Give your ISA a six-pack
The mid cap space is home to many exciting investment opportunities. They are generally well-established businesses with revenue and profit; yet they also have plenty of room to keep growing at a much faster rate than the UK’s largest quoted companies.
The mid cap space is generally represented by the FTSE 250 index – which is up 8.8% so far this year. That’s more than double the 3.4% return from the FTSE 100 index. The outperformance is even clearer when you look at the chart for the past 10 years.
The recently concluded first half results season cemented this trend. Analysts at investment bank UBS note: ‘Despite the ongoing uncertainty around the UK economic backdrop, the recent results season saw the FTSE 250 outperform the FTSE 100 in terms of both share price performance and net earnings upgrades, with around 60% of the 150 FTSE 250 companies which reported since 1 July seeing their share price rise on the day, and around 25% rising by more than 3%.’
Here are some examples why mid cap stocks are an attractive alternative to big caps
• Growth potential
First, just by dint of being smaller, mid cap firms typically have more significant growth potential and could increase their profit at a rapid rate if things are going well.
The FTSE 250 is more diverse than the FTSE 100 with areas such as engineering and technology more widely represented.
• Potential for earnings upgrades
Companies on the FTSE 250 are not as widely followed as those on the FTSE 100 so equity analysts are more likely to under-estimate (or over-estimate) earnings.
This can be both a good and a bad thing. Earnings upgrades can lead to increases in the share price although the reverse is true if a company falls short of earnings forecasts.
And although mid cap stocks are typically more volatile than the largest companies on the FTSE 100 they are unlikely to see the wild swings in share price seen in small and micro-cap companies. They are also much more likely to pay a dividend and can therefore offer a winning combination of growth and income.
Candidates for promotion
Another reason to take a good look at the FTSE 250 is that the index contains many contenders for the top tier of the UK market. In simple terms, it provides the pool from which the market giants of tomorrow are drawn.
Which stocks are the most attractive?
Investment bank Berenberg has set itself the task of identifying the large caps of the future, looking not just at the FTSE 250 but also some of the larger companies on AIM.
It comments: ‘Having met over 250 companies in the past four years and screened many more, we have established a framework for thinking about businesses that tries to identify which of them can become materially bigger on a multi-year view.’
Its top picks include computer games services group Keywords Studios (KWS:AIM), financial services group Sanne (SNN), ligitation specialist Burford Capital (BUR:AIM), veterinary group CVS (CVSG) and online travel agent On The Beach (OTB).
The top 10 list is completed with food supplier Cranswick (CWK), identity data firm GB Group (GBG:AIM), document storage specialist Restore (RST:AIM), leisure stock Dalata Hotels (DAL) and gaming machines technology business Quixant (QXT:AIM).
Berenberg has also identified three current themes worth playing alongside these long-term preferences.
Furthermore, it also likes three businesses currently engaged in a restructuring process, namely electronics outfit Laird (LRD), building materials firm Low & Bonar (LWB) and specialist retailer Pets at Home (PETS).
Read on to discover the stocks picked by the journalists at Shares. We highlight six stocks with a mix of value and income attractions from the FTSE 250.
FTSE 250 VALUE STOCKS
The outperformance of the FTSE 250 is longstanding. Over the last decade the mid cap index has increased in value by nearly 75% while the FTSE 100 is up 17.5%.
Against this backdrop it can be harder to find stocks where potentially superior growth potential is not already being factored in by investors.
But there are still some companies which, if not dirt cheap, are yet to receive full credit for the quality of their business and prospects and, as such, offer genuine value.
We now discuss three names which look attractive on several different metrics, including price to earnings and price to net asset value. We have ‘buy’ ratings on all three stocks.
Industrial threads and consumer textile crafts firm Coats is one of those companies unfamiliar to most people yet provides essential things in everyday life.
Its products are used in a wide range of items such as stitching in trainers and threads for making tea bags, to zips on coats and tape around mattresses.
We think now is the ideal time to buy the shares despite them having increased three-fold over the past 18 months. That rally was down to fixing pension problems. With those distractions now out of the way, the investment case is purely focused on the core business, driving up margins and driving down debt.
This is a superb company growing profit each year and delivering a superior return on the money it invests in the business.
‘We expect the retail supply chain to change in the coming years as suppliers combat rising labour costs by placing greater emphasis on automation, localisation, product innovation, and sustainability,’ says investment bank Berenberg.
‘In our view, Coats is one company that is well positioned to benefit and take market share from peers.
‘The shares currently trade on 8.2x 2018 EV/EBITDA, and we think there is potential for upgrades through M&A, market share gains, and productivity improvements.’
Our view is that the shares are too cheap for a company forecast to generate at least 25% return on capital each year, together with 8%+ annual dividend growth.
If you’re looking for value in the banking sector then Virgin Money definitely fits the bill. It is trading on a mere 6.3 times forecast earnings for 2018 despite a very attractive earning profile. As a comparison, Lloyds (LLOY) trades on 9.9 times next year’s forecast earnings.
It is also cheap on other valuation metrics. For example, the shares are trading on 0.8 times to forecast tangible net asset value for 2018, according to Investec estimates.
Virgin Money serves the retail market predominantly with residential mortgages, savings and credit cards. It plans to launch a digital banking service with more details to be announced in November.
Group pre-tax profit is forecast to consistently grow, advancing from £138m in 2015 to £341m by 2019 which adds up to a 147% gain.
Investec analyst Ian Gordon says the market is worried about a slowdown in UK mortgage lending, yet data shows continual growth. He is very bullish on Virgin Money as an investment with a 390p, 12-month price target – implying nearly a 50% potential gain if you buy today.
It is also worth noting market concerns about rising consumer indebtedness and fears about people not being able to keep up on credit repayments if the UK economy deteriorated. Virgin Money says its customer indebtedness is low and reducing.
‘We have no concerns about the quality of our credit card book,’ said chief executive Jayne-Anne Gadhia at the bank’s half year results in July.
Vesuvius is a cyclical engineer that relies on the health of the global steel industry. We think its rating is undemanding given decent earnings growth potential and a nice dividend yield on top.
The £1.58bn company designs and manufactures specialist products that control and protect the flow of steel in foundries, plus other casting units. It also supplies efficiency modules to the industry.
The steel industry is currently in decent shape and the outlook appears fairly positive according to most analysts.
This has played well for Vesuvius, which is one of many UK heavy industry companies to have enjoyed double-digit increases to earnings forecasts thanks to positive trading, growth inspired acquisitions and streamlined operational costs.
UBS anticipates operating profit margins going from 9.5% in 2016 to 11.5% in 2018. A dividend growing in the mid-single digits and yielding 2.9% this year bolsters a modestly-rated share price trading on a 2018 price earnings multiple of 13.1.
FTSE 250 INCOME STOCKS
One of the attractions of mid-caps is that they should have reached a point of maturity where they are generating sufficient cash flow to fund dividend payments to their shareholders.
If you’re looking for income, don’t simply go for the stocks with the highest yield. A falling share price can result in a yield looking attractive, but a falling share price is also a warning that something might be wrong with the business and the dividend could be in danger.
Focus on companies which are generating plenty of cash flow which will allow them to pay a consistent and rising dividend over time. All three of the names which follow fall into this category.
This company specialises in buying portfolios of life insurance policies which are closed to new business and then managing them efficiently so they deliver plenty of cash flow which can be returned to shareholders.
The company boosted its assets under management through the £935m acquisition of Abbey Life Assurance last September.
This strategy puts the company in a different category to stocks which are on a high yield due to justified scepticism over their ability to maintain the dividend.
Berenberg analyst Trevor Moss argues Phoenix’s is ‘one of the most secure and should be for many years to come’.
The dividend payment looks set to rise as the company does further deals, with management on record as saying it has firepower of £500m for M&A.
There should be plenty of opportunities to put this money to work as Moss explains. ‘The industry dynamics continue to change, with companies looking to become more like asset managers, be more capital light, focus on digital models, release trapped capital or simply focus on what they are best at doing,’ he says.
Water group Pennon is a classic utility income stock. It has stable regulated earnings balanced with faster growth from its energy and waste business Viridor.
The two businesses split neatly for investors. Viridor provides the growth, via its 12 energy recovery facilities, effectively energy generation units from waste and recycling.
Its South West Water arm is the regulated water supply business. It provides the big cash engine to pay the vital dividend.
Both sides of the business have been ticking over nicely with full year to 31 Match 2017 results slightly ahead of analyst expectations.
The only drag comes from a renegotiated contract in Manchester, with the local authority client pleading penury thanks to the government’s ongoing austerity penny pinching. It explains the recent share price weakness with the stock down 14% since late May. That issue now seems to be settled.
But Pennon has again reiterated its promise to lift the dividend by 4% over and above RPI inflation going forward, securing attractive inflation-proofed income for investors.
Analysts at UBS anticipate 7.5% dividend growth this year to 38.7p per share, implying a 4.8% income yield.
Budget greetings cards-to-gifts seller Card Factory is providing a steady stream of progressive ordinary dividends and special dividends amid inclement retail conditions.
Card Factory’s positive half year update (10 Aug) flagged 3.1% like-for-like sales growth, while its vertically integrated model allows the retailer to maintain strong margins, generate oodles of cash and keep prices low.
Stockbroker Peel Hunt has upgraded its 12-month price target from 400p to 430p, flagging the continuing woes at Clintons, Card Factory’s main competitor, which is shuttering stores.
Card Factory yields 7.5%, based on Peel Hunt’s year-to-January 2018 forecast for pre-tax profit of £87.8m (2017: £85.1m) and a 25p dividend (including an expected 15p special dividend on top of a 10p ordinary payout), rising to £96m and 26p respectively for the financial year ending January 2019.
These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell Youinvest.
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