UK Mid Cap strategy - September 2022

Central banks are continuing their fight against supply side induced inflation despite declining economic data

• September rounded off what proved to be another tortuous 3-months
• In a volatile and unpredictable month, the strategy outperformed the FTSE 250 Ex. IT
• We initiated a position in an insurance company

What’s happening?

Following the encouraging start to the quarter, September rounded off what proved to be another tortuous 3-months for equity markets.  In the UK, the FTSE All Share (-5.88%) and its constituent parts, the FTSE 100 (-5.16%), FTSE 250 (ex-Investment Companies, -10.74%) and the FTSE Small Cap (ex-Investment companies, -8.50%) all lost significant ground in September. Year to date returns for the FTSE All Share Index are -7.87%. The divergence of performance between the FTSE 100 (-3.66%) and the Mid and Small cap indices mentioned (-27.73% and -23.97% respectively) remains historically very pronounced and is being generated by a very narrow sector leadership in Energy & Commodities, Tobacco, Defence and some Banks.

As has been the case for quite some time, Central Bank actions have been at the centre of investor concerns. Over the quarter, Central banks backed up their tough talk on combating inflation with policy rate hikes totalling +1.5% from the Fed, +1.25% from the European Central Bank and +1% from the Bank of England, with promises to do more. In addition, during September, the UK faced further challenges as the Conservative leadership race brought a new Prime Minister who, alongside her new Chancellor, unsettled markets with plans for unfunded tax cuts which threaten to substantially increase government borrowing. Sterling was a notable casualty, alongside UK pension funds and insurance companies, as the bond market fell heavily on the news of the likely increased supply of gilts and was only brought back into line by some swift intervention by the Bank of England who stepped in to buy them. Over the last 300 years, 3 of the 5 biggest daily moves in the price of UK gilts have occurred this month. With consumer confidence dipping to new ‘all time’ lows (since records began in 1974), despite private sector wage growth running at an annual growth rate of 5.5%, economic data continues to deteriorate.

Portfolio positioning and performance

In a volatile and unpredictable month, the strategy outperformed the FTSE 250 Excluding investment Trusts. From a sector perspective, the underweight in Financials was a negative contributor, whereas the underweight positions in Travel and Leisure and Property was positive.

Detractors from performance included Darktrace (Technology), which announced that takeover talks with Thoma Bravo had ended. In addition, shares in OSB, Safestore and CLS underperformed as interest rates rose.  Positive stock contributors over the month included positions in GB Group (Technology) which reported a preliminary take over approach (subsequently terminated), Spirent (Telecomms), Energean (Energy) and Dunelm (Retail).

We continue to focus on well capitalised companies that have growing profits, cash flows and, where appropriate, dividends. Market volatility was used to add to and reduce core holdings. Over the month, a new holding was taken in Beazley. No holdings were sold.

Outlook

At the time of writing, the prolonged process of electing a new conservative party leader and Prime Minister has finished, with Liz Truss achieving a slimmer majority than predicted. Leaked reports suggest that material fiscal support (some reports suggest up to £140bn) is planned in order to protect the UK consumer from the unaffordable energy price rises implied by the wholesale gas price. If this becomes a reality, it will potentially reduce UK inflation and could mean that UK inflation has peaked. Global supply chains are easing, the price of West Texas Intermediate crude oil has fallen back to circa $85 from circa $125 (just after Russia’s invasion of Ukraine) and the cost of moving freight from Asia to the West Coast of the US is down 70% from its peak. Wage inflation remains stubborn and it remains to be seen whether the balance of power moves demonstrably from the employee to the employer as the economy slows.

UK equites, in many parts of the UK stock market, have priced in a very poor economic outlook. This may transpire, yet innovative, well capitalised and well managed companies continue to reside on the UK market that will increase their market share through this economic cycle and will, in time, enjoy materially higher valuations. This combination of factors, together with weak sterling relative to the US dollar, is catalysing more take over approaches of UK companies. This will continue and illustrates the opportunity available for investors with a rational investment horizon, driven by fundamentals and not short term hysteria.

We remain focused on UK and internationally exposed businesses, where the fundamental profit drivers remain entrenched and equity holders benefit from the capital allocated and risks taken by management. We continue to believe that a rewarding strategy is to actively invest in UK-listed companies that are compounding their earnings and dividends, where corporate governance is world leading, where contract law and title law are dependable, and where company management teams are permanently accessible.

No assurance can be given that the UK Mid Cap Strategy will be successful. Investors can lose some or all of their capital invested. The UK Mid Cap strategy is subject to risks including; Equity; Smaller companies risk; Liquidity risk.