In Focus interview: mid cap equity funds
Why it’s worth paying for growth stocks and the mid cap market are both on the agenda as Richard Watts (Lead Portfolio Manager on the Old Mutual UK Mid Cap Equity Fund)talks to Ian Aylward (Head of Manager Selection at Barclays) about his approach to investing.
IA: Richard, you manage the Old Mutual UK Mid Cap Fund. Could you start off by explaining what exactly this entails?
RW: Old Mutual has one of the largest and best resourced teams dedicated to managing UK mid-cap equities; these are companies that typically have a market capitalisation from around £0.5-5bn.
However we have the flexibility to remain invested in companies that grow past this £5bn mark, as well as invest in smaller and AIMs listed companies (unlike some of our competitors). Because of this we work very closely with our small and large cap teams to leverage ideas on companies and the wider market.
IA: And has the fund’s strategy changed much over the time that you’ve been managing it?
RW: Yes, I’ve been managing the Fund for close to a decade and over that time I’ve learnt a great deal. My approach to investing has changed as a result, for example, the portfolio has certainly become more concentrated. When I first took on the strategy back in 2009, the Fund held around 80 stocks, where as today it has less than 50.
This has nothing to do with the opportunity set, but rather the idea that if you’re a good stock picker and select those stocks that will outperform, then as you select more and more outperforming stocks from your investment universe the probability of subsequently selecting an underperforming stock exponentially increases. This is a very powerful concept. It basically says that you should hold fewer stocks and focus on backing your highest conviction ideas.
IA: What kind of opportunities do you find the mid cap market offers?
RW: UK mid caps have historically offered greater returns relative to larger and smaller areas of the market. This makes sense if you consider that mid cap companies still have the room to develop and grow. Whereas large cap FTSE 100 companies tend to be in a more mature phase of their business cycle, having already exploited these opportunities for growth.
Small caps on the other hand display similar high growth prospects; however these can generally carry higher risks and so exhibit a much higher variance in performance with a greater proportion of companies failing.
Also when looking across mid cap sectors, the best 30 stocks on average have outperformed the benchmark by around 50% per annum, whilst the worst 30 have underperformed the benchmark by around 40% per annum. So the dispersion between the best and worst 30 stocks is around 90% per annum, much higher than you would find in the large cap space. So this is a clear opportunity for active managers when selecting stocks.
IA: ...and the challenges?
RW: Yes investing in smaller companies does carry its challenges. Liquidity can be one given that these companies are traded less frequently and in smaller volumes. The size of the Old Mutual UK Mid Cap Fund (£3.7bn), would probably pose greater issues if investing exclusively in the small cap market, however, the mid cap space has historically offered adequate liquidity for our needs.
IA: There tends to be a fairly ‘bearish’ approach to UK equities currently. What’s your outlook on the market?
RW: You’re right; I’d say that there’s a great deal of negative sentiment around the UK market currently, pricing in a lot of uncertainty. Though for me, that’s the time to buy.
There are of course risks that it is important to be weary of; Brexit is certainly a prominent one. However, to a degree I don’t buy into the “scare stories” of a no-Brexit deal, I think that there will be contingency plans in place and that the UK economy and labour force have the flexibility to ride out the disruption.
Having said this, a significant proportion of the portfolio is actually internationally sensitive and not too reliant on the condition of the domestic UK economy. Names such Ashstead Group, Melrose and Bodycote are far more dependent on the global and US economy which looks in great shape.
IA: Do you manage your fund by looking for companies that are growing at a faster rate than the market?
RW: Yes, the outperformance of the Fund in recent years has been a result of the positive surprises in earnings growth of the underlying companies.
This is essentially our investment philosophy; we invest in companies that we believe have the capability to grow their earnings beyond the markets expectations, and therefore exceed the rate of growth that is priced into the stock.
Therefore the valuation premium that we sometimes pay for these companies is eroded over time by a superior rate of growth, and results in the price appreciation of the stock.
Old Mutual is one of the world’s largest UK equity managers, with teams covering the full capitalisation spectrum. Richard Watts has researched and managed UK mid cap stocks at Old Mutual for 16 years.