Q&A: Mid-cap investing

Andrew Neville, mid-cap specialist at RCM, the equity manager of Allianz Global Investors, explores the asset class.

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Q What is the definition of a mid-cap company?

A Quite simply, they are medium-sized companies. To put this in context, the largest mid-cap company could be £3bn in a raging bull market or £1.2bn in a bear market; the smallest company, £250m to £400m. It is decided by market capitalisation.

Q What benchmark indices cover these companies in the UK?

A The purest benchmark is the FTSE 250. The FTSE 100 is the 100 largest companies. Then you have the FTSE 250, the next 250 largest companies. It is a very transparent index. It is consistent and is readily available at www.ftse.com.

Q Of the overall UK stock market, what percentage is FTSE 100, what percentage is mid-cap and what percentage is small-cap?

A FTSE 100 is 86%; mid-cap is 12%; small-cap is the rest.

Q Why are mid-caps a specific breed of investment?

A There are two reasons. First, they have the advantages of smaller companies: they can grow quicker. That is the maths of being a smaller company; they can invest their capital to generate higher than normal returns, but more importantly the management of a medium-sized company can determine the success or failure of that company through their actions. This, of course, carries risks; the main risk being management cannot accommodate that outcome
successfully.

Second, they also have some of the advantages of large-caps. They have access to the capital markets: not only equity capital markets but the bond and convertible bond markets. They have quite broad shareholder bases, and they are much broader into geographic end markets and end revenue streams than small-caps. Importantly for investors, they are quite liquid companies compared with smaller companies.

Q What would you say are the typical characteristics of a mid-cap stock?

A I think the main characteristic is about 35% of mid-caps tend to be UK consumer, and a further 20% of mid-caps are exposed to the UK economy. That means at least half of mid-caps are exposed to the UK economy, so you have to have a fairly clear view of what you think the UK economy is doing.

Examples we have all heard of include: JD Wetherspoon, the pub company; Mothercare, the retailer; or Persimmon, the house builder. The rest of the mid-caps, the non-UK consumer ones, are companies people probably have not heard of. They tend to be market leaders in what they do, and by that I mean global market leaders. Take Chemring, for example. It is the global market leader in countermeasures, so flares coming out of aircraft and ships to divert guided missiles. People have never heard of Chemring, but it is the market leader in what it does.

Q Are there any other characteristics?

A What is interesting is oils, pharmas, banks and mining make up 55% of the FTSE 100 but only 8% of the FTSE 250, so there are some key differences to the FTSE 100. The largest sectors within the FTSE 250 would be support services, financial services (by that I mean asset managers, and travel and leisure.) Another characteristic is shareholders. In the FTSE 100 you get quite a lot of international shareholders. For the FTSE 250 it is predominantly, in fact almost entirely, UK. You do get some overseas shareholders but this is a UK-based index.

Q You mentioned the talent of management is very much tied up with company performance. Why is that link stronger with mid-caps than with large-caps?

A Predominantly it is a function of size. A mid-cap company can make a successful acquisition, it can break into a new geography or it can win a new contract, and that can be quite a large percentage of the current revenue or its profit base.

A large-cap company by definition cannot do that. British Petroleum (BP) cannot break into a new territory or make an acquisition that would add 10%, 20% or 30%, unless it was a blockbusting acquisition. By contrast, Dana Petroleum can. A few wells can come through in Egypt successfully and soon you have added 20% to the company.

Q What makes researching mid-caps different from researching large- or small-caps?

A There are two main things. Mid-caps are not as well covered as the FTSE 100, but they are not lowly covered either. Management decisions can be a key determinent to a company’s success or failure. That means you have to see those companies. You have to see every company held a minimum of twice a year, and you should try to see the other
companies at least once a year.

You need a fairly clear macro view, but you had better be sure you have a very clear micro view. For example, you have to be clear the strategy is viable. Not only that: does the management have the capability of carrying out that strategy? You can see within sectors doing the same thing. The best example is house builders. You can find house builders that do predominantly the same thing but their share price performance is widely different, which is down to management expertise and ability to execute.