This is part two of a three-part series on the FTSE 250. Read part one here and we’ll conclude the series in next week’s issue. 

In our three part series on the FTSE 250 we are aiming to slice and dice the index to identify stocks with different inherent qualities and generate ideas for investors. This week in part two we look at the FTSE 250 from the perspective of growth versus valuation and dividend expansion, and finish with a look at funds which focus on mid-cap stocks.

GROWTH VS VALUE

Historically, earnings for the FTSE 250 have grown at a faster clip than FTSE 100 earnings for the simple reason that smaller companies tend to grow more quickly.

Moreover, many of the biggest stocks in the FTSE 100 are in low-growth sectors like energy, mining, banking and consumer staples, which lowers the average rate of earnings growth.

In contrast, many of the biggest stocks in the FTSE 250 are in faster-growing – albeit more volatile – sectors such as industrial goods, media and travel and leisure.

As a result of their higher earnings growth, mid-cap companies tend to trade on a higher multiple, so whereas the FTSE 100 has typically been valued at around 14 to 16 times cyclically adjusted earnings over the last decade, the FTSE 250 has traded at over 20 times cyclically adjusted earnings over the same period.

Therefore, the question is how much should you pay for growth? One simple screen which was popularized by legendary Fidelity fund manager Peter Lynch, and is still used today by Mark Slater to manage client assets, is the PEG or price to earnings growth ratio.

In a nutshell, if a company grows its earnings at 10% and is priced at 10 times earnings, it is trading on a PEG of 1, whereas if it were priced at 20 times earnings it would be on a PEG of 2, which
is clearly less attractive.

The PEG is a useful way of comparing companies with different earnings growth rates in different sectors. On paper at least, stocks with a low growth rate should trade at a low PEG while those with higher growth rates should trade on a higher PEG, as most investors tend to like more rather than less growth, but that isn’t always
the case.

Right now, our PEG screen – which has been constructed using data from Sharepad – is picking up a strong rebound in profits at housebuilders, specialty chemical and consumer stocks, which suffered during lockdown.

It’s interesting to note that among the stocks with the lowest PEGs are Morrisons (MRW) and Vectura (VEC), both of which are bid targets, as well as several of our running buy ideas such as Biffa (BIFF), 4imprint (FOUR), Gamesys (GYS) and Marshalls (MSLH).

Meanwhile, stocks which benefited from us all being cooped up at home with time – and in many cases money – on our hands during lockdown are now losing momentum as customers return to going out and having fun again.

DESPERATELY SEEKING INCOME

Importantly, while we have seen a strong rebound in earnings back towards pre-pandemic levels in many sectors, the recovery in dividends has been much slower.

As Bruce Stout, manager of Murray International investment trust (MYI), points out in his half-year review of the markets, many companies are opting to re-base their dividends while they wait and see what shape the recovery takes.

‘Improving global growth prospects and rising corporate profitability restored confidence that manifested itself in almost universally higher equity prices. But numerous companies remained very cautious when it came to returning improving cash flows to shareholders.

‘Opting to reset dividends below pre-pandemic levels or to keep dividends unchanged until greater transparency emerges was commonplace against a backdrop of viral mutations and constantly changing directives from governments.

‘Unlike previous periods of dividend recessions, the path to income recovery may take much longer for certain economic sectors and businesses this time around. A focus on strong corporate balance sheets, flexible investment parameters and diversified geographical exposures remains key for driving sustainable income growth in and beyond the current environment.’

Once again, we have screened the FTSE 250 using Sharepad to identify those companies which are rewarding investors with increased pay-outs and those which have chosen to stockpile cash instead.

Reassuringly, most of the companies which are enjoying a dynamic rebound in earnings are sharing their good fortune with their shareholders as a reward for sticking with them.

Therefore the list of big dividend growers is full of the same house builders and construction-related names as the first table, with the addition of a few software companies and impressively homewares retailer Dunelm (DNLM), which had a good run during lockdown thanks to its online operations but has also seen customers return once store restrictions were lifted.

There are also a few familiar names on the dividend cutters list, most notably the trading platforms, which is probably due to their policy of a fixed pay-out ratio come what may.

However, the presence of several ‘quality industrials’ is also noteworthy, as is the inclusion of automotive systems firm TI Fluid Systems (TIFS) which is enjoying a big recovery in earnings but not sharing the love with its investors.

FUNDS TO PLAY THE MID-CAP MARKET

There are plenty of funds and investment trusts specialising in mid-cap stocks, run by respected fund management firms as Allianz, JPMorgan and Schroders (SDR) and raning in size from
£50 million to over £3.5 billion.

The top-ranked fund over three years is the ASI UK Mid-Cap Equity Fund (B0XWNT2), which was moved to the smaller companies team three years ago and is run by Abby Glennie and Amanda Yeaman.

The fund targets an annual return of 3% over the FTSE 250 index over three years, but has actually delivered more than three times the return of the FTSE 250 index and the Investment Association’s UK
All-Companies index over the last three years.

The duo’s stock selection process identifies ‘companies which show a range of high-quality characteristics, operate in growing markets and display positive business momentum’, which inevitably means the portfolio can look a lot different to the underlying index.

Currently the highest weightings are in technology and financial stocks, which make up 21.9% and 16.2% of the fund respectively. The top 10 holdings, which make up almost a third of the portfolio, are very different to the top 10 FTSE 250 stocks by weighting which make up just over 10% of the index.

The trade-off for the outstanding performance is a dividend yield of just 0.5% compared with a current dividend yield of 1.88% for the FTSE 250 but given the fund’s approach to stock picking this shouldn’t be a great surprise.

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