Corporate balance sheets are particularly strong by historic standards, and this is affording company managers the opportunity to significantly influence future shareholder returns.
In particular, there has been an increase in capital returns via special dividends, with a number of companies becoming more explicit about the thought process behind them.
An example is Elementis, the chemical company, which has suggested it will invest surplus capital on an annual basis by making accretive ‘bolt on’ acquisitions and, if it is unable to find such targets, will return capital allocated for this purpose to shareholders.
One of our long-term holdings, Rightmove, has a strong focus on total shareholder return.
As the leader in the online residential property advertising market, Rightmove is a prodigious cash generator, continues to grow profits strongly, has pricing power and employs relatively little capital. Companies that show these qualities, together with shareholder focus are rare.
Macroeconomic influences have had a big impact on the UK mid cap sector, and in many cases this has been positive. There are a number of UK stocks that have seen a competitive advantage arise from the economic stress caused by the credit crisis.
For example, Booker benefited from the excessive financial leverage of its main competitors, Dixons Group was aided (among other things) by the demise of Comet and Sports Direct was able to increase its market share following the administration of JJB Sports.
The government’s stimulation of the housing market over recent years has been a positive force for companies exposed to the housing sector. House builders such as Barratt and Bellway have provided positive returns as improving sales rates, price inflation and cheap land, have fed through to accelerating profitability.
House builders remain attractive to us, mainly because these companies can still buy land at levels equal to, or above, their targeted returns. Other stocks impacted by the housing market such as Travis Perkins and Howden Joinery, which have prospered from operational excellence to date, should now benefit cyclically as housing transactions increase.
Influences from across the pond
Around half of FTSE 250 corporate earnings come from outside the UK, therefore it is not just domestic UK factors that are relevant to the success of UK mid caps. For example, the theme of US reindustrialisation has benefited a number of stocks.
The nascent recovery in the US construction market has added a cyclical tailwind for UK-based mid cap stocks such as Ashtead, a plant hire company.
Ashtead is well capitalised, has a comparatively young fleet and continues to differentiate through service. It has a 6% market share in a market that is not only experiencing a cyclical upswing but is structurally growing, as construction companies continue to reduce the amount of capital tied up in industrial plant.
US non-residential construction is closer to the beginning of an upturn than the start of a downturn and while we accept that this company is ultimately beholden to a cycle, the investment case appears attractive.
Chris St John’s economic outlook
The growth outlook appears to be improving and those looking to increase allocations to UK equities should not ignore the potentially significant opportunities in UK mid caps.
The economic picture in most geographic regions appears to be stabilising, or even improving, and the time is drawing near when this should hopefully be reflected in corporate earnings.
As confidence improves, we are optimistic that corporate profitability will grow as a result, not only of cost cutting, but turnover growth. UK company balance sheets are strong, with gross cash of £0.5 trillion, which gives management teams the flexibility to grow organically, increase dividends, become involved in corporate activity or increase capital expenditure, all of which benefits equityholders.
In addition to an improving economic outlook, management confidence now appears to be growing, and as these ‘animal spirits’ are awoken this should lead to an increase in corporate spending, which would benefit UK mid cap stocks. With forecasts prudently set, certain companies will be able to grow their earnings impressively and those that do should be rewarded with an appreciating share price.
Geopolitical influences will continue to affect stock markets and this is a fact that must be accepted, however, there are many compelling investment opportunities. There may be more volatility in stock markets in the short term, and this will create buying opportunities for investors. In our view, The long-term prospects for UK mid caps remain strong.
Chris St John manages the AXA Framlington UK Mid Cap fund which is second out of eleven funds in the UK Medium Companies sector over one year. St John has returned 33.8% against the average manager's 27.5%.