Mid-caps give hope after low returns

Fund managers are lagging the index because of poor performances by small and large companies. But low market volatility and takeovers offer promise from mid-caps during the next quarter.

This year is proving to be an unusual one for investors. The average active manager is lagging the index, despite a broadly-based market and some strong share price moves in the FTSE Mid 250. It is proving a difficult market to beat, with some share price patterns challenging conventional wisdom. Even in the hedge sector, macro and equity long/short funds have found the environment tough, with average returns in single figures. Will these trends continue into the new year?

One problem has been the poor performance by many smaller companies – Alternative Investment Market stocks in particular – as liquidity and interest have drained away. Investors have become selective, focusing only on companies that might be bid targets or are consistently beating market expectations.

New issues of small or Aim companies have dramatically slowed, with the easy profits that drove hedge fund performances in 2005 now a distant memory. The few Initial Public Offerings of smaller companies that are succeeding are in strongly growing businesses in the sectors of the economy where investors already feel the need for exposure, and are being issued at heavily discounted prices.

This drop in IPO activity, and the low liquidity in smaller-company trading, has already taken its toll on some of the brokers involved, such as Evolution and Bridgewell. Further consolidation in this sector or withdrawal of capital is inevitable. The usual December and January small-cap rally is looking less likely.

While smaller companies have dented many portfolios, shares of the largest companies have also helped little. Major components of the FTSE 100 index have been making long-term relative lows. HSBC, Royal Bank of Scotland, Glaxo and BP have underperformed the market averages over a long period. Glaxo’s shares are at a 10-year relative low, following delays in its drug pipeline. Share buybacks for the company have done little to slow the decline. Large-cap is not where investors are putting their money, even though maintaining portfolio liquidity matters more.

Some large British companies, despite their international expansion, are achieving little real growth. With American bank shares continuing to perform poorly, it seems unlikely the main British banks will pick up in the short term, despite apparently low ratings. Instead, investors have moved money into insurance and other financials, where growth is clearer and bids are likely. The insurance sector is consolidating and almost all the major British businesses could be targets, given the scale of some of the overseas competitors. Among financials, the property companies are good. The prospect of Real Estate Investment Trusts next year, combined with a strong underlying rental market, has triggered strong performance.

Bid activity is also the key to one of the market’s strongest patterns over the past quarter. Medium-sized companies are outperforming both small and large. The Mid 250 may have few pharmaceuticals, oil majors or banks, but it does offer growing sectors such as support services and housebuilders. The mid-cap area has also benefited from the strength in many consumer businesses. Pubs and leisure have delivered strong results. Even the junior oil stocks,

with their strong exploration programmes, have outperformed the majors and also seen corporate activity. Recent months have seen a bid for Hardman Resources from Tullow Oil, and an approach to Premier Oil. Indeed, with Cairn floating its main assets on the Indian market, investors looking for oil and gas exposure outside the two majors will soon have little choice. British Gas, Tullow Oil and Dana will be the only real options.

In the housebuilding sector, there has been a bidfor Crest Nicholson and rumours of other takeovers. Utilities have also been strong performers in recent months. Bid activity among water companies has triggered a re-rating. With strong corporate balance sheets and substantial private equity finance available, further bid activity looks likely and many of the targets will be in the Mid 250.

Not all of the FTSE 100 has disappointed: food retailers have performed well. Marks & Spencer is demonstrating the impact of management change, and both Sainsbury and Morrison Supermarkets are in the early stages of a similar recovery. Many mainstream UK institutional investors have low exposure to this trend, triggering a steady re-rating of these businesses.

A feature of the past quarter has been sharp volatility in some individual shares. For example, industrial group Invensys saw its shares jump 15% on good results. This type of move may be triggered by the closing of short positions by hedge funds, but it does highlight the potential for gain in the Mid 250. Surprisingly, overall market volatility has been extremely low, with confidence quickly returning after the early summer sell-off. It seems likely these trends will continue in the coming months, with takeovers and restructuring providing good performance in many mid-cap businesses.