Beyond the FTSE: 100 opportunities in small and mid-caps

After a tough few years, the UK market has been showing signs of life over recent months, with outflows easing and performance reviving. To date, the market has focused on the opportunities in larger companies, with the FTSE 100 hitting new highs. However, the real opportunities may lie beyond the UK’s mega caps.

Larger companies have some clear advantages as confidence returns to UK equities. After a period of instability, it can feel safer to stick with the index heavyweights, rather than looking further afield. And with the large caps performing well, it has seemed unnecessary to move beyond the blue chips of the FTSE 100.

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The large caps have also had a strong pipeline of merger and acquisition activity supporting valuations. Most recently, this has been evident in FTSE 100 stalwarts Anglo American and DS Smith, both of which are held by the abrdn Equity Income Trust (LSE:AEI), but bids have also started to emerge among mid-caps and small caps. This has brought some hope that if investors don’t see the value in UK markets, trade buyers and private equity will.

The FTSE 100 has also been helped by some significant buy back activity. In the first six months of our financial year, 19 of our holdings, representing 45% of the portfolio, have undertaken a share buyback.  The sectors that dominate the list of companies generating sufficient capital to be buying back shares include resources, financials, and tobacco. 

In our portfolio, Imperial Brands (LSE:IMB) has bought back £600 million of stock in the first half of its current financial year, equating to an annualised rate of around 7% of the shares in issue, in addition to the 8% dividend yield. These vast buyback programmes have become commonplace as CEOs have becoming increasingly frustrated with the valuations placed on their shares.

Among large caps, our preference is for sectors that are throwing off the most cash, namely the banks, the oil and gas majors and the tobacco stocks, all of which are trading at valuations that provide ample room for re-rating as the wider market recognises the scale of their cash generation. However, we also believe that investors should be alert to the valuation opportunities to be found among small and mid-cap companies.

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A tough period

Unlike most major international indices, the FTSE 250 index failed to generate a positive total return in the first four years of this decade. After a prolonged period in the wilderness, small and mid-cap stocks have started to revive in 2024 as confidence begins to return to this part of the market. We see a number of reasons why this could continue.

The most striking is valuation.  The FTSE 250 has tended to trade at a higher valuation than the FTSE 100 over time for a very sensible reason – mid-sized companies tend to be nimble enough to seize on new growth initiatives and subsequently generate faster earnings growth.  This has tended to result in the FTSE 250 trading at a higher PE multiple and a lower dividend yield for the vast majority of the past 2 decades. So, it is notable that, after a long period of under-performance, the FTSE 250 dividend yield exceeded the FTSE 100 yield. This is a rarity, having happened only twice in the past 20 years. The attractive yield isn’t just a function of lower share prices; it is also a reflection of the ability of mid-sized companies to deliver strong operational performance and generate large amounts of cash.

As we scour the entire UK market, we are finding plenty of companies paying 7-8% yields, where the dividend is secure, but the stock may have been hit by weak sentiment which can be transient.

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Buybacks continue

Equally, while large caps have been grabbing the headlines for their billion-pound buybacks, we are also finding small and mid-cap stocks that are buying back their own stock, providing support to their share prices.

In the abrdn UK Equity Income Trust portfolio, OSB (LSE:OSB) is a mid-cap holding that has announced significant buybacks. It is the UK’s largest professional buy to let lender, pays a 7.2% dividend yield and is still generating enough cash to buy back its own shares. 

Merger and acquisition activity has also been buoyant in this part of the market. Data from Peel Hunt shows that there were 40 public market M&A transactions of more than £100 million in 2023, with an aggregate value of £21 billion. All of them were for mid and small cap companies. The research also showed that the average premium to the current share price was 51%. This has continued into 2023.

In our portfolio, we have seen a bid for industrial equipment group Tyman (LSE:TYMN) from US building materials peer Quanex Building Products (NYSE:NX). Despite achieving operational progress in recent years, Tyman’s share price had gone sideways for some time. We concluded that the cheap valuation did not tally with the high returns and market-leading position, plus a refreshingly proactive approach from its new Chair. These bids are finally helping close the glaring gap between UK companies and their global peers.

This comes with a downside for the UK market, as the universe of UK companies will continue to shrink until such time as the IPO market revives. However, for existing shareholders it is an important way to catalyse the latent value in the portfolio.

As the clouds dissipate, we expect investor interest in small and mid-cap stocks to return. Remaining alert to the income opportunities that abound further down the UK market remains an important edge for the abrdn Equity Income Trust, allowing us to seize on ideas across the market cap spectrum.

Thomas Moore is Investment Manager, abrdn Equity Income Trust plc

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