12 heavily sold mid-caps with growth potential

Some of these companies look cheap and are being overlooked by investors. Stock screen expert Ben Hobson tracks down a dozen self-reliant, cash-positive and profitable businesses to follow.

Britain’s FTSE 250 index has lost around a quarter of its value over the past 12 months. But while rising inflation and the threat of recession are dragging on prices, some heavily-sold mid-caps look more than capable of weathering tough times. So has the market been unfair?

The plummeting price of mid-caps this year is stark compared to the FTSE 100. While the blue-chip index isn’t immune from volatility, it has held up impressively well - and there are good reasons for that.

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For a start, the flagship index boasts mega-cap shares in the energy, healthcare and consumer defensive sectors, which have all performed better than most in 2022. These shares are also a huge source of dividends, which makes them an appealing option for investors looking for comfort.

Another much-heralded advantage for FTSE 100 valuations is that 70% of its revenues come from abroad. Given the strength of currencies such as the US dollar this year, that’s a huge foreign exchange boost for earnings.

Hidden resilience among the mid-caps

By comparison, the mid-cap FTSE 250 index is smaller than its big brother in terms of market-cap, but it is more diverse in terms of industry exposure. Its heaviest sector weighting is in financials, but around 50 of those constituents are actually investment trusts, which invest across all sectors and locations.

The diversity of company sizes and industry exposure means the FTSE 250 is often seen as a truer reflection of the UK economy. That’s partly why it has sold off more heavily this year.  But it’s also the case that half the revenues in the FTSE 250 come from abroad - which makes it much more internationally exposed than many might realise.

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The challenge for investors is to understand whether these mid-cap price declines this year are fair or whether there has been some dislocation in prices. When the economy shows signs of recovering, it could be here that you might find the resilient growers with prices that can rebound fast.

So what measures are worth looking for?

Positive cash flow is a must. With inflationary pressures making consumers think twice about where they are spending money, it pays to look for companies that are self-sufficient in terms of cash. With equity valuations falling and interest rates rising, the climate of easy money - either through new share issues or cheap debt - is over. Those companies with positive cash flow have much more flexibility than those that don’t.

Sales growth is essential. In recessionary times, sales growth can be a strong indicator about the momentum in a business. If you can find ones where brokers are revising their sales forecasts upwards, even better. In the search for shares that might have been unfairly caught up in a sell-off, sales growth can be a clue to positive trends and firms that could grow quickly as the economy recovers.

Find companies with good margins. Inflation is likely to be pushing up the costs in many businesses, so profit margins are crucial. For firms that have some kind of pricing power, it’s easier to absorb or pass on rising input costs without sacrificing profits too much. Margins are something that tend to be best compared on an industry-by-industry basis. But generally speaking, double-digit margins can be a clue to higher quality companies.

Here is a list of some of the biggest fallers in the FTSE 250 over the past year that pass these screening rules:

Price declines here range from -17.1% at specialist technical products business Diploma (LSE:DPLM) to a much more severe -66.2% fall at landscaping materials group Marshalls (LSE:MSLH).

More broadly, a common theme is that these screening rules pick up shares in the technology sector, which has been badly hit around the world in 2022. The UK market doesn’t boast the breadth of tech shares seen in the US, but many have been marked down, including Darktrace (LSE:DARK), Bytes Technology (LSE:BYIT), Baltic Classifieds (LSE:BCG), Kainos (LSE:KNOS) and Ascential (LSE:ASCL).

Remember, these screening rules are looking for positive cash flow this year in firms that are forecast to see growth in sales next year and the year after. They all have double-digit operating margins, which is a pointer to encouraging profitability. And for what it’s worth, they are all positively rated by the broker consensus.

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It’s important to note that some companies may deserve their share price performance over the past year. While these screening rules are designed to detect positive signals, it’s worth looking closely at businesses to really understand whether they might have been unfairly caught up.

A good example is the bakery chain Greggs (LSE:GRG), which has been a very strong performing share over many years. However, substantial and costly plans for expansion in the future could mean a change in the performance of the business. So while it passes a sense-check for being a solid and historically strong firm, that could potentially change.

Quality growers could be poised to recover

Overall, the FTSE 250 has generally performed well against the FTSE 100 over the past decade. In that time, its diverse nature and depth of mid-cap shares has enjoyed several years of strong performance. It didn’t fall as badly as the FTSE 100 during the Covid pandemic in 2020 and recovered admirably in the year that followed.

Over the past 12 months, the index has paid the price for having exposure to industries sensitive to the economy and parts of the market that investors have become wary of. That has resulted in some startling price falls across the index. In some cases, those re-ratings might be deserved, but it’s possible that others have got caught up in widespread selling.

It’s the self-reliant, cash-positive, profitable and growing shares that could be among the first to rebound as the economy recovers.

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