Page 13 - DIY Investor Magazine | Issue 40

‘GIVEN THE EXTENT OF UNDERVALUATION THAT WE SEE, THIS COULD BE THE START OF A MUCH LONGER-TERM TREND’
This is a part of the market that is particularly sensitive to inflation and interest rates, so it seems likely that the growing belief in markets that UK and US interest rates have now peaked, has played a role in the recent resurgence of interest in UK mid cap stocks.
Jean Roche, portfolio manager of the Schroder UK Mid Cap Fund plc, explains:
“UK mid caps are an inflation-sensitive part of the market, so the recent decline in consumer price inflation data both here in the UK and in the US, is seen as a positive for our sector.
Most economists now expect interest rates to fall, with the average forecast now for a 1% rate cut this year, followed by another 1% in 2025. This appears to have prompted renewed interest in UK mid caps in recent weeks but, given the extent of undervaluation that we see, this could be the start of a much longer-term trend.”
BID PREMIUM
Jean also points to the prospect of continued merger & acquisition (M&A) activity as a reason for optimism. M&A activity has been elevated in recent years, as foreign buyers and private equity have been keen to take advantage of
the UK’s depressed valuations. Indeed, in 2023, UK M&A transactions carried an average price premium of 51%, which reflects how under-valued UK equities have become.
Due to their size, small and mid-sized companies are much more likely to become acquisition targets than large companies. Despite this, the number of bids being received by UK mid cap companies was surprisingly low last year. This may signal pent- up demand, which could point to greater M&A activity among UK mid caps over the next couple of years.
SHRINKING MARKET
UK businesses are also showing tremendous capital discipline in buying back their own shares to take advantage of their current undervaluation. Jean is positive on share buybacks, as long as they are done at the right price.
‘THIS COULD BE A CATALYST FOR IMPROVED SHARE PRICE PERFORMANCE BECAUSE SHARE BUYBACKS MEAN MORE DEMAND FOR UK EQUITIES, ALONG WITH A DIMINISHING SUPPLY’
“Of all the uses of cash flow, share buybacks are among the most attractive if they are conducted when a company’s share price is depressed.
We are delighted to see more share buybacks among selected UK mid caps because it demonstrates sensible capital allocation decision-making in the current environment.
Within the Schroder UK Mid Cap portfolio, financial holdings Man Group and Paragon have both been actively buying back their shares recently and generating high returns from doing so.
Meanwhile, industrial business Bodycote was intending to acquire another company but has subsequently decided to buy back its own shares instead, because the return it can generate from doing so is even greater. This demonstrates excellent capital discipline, which we believe is reflected across much of the portfolio.”
Nearly a quarter of UK mid cap stocks bought back at least
1% of their outstanding shares in 2023, which is significantly higher than the historical average. In its own right this could be a catalyst for improved share price performance because share buybacks mean more demand for UK equities, along with a diminishing supply.
In simple economic terms, increased demand and lower supply tends to be reflected in higher prices. Share buybacks in aggregate could, therefore, represent a very significant buyer of UK equities, which the chart above suggests has been absent for many years.
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April 2024
DIY Investor Magazine ·