This article was originally published on LivewireMarkets.com on June 16th, 2021

They say from little things, big things grow. And that is certainly true for Australian companies. But on every company’s way to the top, they have to pass through a funny little area in the middle. Ladies and gentlemen, let us introduce to you – the mid-cap universe. These companies may not have the same balance sheet strength as names at the top of the market, and may not be the pocket rocket growers down the bottom, but according to Lonsec’s Peter Green, this diverse equity class deserves a spot in your portfolio, particularly when considering downside protection.

Mid-caps embrace companies between 100 and 51 on the ASX-100 index and have been some of the best performers over the last twelve months. Thanks to companies including Oz Minerals and Nine Entertainment (up 151% and 102% respectively), investors have been pleasantly surprised as this equity class shot up around 30% over the last twelve months.

As the market continues to rally, will the fertilising ground for these Aussie zingers turned large caps follow suit? According to Bruce Williams and Catherine Allfrey, we may be approaching the end of the stellar run.

In this thematic episode of Buy Hold Sell, Livewire Markets’ Bella Kidman sits down with Bruce and Catherine to talk all things midcaps, where they’re seeing opportunity in the space. Plus, they’ll share one mid-cap stock that has been misunderstood by the market.

Note: You can watch, read or listen to the discussion below. This episode was filmed on 9 June 2021.

 

 

Edited Transcript

Bella Kidman: Welcome to Buy Hold Sell, brought to you by Livewire Markets. My name is Bella Kidman, and today we’re going to be discussing a funny little area of the market, the mighty mid-caps. Even Lonsec’s Peter Green recently said that mid-caps should be on everybody’s radar. A few stats for you:

  • The ASX Mid-Cap 50 Index is up around 30% over the last 12 months.
  • In the last decade, it’s returned more than double the ASX 20 and four times the ASX Small Ords index.

So to talk to me about this today, I’ve got two mid-cap maestros, we’ll discuss the 411 of mid-cap investing. I’ve got Catherine Allfrey from WaveStone and Bruce Williams from Elston.

Defining the mid-caps

Bella Kidman: Bruce, I’ll start with you. When we talk about mid-caps, it goes about from 100 to 51. Is that the right way of looking at a mid-cap or would you prefer to define it a different way?

Bruce Williams: You could probably extend it a bit further than that, Bella, but for our purposes, we’re limited to the ASX 100. So the definition suits us fine.

Bella Kidman: And Catherine, would you prefer to look at it more broadly or is that the right definition?

Catherine Allfrey: Well, we’re broad cap managers, so we invest in anything from $200 million up. So yes, 50. We’re happy with 50 to 100 as mid-cap.

Bella Kidman: And mid-caps have obviously performed extremely well over the last 12 months, over the last decade. So when you’re looking at mid-caps, what is it about this area of the market that’s so exciting, compared to perhaps the small and large-cap areas?

Catherine Allfrey: Well, usually you’ve got a few zingers coming through, they’ve come through the small caps and then ongoing. They’ve got some industry tailwind behind them or some amazing commodity price. So you’ve seen the benefit for OZ Minerals (ASX:OZL) and Mineral Resources (ASX:MIN) they’ve performed like 150% in the last 12 months. And so that’s what drives these stocks through. In the past, we’ve seen things like healthcare stocks that have just raced on through from small-cap, mid-cap, into the large-cap sector. And currently in that universe, 50 to 100, there’s only one healthcare stock.

Bella Kidman: There you go. Well, I mean, what are the pros and cons of investing in this space? You don’t have your small pocket rockets as you do in the Small Ords, but you don’t have those sturdy names as you do in the large-cap. So what’s the pros and cons of investing in mid-caps?

Bruce Williams: Versus large-caps, we see it as probably more diversified. So the large-cap index is very concentrated in its structure. So we see it as a good diversifier to that. We also see that it is a sector that has or it is a section of the market that has a lot more growth than the more mature industries in the large-cap. So that’s why we certainly go in there, is for the growth.

Are mid-caps about to slow down?

Bella Kidman: What is behind the performance that we’ve been seeing in mid-caps? Do we think that this is a sustainable pattern or are we going to slow down soon?

Bruce Williams: Yeah, I think we’d see it slow down. Basically, we’ve seen a couple of big sectors, particularly financials in the large caps, underperform over the last decade. And that’s starting to back out. At the same time, you’ve seen the mid-cap sector aided by low-interest rates, low growth environment, structural growth companies. You’ve seen multiple expansion there. And again, that tailwind is starting to ease off. So we think the large caps will probably have a resurgence versus the mids.

Bella Kidman: Do you agree Catherine? Is it about to slow down? What is driving the performance of these mid-caps?

Catherine Allfrey: Well, when you look at those 50 to a hundred, like when we look at stocks, it doesn’t matter which stock it is. We’re looking at bottom-up fundamentals. Are there industry tailwinds behind it? Does it have what we define as superior corporate DNA? Which means a really solid track record, strong operating margins, logical expansion. And so they’re the sort of things that we’re looking for when we’re looking for stocks. And so with that 50 stocks that you’re talking about in mid-caps, there’s actually about 15 of them that have actually severely underperformed the market in the last 12 months. And they’re the structurally challenged companies like the AMPs (ASX:AMP) of this world that have continued to fall on out. Whereas conversely, you’ve got these new up and comers. But as Bruce says, what’s happened is particularly those three stocks, Lynas Rare Earths (ASX:LYC), Oz Minerals, and Mineral Resources, up 150% each in the last 12 months. Is that sustainable to continue? I don’t think so.

Bella Kidman: So taking that into consideration, looking at your allocation to mid-caps, is it higher or lower than it usually would be?

Catherine Allfrey: It is actually higher at the moment because there are quite a few stocks that we’ve done really well with during the last 12 months. We’ve done well out of Nine Entertainment (ASX:NEC), ALS (ASX:ALQ), Reliance Worldwide (ASX:RWC). These stocks have all performed really well for the funds. So we’re happy to hold them.

Bella Kidman: What about you, Bruce? Are you lowering your exposure to this area?

Bruce Williams: We are only allowed about 20% of our portfolio in the 51 to a hundred and we’re generally there or thereabouts. As Catherine says, we see a lot of value within that part of the market still, even if there are some excessive valuations out there. So we’re happy to continue to have exposure to it.

Opportunities in the mid-cap space

Bella Kidman: And where are you seeing some opportunity in this part of the market?

Bruce Williams: Probably stocks that were disrupted by COVID or hurt by COVID. So if you look at travel, for example, we see some opportunity there. We also see energy, again, it’s been an under-performer off low commodity prices and also the transition to renewable energy. So we see opportunities in there as well.

Bella Kidman: Catherine, you’ve given us a few names, but where are you specifically seeing opportunity in the mid-cap space at the moment?

Catherine Allfrey: We only own nine stocks out of that 50, and it’s very similar to Bruce, around 20% allocation to that sector, but it’s sort of bottom-up driven in terms of the portfolio allocation as well. I would have to say, a bit like what Bruce is saying, we’re seeing more opportunity in the small-cap, the ex-100, and also in the top 50 names.

Bella Kidman: Catherine, looking at your portfolio now it’s important to have those reliable, sturdy names. So what’s one example that you think in your portfolio is reliable that people have forgotten about?

Catherine Allfrey: Look, one that’s been sold off recently is TPG Telecom (ASX:TPG), that we’ve been nibbling at. That one has been hit hard because the founder David Teoh obviously stepped down. But we still think there’s a solid business there with a cost out story. Plus, you’ve got some improvement in terms of pricing, both in mobiles, as well as NBN. On the face of it, the multiple looks quite large. But actually, there are some significant tax losses there. So the free cash flow that the company will generate over the next couple of years will be quite high. So they’ll be allowed to increase its dividend over time. So it’s a good income opportunity as well. So we like that one.

Bella Kidman: Bruce, same question to you. What’s one example of a company that you think is reliable that investors may have forgotten about?

Bruce Williams: We really like Flight Centre (ASX:FLT) in that sector. And I wouldn’t probably call it reliable right now, but we do like it. It was obviously absolutely hammered by COVID in terms of its business model. It operates the two areas, so you’ve got corporate travel – we don’t see that coming back to the same level it was due to the use of technology such as Zoom and so on. But they’ve made up for that through market share gains and contract wins. And that comes down to client service. The other side, which will require more time, is leisure travel. And that’s both domestic and overseas. So domestic, nothing much will happen there until our borders open. But overseas certainly the Northern summer is very important for them. And we think people wanting to holiday is pent up. It hasn’t disappeared. So we think once they get going, they’ll be fine. The last point is they had a major cost out program. They squeezed three years into one. So it is structurally a different beast to what it was before.

Bella Kidman: Okay, Bruce, your time to shine. What’s one classic example of a mid-cap stock that you think represents good value?

Bruce Williams: We really like Virgin Money (ASX:VUK). It isn’t really well known domestically because it was spun out of National Australia Bank (ASX:NAB) in 2016, its operations in the UK. But it’s one of the few banks that has a positive net promoter score, which is very unusual for a bank in this post-Royal Commission world. So we very much like that. Good management, good growth prospects and very well capitalised.

Bella Kidman: Catherine, can you beat Virgin Money?

Catherine Allfrey: Well, I’m going to go with an ongoing winner, to be honest. I’m going to go with Nine Entertainment, which I have obviously backed for some time now. But again, I still think there’s upside, about 20% or more. The company’s performing exceptionally well. Coming out of this COVID-hit that it came through with TV advertising, radio advertising last year. It looks like advertising is up 40-50% year on year, which is more than it was in 2019. Domain (ASX:DHG) is obviously doing exceptionally well, Stan is still hanging in there, post-COVID. And so the groups still only trading on 17 times next year’s earnings and generating a really good yield with a really strong balance sheet. So we expect further returns and it’s just upgraded earnings again for ’22. So I think you’re still on a winner with that one.

Bella Kidman: Well, they may be mid-caps but one thing is certain, they’ve got big potential. If you’ve enjoyed this episode of Buy Hold Sell, make sure you subscribe to Livewire’s YouTube channel for more.

If you would like more information please call 1300 ELSTON or contact us to speak to one of our advisers.