UK Equities: Mid-cap 25th anniversary

Richard: I'm Richard Bullas, portfolio manager of the Martin Currie Mid-Cap strategy. We're here today with a special guest, Stuart Sharp, who was the original architect of the Martin Career UK Mid-Cap strategy that was launched back in 1999. So we're here today to celebrate 25 years of mid-cap investing. I joined the firm in January 2000, so I've been with the firm for an awful long time, and I've seen the development of the market and the portfolio over that time.

Stuart: So, Richard, you joined the investment team in 2000, is that right?

Richard: Yes, from January 2000.

Stuart: I can't recall any of the other applicants for the role. I know there were quite a lot actually. The two things I recall about you are your background as an accountant in a firm in Huddersfield. You also had some time at CGNU, a former commercial union.

And those two items stuck out quite well, positively in your CV. I also recall, the first thing I recall, actually, is that you had a private pilot's license and no one else applied for the job, had a private pilot's license. So that was that was very impressive. But you came across positively in the interview. Asked sensible questions and the job was yours, and the rest is history.

Richard: It is and well thank you, Stuart. I was incredibly lucky to join the team. I was the first, I think, employee for a number of years. I mean, the beauty of the job, certainly for me, was working directly with yourself and clearly with Mark Hall and Colin Morton. You three in particular were big mentors to me, during my early career.

But, what came across really I think, was all of your passion for the stock market, your passion for stocks, but also the amount of effort and legwork that you had to put in to unearth some of these companies. The investment in the portfolio, certainly in mid and small-cap. And of course, we're talking now with pre-Bloomberg.

Talking pre any technology intervention to a pre using spreadsheets or indeed Excel. A lot of longhand but a lot of using, yes brokers wasn't it. A lot of direct company access. And I could see early on that was your passion meeting the businesses. And I've definitely developed that passion from you.

You know, sitting down with the chief executive or chairman for an hour and just hearing the story, the investment case, first hand and then going away and digesting that and building a bit of a mental picture on how the business can develop over 5 or 10 years is, is fascinating. It's a fascinating part of the market that they operate in.

So, definitely lucky to have that sort of hands-on experience from a very early age. See the winners, see the losers. But also, with skilled captains at the helm through periods of dislocation and indeed, stressors if you think of the collapse of the tech boom and the recovery push, the tech boom and went through the financial crisis as well. It's amazing what we can learn during difficult periods.

Stuart: You know they were at the time and I think, Richard, you brought an additional facet to that team of what had been three and then became four. And then we added a few others. I think you had really good analytical strengths in terms of number crunching, which I appreciated. I spent a lot of time on the road.

I was in London probably once a week in those days. I reckon we were seeing about 2000 companies a year. Small-cap, and some of them were mid-caps, obviously, latterly. A lot of leg legwork, so having you around to do a lot of the analysis. The numerical analysis significantly helped me in my role, running in those days, the mid-cap strategy.

A smaller company portfolio, which was launched in 1991-1992. I didn't start running it until about 1994, I think 1994 or 1995. A number of stocks that we identified and this was pre Teams and pre Zoom. So a lot of the companies, most of the small-cap companies we went to visit, either came to see us in the office or preferably went on a site visit to see them without any veneer, if you like.

And a number of small-caps we identified, we thought were really quite special. One was Sage, the accounting software company which was based in Newcastle. We saw in 1992, 1993, I think. We bought stock in 1994, the market cap was about 84 million from memory, amazing how all these numbers stick in your mind. And six years later, it was a constituent of the FTSE, well over 2 billion market cap.

Aided, of course, by the tech bubble. But what set that company apart. I went to visit the company, before you joined Richard. And in their head office, they were building another huge office on the grounds, and I discovered this was purely for, sales of the software. Now, they were very, very clever.

It wasn't the best accounting software in the market at the time. I can't remember the name of the leader in the market then, but it wasn't Sage. But what they had was quite special because all the accountants that they were providing software to, they asked for feedback every few months. How is it going? How could we improve it?

So the next version had all those improvements in and they could sell to the accountants. So this building was to accommodate s sales team to fill in the accountants, who were very happy to buy the next version. You know, the rest is history. Really, really good team. Paul Walker was Chief Executive in those days, exceptional management team.

So I think in the small-cap arena, we identified companies which had exceptional management. And as they demonstrated their ability, the stocks went up into what is now the mid-cap arena. It was part of the benchmark in those days. The Hoare Govett index, now call the Deutsche Numis Smaller co's index So it was still within our benchmark. I think one of many lessons about these stocks that start off being real tiddlers and can become members of the FTSE 100 index eventually, is to try and identify the long-term pool effect of earnings.

If you can identify a company which has the management, the skill sets, the product, whatever the company does to extrapolate earnings growth over the long-term. Eventually that leads to your superior share price performance. And I think that's what we saw on quite a few of the small-caps that became mid-caps. And some became FTSE constituents.

Richard: Probably a good lesson to run your winners, isn't it? Stick with it, and have that compounding effect over multiple years, without giving in to the temptation to sell too early. But let them, let's say foster and grow and eventually flourish in the FTSE 100. And good point, selling recycled back in to the next small-cap.

Stuart: Yeah, so running an equity and bond strategy, or let's say a balanced strategy. Nobody was actually analysing where you were positioned. So there weren't these sophisticated, portfolio analysts that now exist all over the place, who will see your portfolio every month and see where your differing from the peer group, from the benchmark.

Richard: In those days, you could go anywhere. And looking back 30 plus years, there were big benefits in that. I think for unitholders there were big benefits. But if you, overweighted a stock that wasn't in perhaps in a benchmark and it went sour, then unitholders felt it. So I think there was a little constraint as to where you were positioned.

Stuart: But I think there was self- constraint, knowing that if you got it wrong, your unit holders would suffer. And I think by and large, and I've got some statistics here going back to 1998, by and large, we did pretty well. Our three main portfolios in the late 90s period, for several years were in the top five in the sector, in the Saturday edition of the Financial Times. Our small-cap portfolio, BWD UK Smaller companies, a balanced portfolio and our income portfolio all were performing extremely well against the peer group.

Again, probably not the same benchmarking as there is today. Fast forward Richard, 25 years, how much has changed and are there still opportunities in in the mid-cap arena?

Richard: Yeah, goodness me an awful lot has changed wasn't it. We talk talking earlier about the number of stocks on the UK market. How that period of the de-equitisation of 20, 30 years.

And I think I look at the stats before, you've had probably a 70% contraction in the number of full list stocks on the UK market, a lot of those in the small-cap arena.

But, I mean, the beauty about FTSE 250 index is obviously a fixed number of stocks. Of course it's dynamic, sort of every quarter it rebalances. You get some of the largest small-caps that come into the universe and then the big stocks, that go into the FTSE 100.

There's been a massive culling of tail of the small-cap end and probably an element of concentration into a small number of stocks. And that doesn't seem like it's going to reverse anytime soon, given the lack of IPOs. But of course, what it does and what it did 25 years ago, was obviously it plays into the stock pickers hands.

And it’s because we know the market is inefficient. Probably as inefficient, do you think, to 20 to 25 years ago or more efficient?

Stuart: You tell me, Richard, you're the professional.

Richard: Well, I think there's huge inefficiency in (mid) and small-cap. And of course, one of the big issues, on the back of the reduction in the number of stocks has been the amount of broking capacity that came on the market.

Stuart: And that's a very salient point. But for the typical mid-caps, I interrupt you, but for the typical mid-cap, how many analysts would be covering the stock in the city?

Richard: Yeah, the small end and mid-cap, it could be 3 or 4. Top end, edge of the FTSE 100 you're probably seeing 7 or 8. But in small-caps it could be a handful, 1 or 2.

And of course the difficulty for the broker community has been a lack of commissions and revenues. Your capacity came out the market. I mean, back 25 years ago, goodness me, the number of quality brokers, that was the lifeblood of information. From analyst to sales to strategy manager and hardcopy research.

So I think there is a certain held amount of inefficiency across the market, across the UK market. But again, that sort of plays into the act of stockpicker, because we place that heritage and the history of the foundations of the old Rensburg business of getting out there, kicking the tires and doing the legwork to, to uncover some these opportunities.

But I do think this is a really interesting time, at the moment, for the UK mid-cap market. You know, if you look top down. If you look, hopefully the economy now has come through a difficult period, for the past two years of a shallow recession, at the back end of 2023. So hopefully turning now to one bit more positive, a few green shoots coming through from the economy to getting the PMI data.

We certainly think it's a better backdrop now for the UK consumer, hopefully come through the worst of the cost-of-living crisis and appear now real wage growth. Hopefully confidence can increase. And consumers feel confident enough to spend and to grow the economy. We do think it's an interesting time now to be looking at the UK mid-cap market.

I think from a from a top-down point of view, you know, we've got an economy now, hopefully transitioning from one that's been through the doldrums in 2023, transitioning now to hopefully a period of growth. And we suddenly get the green shoots coming through in the economy, with GDP coming in higher than expectations. So hopefully setting the scene for a stronger growth for 2024 into 2025.

And of course, we've got that overlaid with inflation back at target, now back at 2%. And fingers crossed it stays down there, which I think is going to allow the central banks to start easing on interest rates. So I think top-down we're getting quite excited. But more fundamentally if you look bottom-up now, I think what you've seen over the past two, two and a half years is a huge derating in UK mid-caps.

Trading on a forward multiple now about 12x versus a long run averages of about 14x. So we're sat today with a bit of a discount of 15-20%, compared to average. And can you believe now, mid-cap we can get a yield. The mid-cap index is now yielding 4%.

So the yield and the valuation are almost at parity with the FTSE 100. It's very rare for the two to meet. So I think fundamentally valuation looking attractive, backed up by yield. Nothing more important, than what we're seeing also, is probably a bottoming of earnings for many UK mid-cap stocks. I think we're getting a real feeling that expectations are set for 2024, 2025 and actually the market willing to look through some of the shorter term challenges with earnings, suggesting a lot of the bad news is already sort of priced in.

We’ve got one eye now looking forward to 2024 and 2025. So, we do think the pendulum is really starting to shift actually, back into favour for mid-caps. And hopefully now at the start of a hopefully period of reassertion of the out-performance that we've seen historically.

Stuart: Two obvious questions. I'm not up to date on this, but I'm sure you are Richard. How UK domestically orientated is the mid-cap index now? And has there been any move in M&A in that segment, that tells you that the valuations are really rock bottom?

Richard: Yeah. Well if you look at the strategy, we're about 55% UK domestic revenues, very similar to the FTSE 250 index, which means we have 45% overseas exposure as well.

And a lot of the overseas exposure is coming through our industrial overweight companies. So a lot of companies are operating in America, obviously out in Asia, Asia Pacific, and indeed Europe. But 55% is domestic revenues, which we believe then,  really set for hopefully better times with the economy. But you're right, if you look back now, for the past probably six months, a year to date, we've seen a proliferation of M&A in the UK, mid-cap space in particular, as well as small-caps, I think, the source of capital really taking advantage of the valuation discount we're seeing here in the UK.

So not only private equity taking advantage of the valuation discounts, but also a lot of corporate activity from corporates, public roles, private. Again, using the strong balance sheets cost of financing coming down. But also I think a feeling of increasing confidence hopefully about the outlook for the next 12-18 months and beyond. So willing to deploy that capital into, you know, valuation opportunities in the UK.

Well, thank you Stuart for joining us this afternoon. It’s been great to catch up and hear about the old times. And it is quite remarkable the UK mid-cap strategy has been run for 25 years. So hopefully we can keep up the good work and here's to the next 25.