industrial production as we’ve seen some recovery in this sector. This includes companies involved in manufacturing engineering, electrical and electronic components with a geographical bias towards the United States.

That said, mid-cap stocks in many international markets have become too expensive to justify, in our view. However, we do see areas in the domestic mid-cap space that have potential for long-term value. Which is why we look more favourably on stocks with a domestic bias.

According to our research, roughly 55% of FTSE 250 Index operating profits are derived from the United Kingdom, so the index is more exposed to the prosperity of the domestic economy than the more internationally biased FTSE 100 Index.1 This reflects mid-cap exposure to sectors such as retailers, travel and leisure, transport, construction and real estate.

With that in mind, we look less favourably on areas that are particularly reliant on domestic discretionary consumer spending. Many companies involved in these sectors face structural and macro-related pressure from weaker sales growth, rising costs and changing consumer spending patterns.

Taking the Contrarian Route

As active managers, we’re convinced that investing in companies that trade significantly below their intrinsic value is the route to sustained, long-term investment opportunities. So, at times, this may involve taking a contrarian stance with shares which appear deeply out of favour. Equally, it means avoiding companies where the valuation seems to be detached from reality—or as we saw in a broker note recently, that “shares are reassuringly expensive”.

And, as the legendary Sir John Templeton once said: “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate rewards.” While we haven’t seen enough evidence to be hugely optimistic on the UK’s economic outlook, we do see reasons to consider focusing our attentions on domestic mid-cap stocks.

The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.

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1. The FTSE 100 is a capitalisation-weighted index of the 100 largest companies listed on the London Stock Exchange. The FTSE 250 is a capitalisation-weighted index of the 101st to the 350th largest companies listed on the London Stock Exchange. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges. Past performance is not an indicator or guarantee of future results.