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How the mid cap index works and the companies driving the market
Thursday 30 Aug 2018 Author: Steven Frazer

In a companion piece to last week’s FTSE 100 special, this week Shares investigates the FTSE 250 index, the authoritative measure of UK-quoted mid cap companies.

It could be described as Anteros to the FTSE 100’s Eros; the FTSE 250 is more obscure than its larger and more celebrated sibling index yet it has attracted investment right from its October 1992 launch.

Perceived as the better barometer of the UK economy, FTSE 250 constituent revenues are more evenly split between overseas and domestic sources than its bigger brother yet 51% of revenues still come from aboard. Evidently, the FTSE 250 is not the UK pure-play index that many believe it to be.

WHAT MOVES THE FTSE 250?

The FTSE 250 is heavily influenced by the FTSE 100 because investors and markets respond to macro events and data more than anything else, as we have seen with aspects such as rising oil prices, trade war concerns and Brexit.

Putting that to one side, the mid cap index is widely believed to enjoy a more balanced split between sectors, unlike the FTSE 100, where banks, resources and consumer companies dominate.

This point is arguable. According to 31 July 2018 data from FTSE Russell, more than 78% of the FTSE 250’s weighting is split between just three sectors: financials, industrials and consumer services.

This is illustrated by the presence of insurance firms Hiscox (HSX), Phoenix (PHNX) and engineers Spirax-Sarco (SPX) and Weir (WEIR) which feature among the index’s most influential by weighting.

Financials exert an enormous influence over the index’s direction with 40.5% of the FTSE 250 weighting alone.

The explanation is the high density of investment trusts in the FTSE 250. More than 40 are listed on the index with approximately half of them valued in excess of £1bn, with Alliance Trust (ATST), Monks (MNKS) and Templeton Emerging Markets (TEM) among the biggest, so they have a broad influence on the FTSE 250’s direction.

FAMILIAR NAMES

While investors might be on less intimate terms with the FTSE 250 in general there are many companies in the index that will seem like part of the furniture. Who doesn’t know breakdown firm AA (AA.), for example, or pile ‘em high, sell ‘em cheap sports retailer Sports Direct (SPD)?

Others you’ll also know include Domino’s Pizza (DOM), Moneysupermarket (MONY), TalkTalk (TALK) or cinemas operator Cineworld (CINE), by name if not by stock market index membership.

Perhaps the most important assumption investors make about the FTSE 250 is that smaller companies have a greater capacity to grow, and grow faster. Elephants don’t gallop, but fleas jump, to repeat the stock market idiom.

PERFORMANCE & PROSPECTS

Since the global financial crisis ended the FTSE 250 has beaten the FTSE 100 in annual performance terms every year bar two (2011 and 2016). According to FTSE Russell data last year, the FTSE 250 total return (assuming dividends were reinvested) for the index since its debut was 1,637% (to 31 Aug 2017).

Pessimism towards UK equities has become entrenched since the nation voted for Brexit. The ensuing economic uncertainty and political backdrop ahead of the UK’s exit from the EU is still weighing heavily on wider market sentiment.

As analysts at Schroders recently put it, the UK stock market is ‘currently viewed by international investors as one of the least favoured asset classes’.

This level of negativity is at odds with much of the news and corporate results we’ve seen from many mid cap companies this year, whose earnings have often exceeded market expectations.

It isn’t to say there aren’t some highly challenged mid cap sectors and companies, as the seemingly never ending litany of woe from the traditional bricks and mortar retailers reminds us, for example.

Yet prospects for UK mid cap companies are not, we believe, as poor as the wider investment community perceives it, a point on which Schroders’ experts agree, who conclude that ‘this could be to the stock picker’s benefit’.

 

FOUR OF OUR FAVOURITE FTSE 250 STOCKS

ENTERTAINMENT ONE (ETO) 365.8p BUY

Over the long-term we expect TV and film rights business Entertainment One (ETO) to be a
major beneficiary of strong global demand for media content.

Streaming services, such as Amazon’s Prime Video and Netflix, as well as subscription channels offered by the likes of Sky (SKY), need plenty of films and TV shows, such as those produced by Entertainment One, to hold on to their prized subscribers.

The company’s rights ownership of leading pre-school brand Peppa Pig is also a big plus point.

The proliferation of Peppa into new markets, including China where a new movie is set for release in February 2019, offers an increasingly global shop window for a highly lucrative range of toys and other merchandise from which the company takes a healthy cut.

Launched in 2004, Peppa’s appeal shows no sign of fading. In the year to 31 March 2018 the brand generated $1.3bn of retail sales.

There are early signs Entertainment One is repeating the trick with its PJ Masks series which generated $1bn of retail sales in the same period – up from just $300m a year earlier.

An independent valuation of its existing content library at $1.7bn provides a good underpinning to the current market cap (£1.69bn or $2.18bn).

The main issue investors have had with the business, which helps account for the volatile share price in recent years, is the company’s weak cash conversion. However, as an increasing volume of content is produced in-house, giving it greater financial control, we reckon this could become less of an issue in the future.

 

FDM (FDM) 935p BUY

Every business and organisation is grappling with the problem of staying relevant in a disruptive, digital world and FDM (FDM) has the technology expertise to provide advice and solutions.

The company is an IT services and contract staffing provider operating around the globe. At the heart of its strategy is what it calls the Mounties model, under which graduates (and increasingly ex-military services personnel) are trained for free by FDM in return for at least two years of full-time service.

Parachuted in to clients, Mounties provide a wide range of technical and business functions, such as business development, testing, project management, data and business analysis, and production support.

It has now decided to trust in its Mounties workforce and stop using for-hire contractors. This is the right thing to do. Mounties are in use about 98% of their time so the more FDM can get out in the field, the better the growth.

If you strip out currency oscillations and look at earnings from a constant currency perspective, revenue in the first six months of 2018 rose 17% as the company continues to win new customers.

First-half adjusted pre-tax profit increased by 12% to £25m. That’s pretty much bang on track with full year’s £50.2m pre-tax profit forecasts, based on Stockdale estimates.

FDM has a proven record as a nimble, high-quality execution business with substantial UK and overseas growth potential. Investors need to consider the stock has rallied from 287p to 935p in four years, putting it on a 2019 price to earnings multiple of 21.6. But we believe that is not an enormous premium given the growth prospects.

 

FOUR OF OUR FAVOURITE FTSE 250 STOCKS

B&M European Value Retail (BME) 409.3p BUY

In a wider retail sector beset by challenges, general merchandise discounter B&M European Value Retail (BME) is flourishing. The multi-price discounter is a high quality structural winner, more than meriting its premium rating (it trades on 20 times forecast earnings).

It is participating in two of the three key trends re-shaping modern retailing: the rapid expansion of the value sector and the rise of convenience. It has yet to participate in online retailing as its bargain wares arguably don’t lend themselves to online transacting and CEO Simon Arora is loathed to add costs to a winning low cost model.

B&M’s disruptive value model has traction with consumers who delight in its constantly changing, seasonally-adjusted ranges.

Furthermore, B&M prospers in economic weather fair or foul, benefiting from higher average transaction values in the good times and rising footfall and volumes in the bad.

B&M is seeing good footfall at both its in and out-of-town outlets, while the collapse of competitors such as Poundworld provides a trading tailwind.

Significantly, the cash-generative, progressive dividend payer is expanding its high street footprint at a time when rival bricks and mortar retailers are retrenching. With 578 UK B&M stores at last count, Arora reckons there are ‘hundreds of catchments’ where the retailer has yet to plant a flag and sees scope for at least 950 B&M fascia stores across the UK in the years ahead.

As if all that weren’t enough, 2017’s £152m acquisition of Heron Foods is allowing B&M to roll out a complementary discount convenience grocery brand and provides a platform for introducing frozen and chilled foods into B&M stores. The group also has a platform for growth in Germany via its Jawoll chain.

 

SYNCONA (SYNC) 264.8p BUY

Life sciences fund Syncona (SYNC) has a portfolio of innovative companies that tap into the lucrative healthcare market.

Global healthcare expenditure is anticipated to hit $8.7trn by 2020 according to Deloitte.

Syncona focuses on cell and gene therapies to treat a range of diseases and provides investors with access to a £515m life sciences portfolio and £465m investment portfolio.

It hopes to tighten its focus on life sciences even further, which in the year to 31 March 2018 delivered a 57.2% return, dwarfing the 7.5% return from the investment portfolio over the same period.

The fund is aligned with original founder The Wellcome Trust and Cancer Research UK, both significant shareholders in the business.

Syncona looks for businesses that develop transformational treatments. It takes a significant stake in portfolio companies and works with them to help build a successful long-term commercial entity. This strategy appears to be paying off as the fund delivered 18.7% net asset value return in 2017.

One of Syncona’s top holdings, gene therapy developer Autolus, works on cancer treatments via CAR-T therapies, which aim to use the immune system to identify and attack cancer cells.

It has been a big year for Autolus after floating on the US NASDAQ market in June, enhancing the value of Syncona’s stake from £69.6m to £86.7m and prompting the fund to invest an extra $24m (£18.1m) in the business.

Other investments include Blue Earth which has developed Axumin, a diagnostic imaging agent.

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