Why the prospects for the UK mid-cap market are still positive
The decision to leave the European Union has introduced a considerable amount of uncertainty for the UK economy, but the country’s economic indicators have held up well and the domestic economic backdrop remains relatively robust. However, sentiment towards the FTSE 250—widely regarded as a proxy for the UK economy—has dampened in recent months. Guy Anderson, Portfolio Manager for The Mercantile Investment Trust, explains this disconnect, why he believes the UK economy should continue to grow, and how the portfolio is positioned for the current environment.
It goes without saying that the UK faces a number of idiosyncratic risks on the horizon—not least uncertainty over what happens once it finally leaves the European Union. In the near term, however, what we do know is that the sustained depreciation of sterling will ultimately bring about imported inflation, which will most likely hinder—not help—the UK domestic consumer. With imported inflation lurking around the corner, the outlook for the UK consumer is no longer as strong as it was one or two years ago.
Our current focus is geared towards seeking out internationally-exposed industrial cyclicals, which are gaining from higher growth and inflation in overseas markets, and away from UK domestic cyclical names, where the outlook is no longer as robust. We are becoming increasingly bullish on the industrials, oil & gas and basic materials sectors which, together, make up around 35% of the portfolio.
This gives us a more even split between domestic and overseas revenue exposure. The Mercantile Investment Trust portfolio continues to maintain selective UK consumer exposure in companies where we feel the investment case remains compelling. For example, within consumer services we hold over 10% of the portfolio in companies that operate online market places, an area of encouraging growth.
With the spotlight currently on the FTSE 100 and its extended Santa rally, there are several reasons why we believe exposure to the mid-cap market can be beneficial over the longer term:
1) Higher growth: smaller companies can generate higher growth that is not driven by the strength of economic growth, unlike their large-cap counterparts.
2) Nimble: this segment of the market can adapt to most forms of change. There are many examples of disruptors in this part of the market, who can challenge incumbents and find creative ways of growing even when external forces may be changing and/or stacked against them.
3) Mergers & Acquisitions (M&A): according to the Organisation for Economic Co-operation and Development, the UK is one of the easiest markets for foreign firms to do business. Foreign firms are encouraged and enabled to come and buy companies and the mid-/small-cap market is often viewed as a place to find attractive bolt-on acquisition opportunities. Sterling’s depreciation should also support this trend. We anticipate investors could see an uptick in M&A activity coming from a period of depressed activity in 2016 as a result of Brexit uncertainty.
With the outlook for UK economic growth remaining positive—even if the road ahead is likely to be a bumpy one, and with the long-term drivers of superior performance from mid- and small-caps still in place, we continue to believe that UK and mid- and small-cap companies offer good prospects for long-term capital growth and income.
Guy Anderson is the portfolio manager of The Mercantile Investment Trust. Read more about the trust: UK Advisers
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