Tomorrow’s Winners Today
January 2010
The last decade has been a poor period for equity investors generally. US equities, as measured by the S&P 500 index declined 24% over the period. However, within the equity market, returns over the period have diverged significantly according to size. Over the same period, mid cap stocks, as measured by the S&P 400 mid cap index, rose over 60%. Indeed mid cap stocks, as measured by the same index have outperformed large cap stocks (S&P 500) in nine out of the last ten years. This highlights the important part that size allocation plays within an investor’s equity allocation. In addition to offering risk diversification benefits, mid caps are a return-enhancing complementary addition to the large cap allocation of an investor’s portfolio. Analysis by Citigroup1 suggests that investors with exposure to both mid and large caps typically have a better risk/return profile than those invested solely in mid or large caps.
This supports our view that Discovery represents an attractive investment proposition for a proportion (5% to 15%) of an investor’s equity allocation. Importantly the fund offers investors exposure to a basket of stocks frequently overlooked by other institutional fund managers. Essentially, the fund objective is to identify quality companies that have established profitability early in their life cycle and to stick with them through their core growth phase. This is typically a highly rewarding holding period as there is a high correlation between cash-flow and earnings growth and share price performance.
Discovery aims to achieve this objective by investing in a diversified portfolio of 45-50 medium sized Pan European and US companies to achieve long-term capital growth. Although many of the fund holdings will not be household names due to their size, many stocks that the fund has invested in over its four year life have grown to become industry bellwethers such as Tullow Oil. The fund looks to invest in secular growth themes such as alternative energy, technology and biotech which offer attractive long term growth potential.
One of the key attractions of investing in mid cap stocks, in addition to the larger universe of stocks, is the lower level of analyst coverage versus the large cap universe. This tends to offer more frequent pricing anomalies and profit making potential for investors. For example, the largest stock in the UK, HSBC, is covered by 37 analysts, while the average number of analysts covering stocks in the FTSE 250 mid cap index is just 15.
Another key attraction of midcap stocks is the potential for M&A activity, which we expect to be a key theme in 2010. Given sizeable cash positions, restructured balance sheets, and a need for companies to boost growth by means other than cost cutting M&A is likely to pickup over the near term.
Although the performance of mid cap stocks since the March low last year has been strong and Discovery gained 32% last year, it is our view that these stocks could continue to deliver excellent performance for some time. Including mid caps as part of an overall allocation to equities is a proven diversifier for increasing returns while enjoying a very favorable risk/reward ratio. With this in mind, it is our view that Discovery represents an attractive investment for part of an investor’s equity allocation.
1 Citigroup Smith Barney: Small Cap Panorama ‘The Case for Small Cap investing’ Oct 04.
