Mid-cap companies have always attracted investors. Seen as large enough to compete on a global scale, but not so big that their capacity for growth is capped, like many FTSE 100 stocks, an increasing number of investors spend time researching stocks on the FTSE 250 index, or simply buy the index through the handful of inexpensive targeted ETF tracker funds that are available.

While many 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 Mike Ashley’s ‘pile ‘em high, sell ‘em cheap’ retailer Frasers (FRAS), for example, or discount flyer EasyJet (EZJ)?

Others mid-caps you may know include Marks & Spencer (MKS), Domino’s Pizza (DOM), Moneysupermarket (MONY), Go-Ahead (GOG), and housebuilders Bellway (BWY) and Redrow (RDW), by name, if not by stock market index membership.

As Shares outlined last year, Jean Roche, lead manager of the Schroder UK Mid Cap Fund (SCP) and co-manager Andy Brough, refer to the FTSE 250 as the ‘Heineken Index’ given its potential to ‘refresh’ portfolios in a way other parts of the market cannot because of the healthy amount of turnover in the index.

The FTSE 250 has become a favourite hunting ground for many UK-focused fund managers looking for an edge because there is less analyst coverage of the companies in the mid-cap part of the market and, it is thought, more room to find mispriced stocks.

Emphasising mid-cap stocks’ capacity to grow further and faster than FTSE 100 constituents, the FTSE 250 has a long history of beating its blue-chip counterpart. Until recently, that is. Data from FTSE Russell shows that since the global financial crisis ended the FTSE 250 had beaten the FTSE 100 in annual performance terms every year bar two (2011 and 2016) through to the end of 2017.

The FTSE 250’s total return (assuming dividends were reinvested) for the index since its 1992 debut was 1,637%.

But performance has become far more volatile during the past five years, during which Brexit, a global pandemic, war in eastern Europe and surging inflation have shaken investor assumptions. FTSE 250 stocks have underperformed the FTSE 100 in three of the past four years.

So far this year, the pattern has repeated, with the FTSE 100 off just 0.5% from its 2022 starting point, according to Google Finance data, versus a near-16% decline for mid-caps.

Georgina Brittain, who manages investment trust JPMorgan Mid Cap (JMF) alongside co-manager Katen Patel, says the FTSE 250 offers exposure to great British businesses with plenty of scope for growth.

‘While uncertainty still remains, which may cause some short-term volatility, we see attractive growth opportunities, with FTSE 250 constituents well placed to thrive in a recovery over the long term.’

WHAT MOVES THE FTSE 250?

Like any equity index, the FTSE 250 responds to macro events and data more than anything else, as we have seen this year with supply chain snarl-ups, a cost-of-living crisis, energy price spikes and Russian invasion of Ukraine.

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

This point is arguable. According from 30 June 2022 data from FTSE Russell, about 70% of the FTSE 250’s weighting is split between just three sectors: financials, industrials and consumer discretionary.

This is illustrated by the presence of insurers Direct Line (DLG) and Beazley (BEZ), engineers Weir (WEIR) and Johnson Matthey (JMAT), EasyJet, Frasers and Marks & Spencer, featuring among the index’s most influential by weighting.

In truth, financials exert a far smaller influence over the index’s direction than the data suggests. That’s because of the high number of investment trusts in the FTSE 250. More than 50 are listed on the index, with the majority of them valued in excess of £1 billion, with F&C Investment Trust (FCIT), RIT Capital Partners (RCP) and Tritax Big Box REIT (BBOX) among the biggest.

Since many of these trusts invest in non-financial companies, the FTSE 250 is influenced by a wider range of sectors than the data implies.

That the FTSE 250 is perceived as the better barometer of the UK economy than the FTSE 100 is also more marginal than you might think. Data shows that something like 70% to 75% of FTSE 100 revenues are earned overseas, versus FTSE 250 constituent revenues that are more evenly split between overseas and domestic sources, with the split nearer 50-50, so the index is not really the UK economic health barometer many believe it to be.

WHAT’S WORKED AND WHAT HASN’T

There are always companies that are capable of bucking wider index trends and this year has been no different. While the FTSE 250 has drifted lower through 2022, stocks such as Go-Ahead and Euromoney Institutional Investor (ERM) have jumped, having been the subject of takeover offers at significant premiums to where the shares had been trading previously, roughly 25% and 40% respectively.

Other FTSE 250 companies have been able to take advantage of their opportunities, such as military technology and intelligence specialist Qinetiq (QQ.). It is 2022’s best-performing
mid-cap outside of takeovers thanks to its strong forward order book to supply governments around the world with weapons and equipment. That demand has only accelerated, and investor interested heightened, by the ongoing war in Ukraine and at 390p, the stock has never been higher.

At the opposite end of the spectrum sit many names feeling the obvious pinch from slowing consumer spending as pressure tightens on household budgets. Companies like Wizz Air (WIZZ), Restaurant Group (RTN) and Future (FUTR) have fallen close to 50% or more this year as growth expectations have been reeled back and valuations have compressed, creating a painful double-hit for shareholders.

Yes, there are victims of large self-inflicted problems. Sports cars maker Aston Martin (AST) is the FTSE 250’s biggest faller this year to date (down 63%) with profits from its expensive vehicles remaining elusive and funding struggles ongoing.

Yet there are other casualties this year that remain perfectly fine businesses that are challenged by wider economic issues that should prove reasonably short-term. People haven’t stopped eating lunch, but fewer are buying it at Greggs (GRG) at the moment, and demand for Dunelm’s (DNLM) home furnishings will presumably pick-up again when Brits feel less financially constrained by rising prices.

This means that investors now have opportunities to invest in many good businesses at price points lower than before. History shows that it is when investors feel most gloomy that equities are most attractive. Are we there yet? That’s the million-dollar question, but Shares believes the following three stocks provide substantial upside for investors willing to be patient and take a medium-term view.

FTSE 250 STOCKS TO BUY

Kainos (KNOS) £13.49

Shares in digital transformation specialist Kainos (KNOS) have rallied more than 40% since closing at a 2022 low of 954.5p on 16 June. It’s a stellar bounce for a stock that at its low point had lost half its market value this year.

Driving this change in investor mood is confidence in the company’s Workday (WDAY:NASDAQ) practice. Kainos is a leading Workday partner and the only specialist headquartered in the UK. Workday offers tools to help manage finance, HR, planning and investment management functions for businesses and large organisations. Having first engaged with Workday in 2011, Kainos’ Workday practice reported revenue growth for full year 2022 (to 31 Mar) of 41% to £102.8 million, representing 34% of the company’s overall revenue.

Recently, the US enterprise applications giant announced that the number of Workday Extend customers has doubled in the past year as more organisations look to leverage the Workday platform to quickly innovate and adapt to an ever-changing landscape. Kainos was specifically mentioned in the press release.

This followed recent Workday news that it was seeing a ‘surge’ in demand for its Adaptive Planning Solution, which provides a scalable platform that supports highly flexible modelling without compromising ease of use.

As a result, the planning process becomes more collaborative across an organisation, helping improve operational efficiency and decision-making, great features for businesses increasingly confronted by workforces operating all over the globe, many from home.

Kainos believes it can outpace Workday’s rapid market growth by continuing its international expansion and by replacing other Workday partners in engagements where they are underserving their customers. Such ambition does not depend on any ‘heroic’ strategic execution by Kainos, say analysts at Shore Capital, but rather on a continuation of the formula that has already delivered five-year revenue compound annual growth rates of 50% from Kainos’ Workday arm.

‘Kainos increased the number of its accredited Workday consultants by 53% in fiscal 2022 to 638, a bold move,’ said Shore Cap. The firm’s Workday practice saw its workflow backlog surge 46% to £127 million as at 31 March 2022. Kainos’ execution chemistry is increasingly appealing to clients. [SF]

Coats (COA) 73.2p

You might never have heard of sewing thread manufacturer and supplier Coats (COA) but you may well have worn an item of clothing which includes its products.

One in five garments sold globally are stitched together using its thread and clients include the likes of Nike (NKE:NYSE) and Adidas (ADS:ETR).

While there may be some short-term headwinds associated with any downturn in the economy, longer term this looks an excellent business and one which can be bought for just 10 times 2023 earnings based on consensus forecasts.

Coats is the market leader in its field with, according to investment bank Berenberg, nearly
a quarter of the global apparel and footwear thread market.

This robust market position is underpinned by its scale, operating in more than 60 countries, an enduring reputation for quality, with origins that go all the way back to the 18th century, and its technological expertise, including in areas like colour matching.

The company has made a material investment in its digital capabilities and it has fine-tuned its supply chain skills, ensuring customers have exactly what they need when they need it. 

These strengths, plus its ESG (environmental, social and governance) credentials and a strong balance sheet should stand it in good stead to grow its market share in the future. 

Berenberg analyst Anthony Plom comments: ‘Management estimates the group took 2% market share over the past 12 months and we think there is potential for this to expand further in the coming years.’

The company also has scope to boost its margins, which have already improved from 7.3% in 2012 to a high of 14.3% in 2019 before the pandemic. The sale of unprofitable operations in Latin America will help, as will internal efficiencies.

On top of all these attractions, Coats offers a reasonable yield of 2.6%, with the dividend growing at a decent lick from the level it was rebased to during the pandemic. [TS]

888 Holdings (888) 147.6p

We believe that a multiple of 8.5 times 2022 earnings doesn’t reflect the value of the synergies expected to be gleaned from 888 Holdings’ (888) William Hill International acquisition or the growth potential from the enlarged business. 

Along with other lockdown winners 888 experienced an increase in customers and activity when people were stuck at home with nothing else to do. 

The shares embarked on a big run-up, eventually gaining 191% from the start of the pandemic to peak at 452p in September 2021.

The shares have since lost around two thirds of their value, effectively returning to their pre-pandemic level, making them one of the worst performing FTSE 250 names.

It wasn’t just tough comparatives and softer trading which pushed the shares down. 

Uncertainty over a rights issue to part-fund the £2.2 billion acquisition of William Hill’s international arm and concerns over stricter regulation from the government’s Gambling Review also weighed on sentiment.

The risks of both events turned out to be less impactful than many analysts anticipated. Instead of raising £500 million in new equity the company conducted an institutional placing which raised a mere £163 million at 230p, a roughly 20% premium to the share price.

In addition, the company lowered the enterprise value (market cap plus net debt) of the deal to between £1.95 billion and £2.05 billion.

Investors can now focus on the financial and strategic benefits of the William Hill acquisition. The deal catapults the combined group into a top three market position in the UK and Spain and top five across several markets.

The combination creates greater scale to exploit online growth opportunities which still only represent around 16% of global gambling and gaming revenues. 

Management expect to deliver at least £100 million of pre-tax cost synergies by 2025. The cash generative characteristics of the group should allow it to quickly pay down debts, adding further potential value to shareholders.

While execution risks should not be underestimated the balance of risk to reward looks favourable at the current price. [MGam]

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