10 quality mid-cap shares with promising momentum

It’s been a largely unloved part of the UK stock market over the past year, but there have been signs of improving momentum - and there could be more to come as confidence returns, believes stock screen expert Ben Hobson.

Mid-cap stocks have traditionally held something of a Goldilocks appeal for investors.

Spanning a market cap range of between £500 million and £4 billion, it’s a part of the market where you find firms small enough to deliver stellar growth rates but large enough to defend themselves against economic headwinds.

Here in the UK, mid-caps are largely represented by the FTSE 250 index (although you can also find them at the higher end of the Alternative Investment Market and the lower end of the large-cap FTSE 100 index). It’s an index that is uniquely placed to benefit from regular promotions and relegations from the large and small-cap indices above and below it, which keeps it constantly refreshed.

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Not only are mid-caps a happy medium when it comes to size, they also offer traits that are absent elsewhere. While many of them operate diverse businesses in foreign markets, they generally have more exposure to the UK economy than the large-caps.

And while FTSE 250 dividends are nowhere near as substantial as they are in the FTSE 100 (large-caps accounted for 88% of the total payout in 2022, versus 10% for the FTSE 250), the capital gains from mid-caps have outperformed the large-caps over the past 20 years.

Here are how the two indices stack up against each other since the start of 2010 - with the FTSE 250 Total Return index (green line), which includes share price and dividends, outperforming the FTSE 100 Total Return index:

SharePad: FTSE 100 Total Return versus FTSE 250 Total Return 01/01/2010 - 10/05/2023

But then there was last year.

Some of the most appealing features of mid-caps actually came back to haunt them in 2022. Exposure to the UK economy meant that many suffered under the uncertainty of high and rising inflation and the threat of recession.

Unlike many large-caps, which gained from the strong US dollar, the domestic-focused mid-caps enjoyed no such tailwind. Neither did they benefit from a strong presence in energy, healthcare and consumer defensive industries like the large-caps did.

As the chart above shows, the year saw the FTSE 250 record a decline of 19.7% versus the FTSE 100, which finished flat.

Are mid-caps poised to rebound?

Today, the FTSE 250 appears to have put the early declines of 2022 behind it. On a 12-month basis the index is flat and there have been some solid price performances.

For investors, all eyes are on how the UK economy will fare in the months ahead. But it’s clear that the market is already making up its mind with some companies. So where is this happening?

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This week I have taken a look at mid-caps with good growth and quality characteristics and promising momentum behind them, trading close to new highs:

#1. Stocks with a market cap between £500 million and £4 billion

#2. Companies that are forecast to see their earnings grow in the year ahead

#3. Companies with an average 5-year return on capital employed (ROCE) of at least 10%

#4. Shares that have performed better than the FTSE All Share over 12 months

#5. The table is sorted by the proximity of shares to their to 52-week high prices

On this basis there is certainly no shortage of evidence that some mid-caps are back at new highs, suggesting that there is solid momentum behind them. Oxford Instruments (LSE:OXIG), the high-tech tools and systems business, leads on this measure and has seen its price surge by 26% relative to the main index over the past 12 months.

The list is strong on industrial-type businesses like OXIG, with others including Rotork (LSE:ROR) and WAG Payment Solutions Ordinary Share (LSE:WPS) all seeing double-digit earnings growth forecasts.

There are also signs that the market is rewarding solid financial quality, with stocks like Games Workshop Group (LSE:GAW) and Moneysupermarket.com Group (LSE:MONY) passing these rules, both of which have consistently strong profitability (in the form of high average ROCEs).

In terms of valuation, the results are mixed, with some signs that mid-caps on the move could be pricey - although their quality might explain it. Alpha Group International (LSE:ALPH) has the highest forecast price/earnings (PE) ratio at 31.2x, while engineering firm Renew Holdings (LSE:RNWH) trades on a much lower forward PE of just 12x.

Clues to finding shares on the move

After 18 months of gloomy economic conditions, risk-off sentiment and concern about the outlook for corporate earnings, it’s no surprise that mid-cap indices have flattened out. Unlike their big brothers among the large-caps, medium-sized companies are much more reliant on the state of the economy and consumer confidence at home.

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With many analysts still expecting recessionary conditions in the months ahead, the near-term outlook for mid-caps remains understandably cautious. However, it’s clear that some stocks are finding favour and that investors are keen to back firms where the future looks promising.

The UK market is widely seen as cheap on many measures, but that doesn’t mean there won’t be more volatility to come. Finding opportunities demands careful research, but looking for quality and momentum in Britain’s battered mid-caps could be the place to start.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.