This is the final part of our three-part series on the FTSE 250. Read our introduction here and catch up on the growth versus value debate in part two here.

In this last part of our mini-series on the FTSE 250 we take a look at some of the higher quality stocks that inhabit the UK’s mid-cap universe. We will discuss some of the companies that demonstrate real financial strength and balance sheet health, show some of the stocks with the largest boardroom stakes, including what this can and cannot tell investors, and finish up with a spin through the index through an analyst lens, showing stocks with some of the biggest upside potential if existing price targets prove correct.

FINANCIAL FITNESS

Most investors will have a reasonable grasp of metrics that highlight a company’s balance sheet strength and overall financial fitness. Things like return on capital employed, free cash flow, revenue and earnings reliability and debt management are part of everyday stock investment.

But there are more ways to skin a cat, and the Piotroski rating is one useful tool to have at hand that can help improve investment returns. Professor Joseph Piotroski, at the University of Chicago, developed the F-Score to improve the returns of an investment strategy, particularly when hunting for companies trading cheaply relative to their assets, or book value.

The Piotroski F-Score is a nine-point scoring system designed to evaluate the financial strength of a business based on its profitability, leverage, liquidity, source of funds, and operating efficiency. Based on his study, a firm with a Piotroski score of eight or, ideally nine, is in a strong financial position while companies with a score lower than three are financially weak and should be handled with caution.

His back-tested study showed that it worked. If you invested in only companies that scored eight or nine on his F-Score scale over the 20-year period from 1976 to 1996, you would have outperformed the market by an average of 13.4% per year.

According to Stockopedia’s Piotroski F-Score list, companies like bus and trains operator FirstGroup (FGP), car dealer Inchcape (INCH) and engineer IMI (IMI) all score top marks. Stand out companies include power electronics firm XP Power (XPP), bakeries marvel Greggs (GRG) and Watches of Switzerland (WOSG), the luxury timepiece seller that is rapidly proving its quality as a business.

WATCHING THE DIRECTORS

Investor opinion is split about how important it is to follow the buying and selling of company directors, and how big their personal holdings are in the businesses they run. Many believe that a large stake in a company indicates that boardroom interests are better aligned with that of ordinary investors. That may be true, at least to a point, but whether stock purchases, or sales of shares, tell us anything meaningful about future returns is moot.

Take, for example, retailer Frasers (FRAS) and TUI (TUI), the holidays company. Based on Sharepad data, this pair have the largest director shareholdings of the whole FTSE 250 index – 63% and 62% respectively. Yet their three-year share price total returns records could hardly be more different, the former up 70.3%, the latter falling nearly 50%.

As the table shows, it is a similar story when directors own relatively small chunks of the companies they run. The bosses of publishing business 4imprint (FOUR) and insurer Hiscox (HSX) both own less than 2% of their respective shares available. Yet here also, returns have been markedly different, 4imprint up 49% over three years versus Hiscox down 41%.

Directors might buy or sell shares in their company for many genuine reasons, and most of the time their rationale is not made public. The thing to be aware of are the stock purchases as PR stunt – just because a director believes their stock to be undervalued doesn’t make it so.

BETTING ON ANALYSTS

Another way of trawling the FTSE 250 for investment ideas is to seek out stocks with the largest potential for gains – that is to say, where analyst share price targets imply the biggest upside.

Taking the data, supplied by Sharepad, at face value may be a mistake, certainly in isolation. On this bases, shares in biotherapeutics company PureTech Health (PRTC) could double over the next 12 to 18 months, and another half a dozen FTSE 250 stocks could rise by more than 50%.

Yet analysts are nearly always optimistic regarding the companies they cover, and data suggests, often too optimistic. Again, observing total returns over the past three years can provide a useful steer. For example, the aforementioned Puretech has delivered a total return of more than 100%, which may make analyst forecasts of 98.8% share price upside more believable, perhaps.

The City number crunchers that cover online white goods retailer AO World (AO.) see share price gains (51.5%) over the months ahead, yet it has a patchy returns track record. Seen as a huge pandemic winner, its stock rallied in the belief that millions of us would in the future be buying our appliances online. That enthusiasm has quickly begun to ebb as the realisation dawns that, as running costs soar, the model has still to demonstrate it can sustain profits and grow them as management hope.

There is value in spotting stocks that have fallen out of favour with the market because of temporary and correctable factors, but the strategy comes with substantial risks if things done work out. At the same time, financially strong companies with structural growth drivers and a track record of operational excellence will typically carry a hefty premium. Investors must decide what suits them.

Disclaimer: AJ Bell, referenced in one of the tables, owns Shares magazine. The author (Steven Frazer)  and article editor (Tom Sieber) own shares in AJ Bell.

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