A Once-in-a-Generation Opportunity in UK Mid-Caps?

As the year draws to a close, the UK stock market presents a polarised picture, with a narrow band of large-cap stocks leading the way. But is the real story in the overlooked and undervalued mid-cap sector? In this episode of "A Value View," Portfolio Manager Simon Gergel joins host Jon Cronin to discuss what he feels could be a “once-in-a-generation opportunity” in UK mid-caps. Simon delves into the reasons behind the underperformance of these more domestically focused businesses and explains why he believes they now offer exceptional value. He shares his insights on specific sectors like real estate and housing, and reiterates the importance of The Merchants Trust’s value-driven, income-focused approach in a market captivated by a few high performers.

This is a marketing communication. Please refer to the Key Information Document or KID before making any final investment decisions. Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Past performance does not predict future returns. The mention of any particular security or strategy should not be considered as a recommendation. For further information on the Merchants Trust please go to www.merchantstrust.co.uk.

JC: Hello, and welcome to A Value View from The Merchants Trust. On this podcast, we have a simple objective. We aim to bring you insights and views on some of the biggest current investment issues of the day. And we do this, as we always have done, by looking at the world through the prism of The Merchants Trust, which boasts a diversified portfolio of well-established and well-known UK-listed companies. To guide us on this journey, I'm delighted to be joined in the studio by Simon Gergel, Portfolio Manager at The Merchants Trust. Simon, it's good to be with you again.

SG: Hi Jon, great to see you.

JC: Well, nice to have the time with you in the studio. Look, Simon, we're fast approaching the year's end, and it's been another eventful one, so I'd like to get your take, get your sense on where you see the markets heading now. Set the scene for us. What’s been driving markets recently? And how's that affected The Merchants Trust?

SG: Yeah, well, I think it's a, it's a good question. So, overwhelmingly the story this year has been coming out of America, and it's been coming out of the technology sector in particular, and the enthusiasm for AI and the huge investment boom that's going on on the back of that. We've also had obviously a lot of machinations about tariffs in America, and we've seen interest rates start to come down in America and in the UK, and so all those things have been driving the markets. But they've become, they've been led by quite a narrow band of stocks, so in America, as you probably saw recently, Nvidia, the biggest stock in America, reached a $5 trillion market value.

JC: It's quite something, isn’t it?

SG: It's quite something, and put it in context, the whole of the UK stock market is worth about $3.7 trillion. German GDP is about $4.7 trillion, so Nvidia is really huge in terms of market cap. And that narrowness of the market, that drive of those tech stocks, has really translated a little bit into the UK. You've seen leadership of the very largest companies, so the FTSE 100 has been performing better than the mid-caps, and you’ve seen pretty… a very polarised market, quite extreme movements on each side, one side and the other.

JC: OK, and as you say, the market's been led by the largest UK companies, while the mid-caps, well, they've lagged a little. So, has the gap… So, why has that gap opened up, and what's behind investors' hesitation towards mid-sized, more domestic businesses?

SG:Yeah, and just to put it in context, in the first 10 months of the year, the all-share index was up about 20% and the mid-cap shares were up about 10%. So pretty big gap and unusual.

JC: What's driving them, because that's quite stark, isn't it?

SG: Yes, I think if you realise that although many British companies are very international in their focus, even many mid-caps are, the mid-caps tend to be a bit more domestic and a bit more cyclical. So, in areas like retail and real estate and leisure and travel, those areas which are more domestic have been a bit under a bit of a cloud. I think there's been a lot of nervousness about the budgetary constraints of the Labour government. A lot of nervousness ahead of the budget, and so there's been less enthusiasm for British exposed companies, shall we say, and yet the larger companies, which tend to be a bit more international, have been more in focus. We've also seen very strong cash flow and profits growth coming out of the banking sector, which is a big sector, resilient cash out of the oil and gas sector. So, if you look sector by sector, there's reasons why the larger sectors have attracted more attention, and investors have been a bit nervous about domestic sectors. And the other thing that goes hand in hand with that is earning momentum where companies have had any type of trading difficulties, disappointment, the shares have typically been hit really hard, and we've had probably more tough areas in areas, as I say, that are more domestic like real estate and house building and those types of industries have been a bit slow.

JC: So, it's a, yeah, a tougher market out there as well. And yet, despite that underperformance, you've called this, I think, “a once-in-a-generation opportunity” as well. So, you know, you obviously see something different here. What makes you so confident that mid-caps are undervalued today and should be in an interesting part of the way that you see investing in the future?

SG: Yeah, well, the interesting thing is normally mid-cap companies tend to grow a bit faster than large-cap companies. They tend to be younger or faster-growing industries. The large companies in industries like banking and energy, and tobacco. They tend to be a bit slower growing. So mid-caps normally have higher growth, and they're normally trade on slightly higher ratings. At the moment, they're on lower evaluations than the large company, and particularly when I talk about once in a generation, if you look at the dividend yield on the mid-cap index, it's actually significantly higher than it is on the FTSE 100, large-cap index. That hasn't happened for over 20 years. That's very unusual, because when you think of large cap, you think of banks, oils, pharmaceuticals, often industries that aren't growing that much but have high, you know, high dividend yields, typically.

JC: They used to pay for our pensions, didn't they? That was perceived, at least as the case.

SG: Exactly, and it's unusual therefore to get the opportunity the other way around, where you can get more exposure to perhaps slightly more dynamic companies, should we say, in the mid-cap area, on lower valuations with higher yields.

JC: So, when you talk about that kind of value, then, that exceptional value. What kinds of companies are you referring to, in particular, or sectors indeed? I think you've touched on one or two of the areas but take us a little bit closer to that.

SG: Yeah, so an example would be real estate. What we're seeing on the ground in real estate is in areas like GP surgeries or student accommodation, or even leading shopping centres, you’re starting to see rents going up. Shopping centres turned actually from seeing rents going down to seeing rents going up in the best destinations. Even offices are seeing more demand in the City of London. So, rental market's improving, vacancies are coming down, and yields are quite high because when bonds yields went up, yields went up. As bond yields are coming down, you'd expect yields to come down. Which means valuation should start to go up. And in fact, valuations are starting to at least bottom out, maybe even go up. And yet the share prices of the companies are down on their knees, trading at very large discounts to asset value. And normally, when you get property values, prices on discounted assets, it’s because people are nervous about those asset values, but those asset values look very well underpinned. So, that's just one area which is a bit more exposed to the domestic economy, to the interest rate cycle. Another area will be housing, both house builders and companies making building materials, companies supplying furniture to people who move house. Those areas are actually very cheap compared to history. Many of the profits are depressed because we're a low stage of the cycle, because housing transactions and housing volumes have been low, as we know. So, there's a lot of recovery potential, and yet the shares are trading on low valuations on low earnings, which is again quite unusual. So, when we look at those type of areas, we see a lot of opportunities.

JC: Yeah, reasons to be optimistic, I guess. Some investors, though, might wonder why not simply stay with the large-cap names that are doing well. What's the long-term case of holding or even increasing exposure to mid-caps at this point in the cycle?

SG: Well, I think we've got to differentiate when you say doing well between share prices going up and profits going up. So yeah, many large companies are performing quite well operationally but share prices have gone up a lot in many cases, and therefore they're less cheap or less attractively valued, and for us it's all about what value you're getting, and we still like a lot of large companies. We have over half the portfolio in the largest companies, let's not get this wrong, you know, keep it in perspective. But we just see greater opportunities in the mid-caps where share prices are generally quite depressed, and you've got really good companies on attractive valuations. So, it's always that balance between what's a good company and what's a good investment. And many large companies are strong companies, but we just don't see them as offering as good value today.

JC: Yeah, and I know that's something that you've touched on before. Look, The Merchants Trust, as we've discussed many times, has always taken a value-driven income income-focused approach. So, how does this philosophy guide your decisions when the market seems to be rewarding a more narrow group of companies? We’re back to Nvidia, the 5 trillion behemoth, that biggest company in the world. That's where the market sees so much of the action, but how does your particular approach, you know… let me try that again. So how does your philosophy play out in light of that?

SG: Well, actually, it helps us because it keeps us grounded. It keeps us focused on what are the long-term cash flows of this business, what income can we generate and what's it worth? And so, we have to stand back and say, look, we're not going to participate necessarily in areas of the market that might be a bit more frothy, a bit harder to value. We're sticking to things that we are confident that we can value, where we see an opportunity to generate strong cash flows and good dividends and growth into the future. And if that means we are increasingly slightly different from the market, that's fine. You know, we're trying to do, we're trying to generate an income. We're trying to generate good returns, and we're confident the shares we own can do that. We can't say what the overall market's going to do. We're becoming a bit more different from the overall market, but I think that has served us very well in the past. I suppose another way of looking at it is when we've had these periods before where a section of the market's been out of favour and there's been, you know, specific reasons at that time, which are quite short-term, that's often been a great opportunity to look into those areas where you've seen the greatest pressure, like during the Brexit referendum or, you know, when Jeremy Corbyn looked like he might become Prime Minister. These types of situations that cause polarisation in the market can give you the greatest opportunity as an investor.

JC: OK, but Simon, if this uncertainty that you referred to, if it doesn't lift, is that a problem?

SG: Not especially, I mean, clearly it'd be great if uncertainty goes away and people get very optimistic, but the companies we're invested in are… they're not just standing still, many of them are performing well, improving their businesses, restructuring where necessary, and there’s a good story of many of the companies themselves, independent of what's going on in the macro world. We tend to focus a lot on questions on macroeconomics and the interest rate cycles. But at the end of the day, we've got companies making products, selling them to consumers, and generally doing a decent job. And if you buy them at the right price, you should get a decent reward as an investor.

JC: Finally, Simon, what message then would you leave investors? Especially as we draw to the end of this year, and especially those wondering whether now's the right time to be invested in UK equities, in particular those mid-caps that we've been discussing.

SG: Yeah, well, despite the move of the market this year, the UK market is still quite modestly valued, certainly on a global basis. And then within that, the mid-cap area is actually cheap, compared to its history, compared to other markets you can invest in, and if anything, hopefully we are seeing interest rates come down. We, you know, the market's been concerned about the budget all year, which could be a clearing event if we can get that out of the way without too much unexpected bad news should we say for the market, we can move on. I think a lot of companies have been holding back on investment decisions and consumers holding back on decisions because of uncertainty. As we go into next year, we could be in a situation where interest rates are coming down, there’s a lot more certainty around - or less uncertain perhaps - and the nature, the value of the businesses, the quality of the businesses starts to come through and that could reward investors handsomely, so I think if you can pick up good businesses on a cheap valuation offering a decent yield, that's usually a sensible thing to do on a medium to long-term basis.

JC: OK, well, Simon, unfortunately, we're out of time now, but thank you very much indeed for your thoughts there.

SG: Thank you, Jon.

JC: And thank you for listening to A Value View from The Merchants Trust. You can find out more about The Merchants Trust and read and watch Simon's latest investor notes by going to MerchantsTrust.co.uk. Thanks again for listening, and until next time, from all of us here at The Merchants Trust, it's goodbye.