UK equities: Are UK mid-caps set to shine?

Key takeaways

• Returns from UK mid-caps have shown long-term resilience.
• UK mid-caps are valued at 20 per cent below their long-term average and offer an attractive income stream.
• Factors that could trigger a resurgence include interest rate cuts, a supportive economic backdrop and strong corporate fundamentals.

Mid-sized companies in the UK have historically offered attractive long-term returns. However, recent years have posed challenges as businesses grappled with the aftermath of Covid-19 and economic uncertainties.

Despite these hurdles, mid-cap stocks, representing both the best of domestic-focused firms and global leaders, are now emerging as compelling opportunities for astute investors. With multiple catalysts aligning, mid-cap stocks stand at the precipice of a potentially rewarding resurgence.

Long-term resilience of UK mid-caps: An enduring trend

Charting back to 1955, UK mid-caps have demonstrated remarkable resilience. They have delivered an average real return (which accounts for the impact of inflation) of 7.8 per cent annually, according to the Deutsche Numis Mid Cap Index. In monetary terms, this means that if you invested £1 in mid-cap stocks in 1955, it would now be worth £4,159.

This consistent performance outshines government bonds and UK large caps, underscoring the enduring strength of mid-cap companies. Despite economic and market fluctuations, mid-cap stocks have historically provided robust returns, which we think makes them an attractive proposition for investors eyeing long-term growth.

Exhibit 1: Annualised Real Returns for UK Assets: 1955–2023

^{Source: The NSCI 2024 — Scott Evans and Paul Marsh as of 15 January 2024. For illustrative purposes only. Past performance is not an indicator or a guarantee of future results.}

Overcoming short-term challenges

In recent years, mid-cap stocks have faced short-term underperformance amid macroeconomic challenges, including a sluggish domestic economy and rising interest rates. As a result, they have lagged their more globally oriented counterparts in the FTSE 100 and currently trade at their lowest valuation relative to large caps since the 2008 Global Financial Crisis (GFC).

Exhibit 2: Mid-cap Underperformance Versus Large-caps

^{Source: Berenberg as of 31 March 2024. Past performance is not an indicator or a guarantee of future results.}

However, it's essential to note that the current market landscape differs significantly from that of the GFC. Mid-cap stocks comprise a diverse array of businesses, including market leaders and globally recognized companies with robust fundamentals, often overlooked amidst short-term market fluctuations.

Moreover, they have demonstrated resilience, emerging from the challenges of the Covid era with strong balance sheets and a proven track record of profitability.

Seizing opportunities amid adversity

For investors, the current market presents an opportune moment to capitalise on attractive valuations. Forward price-earnings ratios, a key metric for evaluating stock attractiveness, currently stand at 11 times earnings, representing a 20 per cent discount from their historical average of 14 times¹.

Additionally, the dividend yield on UK mid-caps, which measures how much a company pays out in dividends compared to its share price, is currently 4 per cent. This is approximately 25 per cent       above its historical average of 3.2 per cent², providing investors with an attractive income stream while they wait for share prices to rise.

Moreover, the recent downturn in mid-cap share prices, driven by concerns over economic growth, belies the underlying resilience of these companies. Despite economic uncertainties, corporate profitability has remained robust, which may lay the groundwork for future share price appreciation.