250. Why the FTSE 250 is great for active investors and long-term growth

13 April 2023 (pre-recorded 27 March 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Staying with the UK equities theme and to celebrate our 250th episode, we’re focusing in on the UK mid-cap market, or the FTSE 250. Today’s guest tells us more about why UK mid-cap stocks can offer investors the best of both worlds: more excitement than their larger peers in the FTSE 100 but without many of the risks associated with the UK’s smallest names. 

Darius McDermott (DM): I’m Darius McDermott. Today, I’m delighted to be joined by Abby Glennie, who is the fund manager on the abrdn UK Mid Cap Equity fund. Abby, good morning.

Abby Glennie (AG): Hi Darius, thanks for having me.

DM: No, thank you for the time.

[INTERVIEW]

DM: So, look, let’s start off with your asset class. I think, hopefully, most of our listeners will be familiar with the FTSE 100, the large cap index in the UK. But maybe slightly less familiar with the mid cap, the FTSE 250. Could you tell us a little bit about it and the types of companies that are in that index and that you look at?

AG: Sure. So yeah, I think everyone’s usually pretty aware about [the] FTSE 100. I think the thing that I sort of characterise is that large percentages of [the] FTSE 100 are what I would call slightly older economy sectors. So, if you think about some of the energy, resources, healthcare, staples [sectors] and actually, if I sort of broaden those a bit, you’ve probably got a good bit over half of that index is in those sorts of sectors. Whereas what we find about the FTSE 250 mid cap space, is that it’s much more dynamic in terms of those newer economy type sectors. So, you know, things like media, technology, a lot of actually new support services type businesses. So, I think that makes it quite an attractive place to invest. 

And also particularly, if you are looking through a cycle. So, without a doubt, FTSE 100 therefore has times that is very attractive and you know, 2022 was definitely one of those. But if you’re taking a longer-term approach, it’s [FTSE 250] much more sector diverse, I think you’ve got much more growth dynamics through that whole space. It’s also, I think it’s big enough and broad enough, so by definition, by the name you’ve got 250 companies. Even if you take out the investment trusts and look at that index, I think you’ve still got a broad enough range. 

And the thing that actually we think is quite important as well, is the AIM index [Alternative Investment Market]. So, you know, for people who don’t really know AIM that well, I would just say, look, it has massively improved over the past 10 or 15 years in terms of quality of business, governance. You know, these are properly profitable, dividend-paying, strong businesses, where a lot of them are actually in the market cap space of equivalent to FTSE 250. So, for instance, in our mid cap fund, we would sustainably have 25-30% of our fund in the AIM index.

DM: And they’re the bigger companies in AIM, aren’t they? [AG: Yeah, absolutely.] They probably would be big enough to be in the mid cap index, were they [to be] on the full London listing.

AG: Yes, we probably look at the biggest hundred companies in AIM. But I don’t know at the moment, but you know, sometimes some of the top companies are probably touching on the market cap range of FTSE 100 even, so, there are some proper businesses in there.

DM: And the other thing about the mid cap index is [that for] the FTSE [100], 75% or thereabouts of its earnings come from overseas. What sort of rough ratio is that then on the mid cap?

AG: Yeah, so mid cap is 50 / 50 basically. And I think you’re right, and it probably has even gone slightly above that. I think one thing that people almost don’t think about sometimes, is you are taking an inherent FX bet in F[the] TSE 100 that you maybe don’t think you’re taking, by buying a UK index. Whereas I would say, once again, sometimes it’s positive and sometimes it’s negative in terms of overseas earnings. But you, through a cycle, are really taking more of a bet on the actual company underlying fundamentals, I would say in the mid cap space.

DM: So, let’s just dig in then, a little bit deeper. What makes this mid cap, these 250 companies – the next biggest 250 – what makes them attractive for an investment case?

AG: Yeah, so I think there’s a few things. 

I think they offer, actually, a lot of the things that people like more about the small cap space. So, they offer a lot of the growth dynamics that a lot of investors are looking for, particularly if you’re taking a sort of longer-term approach in just that opportunity. 

You know, one of the things we like about businesses for instance, is where they can expand into adjacencies. So, that might be a new division, a new product, a new geography, and actually within that mid-cap space, when you’re taking that decision, it’s big enough often that it actually impacts the whole business, if that makes sense. You can shift around the business and really grow dynamically. So, we like that.

We like that also – when we think about the sort of risk of the mid-cap space – actually, we think, due to the diversity of it, some investors are slightly cautious about investing in small cap space, you know, the mid cap gives a lot of the growth opportunities but with a lower risk dynamic. 

And actually, the liquidity’s all right as well. So, you know, this is definitely something that’s been more of an investor focus, if we think about the last five years or so, mid cap liquidity is pretty good, particularly, I think, if you’re willing to sort of invest in businesses for the medium term. 

The other thing is like people are often, have quite a negative view about ‘has the UK been unattractive to invest in for the last 20 years?’ And I think if you look at the large cap space, the number would sort of maybe suggest that. But actually, UK midcap, I think, over the last 20 years, has generated twice the return of large cap, and actually I think has generated better returns than [the] S&P 500 and the MSCI ACWI (MSCI All Country World Index). So, I think people forget actually what a good return universe UK midcap has been.

DM: Yeah, I think you’re absolutely right. I mean investors in mid cap have done very well when maybe the large cap index has been fairly sideways if nothing else <laugh>.

AG: Yeah, I think one other things maybe, Darius, as well, is that, that’s just looking at an index level, but I think one of the interesting things as well is that, these companies are generally less well covered than large cap businesses, you know, in terms of the number of sell-side analysts looking at them. I think there’s more sort of information asymmetry and opportunity to really add value. So, particularly for a sort of active fund manager, I think the opportunity in mid cap is really quite attractive, to try and outperform. 

And you can also be quite … you don’t really have to be that benchmark aware. You know, obviously that comes into play in terms of risk dynamics and things, but it’s very different to FTSE 100 where you’ve got some really large positions that you really have to have a view on all of these. And actually, even if you’re negative on them, you maybe still have to own some of it, just to be quite underweight. The mid-cap space is just very, very broad in terms of percentages of the different holdings.

DM: So, lots of opportunity for an active fund manager to add alpha over and above the sort of returns that the index has given. 

Another part of your style of investing is to ‘run your winners’. Tthat means you’re buying companies when they’re relatively small as they sort of get bigger, and show that dynamism potentially for growth that you’ve talked about. Could you give us an example of a stock that you bought, that was quite small maybe and that the one that you’ve sort of run in to being larger?

AG: Okay, yeah. So, you’re right, we do have a sort of ‘run your winners’ mentality and I would say, if I look at our mid-cap fund, there’s probably different buckets of that. 

So, there’s probably some buckets that we’ve sort of consistently held, you know, strong positions of – so, I would pull out things like for instance, Midwich [Group plc], which is a value-add reseller in sort of audio-visual equipment, [which is] increasingly diversified in terms of geography. Things like Hollywood Bowl [Group Plc], we’ve held pretty consistently – a ten pin bowling operator. Things like Gamma Communications [PLC]. And actually all of those we would have bought as IPOs, but perhaps that would’ve been in our small cap fund, you know, originally when they first listed. And we’ve held those throughout and then now, you know, [they’re] pretty sizeable sort of mid cap names. 

There’s others, and actually some of these have been in existence and we’ve held them for a lot longer though, where we’ve held them in some form for a long time, but actually because of portfolio construction [and] because of how our process works, we’ve either come in and out of these businesses or position sizes have sort of significantly changed over years. So, things like Telecom Plus [PLC], you know, we’ve probably owned for maybe 15 years in sort of some form, but not owned at all times. CVS [Group PLC], the pet veterinary business as well. You know, we had exited that after we thought the investment case didn’t really fit our process anymore, and then I think we bought that back in 2021. 

What other ones? … Greggs [PLC] is a good example. You know, everyone knows Greggs absolutely, we’ve had that for a long, long time. But yeah, similarly the investment case has sort of come and gone during different periods and I think that’s where our process allows us to believe in some of these things for the long term, but also gives us a really good judgment of when we should sort of step away from that, for periods.

DM: Well maybe it’s almost as if we planned this, but that’s a nice segue then into the process and a big part of mid cap and the small cap funds that you are associated with, has something called the Matrix as part of its process. Maybe for our listeners, you could describe what it is that the Matrix does and how that helps you to pick and potentially avoid stocks as well?

AG: Sure. So, I mean the Matrix is essentially a stock-screening tool. And this has sort of been in-house developed and I think maybe what’s different to what other funds might look at in terms of screening tools is that, you know, we’ve used exactly the same screening tool for 25 years. You know, there have been minor changes, but essentially, we’ve looked at broadly the same factors over all that period with broadly the same weightings. And we do also continue to look at whether those factors are still the most relevant and so there have been a few changes over that sort of 25-year period. 

And how we would use it? I guess two main ways would be the Matrix is really useful for stock screening but also for portfolio construction. So, for our whole investable universe, we can look at what is the Matrix telling us about that stock? And it’ll give us a numerical score and we can also look at what all the factors individually are saying.

And essentially, we are looking constantly, and this gets updated twice a week, so it’s live data. We’re looking at what stocks are screening well, should we be paying more attention, should we be going and doing the fundamental research on? So, you know, it’s only a stage in our process, but is quite an important one. 

I think then portfolio construction. So, we also are constantly challenging ourselves on the existing portfolios, of looking at which stocks are not scoring well. And that’s the ones we’re constantly challenging ourselves on in terms of part of our sell discipline. And I think it’s really good because it also … I think this is an industry where, particularly if you’re a long-term shareholders of things, you can become quite emotionally attached to businesses, and actually the Matrix has no emotional attachments to stock. So, it is really good at making you sort of neutral in that way, and also creating sort of team challenge and debate, because it’s very obvious for anyone, why do you still believe in this stock? You know, it’s been scoring weakly for a while, etc.

DM: So, an improving Matrix score of things you potentially look at and a reducing Matrix score if you hold it, at least it causes you to think and revisit?

AG: Yeah, absolutely, and that’s it. You know, we’re not running quants funds but it’s a really disciplined part of our process. I think it provides a lot of consistency as well through the cycle. I think one of the things that’s really useful about the Matrix for us, is that the factors are fit around our investment process. So, they are quality, growth, momentum and we do have 2 of the 12 factors are valuation factors. So, you know, if you believe in our process, you absolutely have to believe in the Matrix, because it’s very aligned. 

But I think the thing that’s quite interesting about it in periods like we see at the moment – and we’ve had a lot of these discussions with clients – is that our processes, you know, we don’t change through a cycle, but what is flexible is what is screening as quality growth momentum. So, that’s where the Matrix helps you to stay aware of where companies or sectors which might not have been your most traditional stocks – maybe you’ve never held them before, maybe they’re in a sector you don’t typically own that much of – actually, those are becoming quality growth momentum, in what is maybe a different economic environment.

DM: And you mentioned some of the factors there, sort of earnings upgrades, momentum. Does the Matrix take any account of balance sheet or is that just a separate piece of work you do on stocks that look interesting?

AG: Yeah, so we have two quality factors. So, balance sheet comes into both of those. So, one is the choice key score which is like a composition actually of lots of different underlying financial metrics. 

Also, Z-score*. The thing about Z-scores, which are quite different, is that it tends to be very important in a small number of periods. So, people often either really care about Z-scores or they don’t care at all. It’s a little bit binary. So, we’ve seen that through the last 18 months or so, in terms of when people actually worry about balance sheets and companies going bust, that becomes quite important. 

But a lot of the other quality factors we would look at in terms of revenue visibility, recurring revenue and contracts, cash generation, improving margins; those are all things that come more into our fundamental research than they perhaps do in the Matrix.

DM: Thank you. So, look, maybe then just to finish up, if we could talk about a couple of your largest stocks – why you like them at the moment, and what maybe some of their sort of growth characteristics are?

AG: Okay, so maybe one that we’ve held for quite a while, which is still one of the biggest stocks in the portfolio, would be Keywords Studio [PLC]. And for people who don’t know it, it is essentially the global leader in outsourced services for video game companies. So, you know, their typical customers are all your big, triple-A games developers, as well as maybe some smaller, indie type developers. And what I’ve seen with this business is, it has really expanded into adjacencies that I talked about before. So, this business is truly global in nature, but also what I’ve seen them do is – since I first invested in this, which would’ve been maybe 2017 probably – I’ve seen them really invest in terms of the number of different services as well, that they offer. You know, these guys can help with games development, artwork, they can help with customer support, all sorts of dynamics. And what’s important about that, is the cross-selling opportunity that they have within these big customers. 

It’s a business which is very driven by organic growth, but also does complementary acquisitions. And for us, that’s really important because, you know, we don’t mind businesses which are acquisitive in nature to some degree, but we really want to always see that supported by organic growth so, you’re not just buying growth. And I think the type of acquisitions that Keywords do, I actually really like, because they’re either very clear skillsets or they’re really actually about acquiring people – it’s a difficult industry to grow people because it’s actually quite competitive in nature, and a lot of these, – particularly in the games  development side – they like to work almost as an independent. And Keywords becomes a really good home for them because I think there’s a really strong culture, but they also let the – particularly the studio’s nature of parts of the business – really drive their own culture and retain that. So, I think they’ve got a really good balance in that, and management have shown they can sort of execute on that strongly. So, that’s a really high return business, good margins, really sensible about their balance sheet leverage as well. And also, it’s in a growth industry, you know which I think …

DM: More people are gaming for sure, aren’t they?

AG: Yeah. And I think one of the things people got wrong about Keywords is that, when we saw the Covid boost of some of the triple-A games because people were selling more because people were at home gaming, everyone thought Keywords would be a Covid beneficiary. And actually, I think a lot of that is on a lag cycle for them, and they’re much more balanced, I guess. So, you know, the potential benefit was actually going to come later, when those companies had great profits and continued to invest in their business. And what I like about Keywords, compared to perhaps some other video game businesses, is you’re not making a bet on a particular game’s success or failure, so they’re really spread across all sorts of games by all sorts of developers

DM: And maybe then just a headline stock – well, you’ve already touched on Greggs, a sort of a high street name that people will know. Is that just a shop rollout – the more shops they have, the more profitable they are? Or is it product? Where is their growth coming from?

AG: Yeah, so I mean Greggs is really quite mixed in terms of actually their growth dynamics. And I think that’s quite important as well because they also do need to drive growth because they definitely have cost inflation at the moment, and probably, they’ve had different periods of cost inflation, but this is an environment where actually there’s a lot of different cost lines are all showing inflation like other businesses have. 

But what we’ve seen about Greggs is really that sort of ability to innovate. I think one of the things, if I compare Greggs now to five years ago, the product innovation and also the social media marketing innovation, I think are very, very impressive. And if you compare that to peers … I mean we’re also seeing at the moment that, you know, their ‘value for money’ proposition is really resonating with clients. 

Well, I think one of the things that there has been, there’s a lot of debate about Greggs in terms of what happens, you know, in a consumer squeeze? And actually, it’s quite hard to judge. So, do people perhaps trade down to Greggs, which is a benefit? Or actually do people trade away from Greggs? You know, but at the end of the day, what I think we’ve learned is that people are on the move and that is your typical Greggs customer. Yes, you could buy all these ingredients and make a lunch at home and take it with you. Actually, the cost benefit in terms of wastage and product, isn’t actually that big, and it’s the ease and the footfall that is really important.

 And I think on the back of that, they’ve really innovated in their estate as well. So, behind the scenes, you know, the bits that we don’t see, in terms of marketing distribution, I think that’s been really innovative. They’ve also got a store rollout, particularly I think we’ve seen them really step away from just being sort of city centre, high street locations. So, actually, it’s your retail park, your industrial sites, it’s where you live. And we’ve seen that, I would say, over a number of years. So actually, at Covid, I think what people badly misjudged was that it would be very driven by just city centres. By that period, they’d really broadened their site locations a lot more. 

And I think that’s one of the things that … we had a really interesting discussion with them two weeks ago actually about it, which is Greggs could make lots of different sites in lots of different locations work. So, it’s not like a cookie cutter approach. And it makes them really flexible in terms of the type of space that they can go for, the landlords they can work with, because, you know, one site for instance, they might want to have a big seating area, they might want to have a full service offering; you know, in other sites they can have something that’s different for that audience. And I think they’re really starting to sweat those assets more as well. So, you know, in future years, I’m sure lots of us will be going for our dinner in Greggs, and we always said before Covid, who knew people would pay for a Greggs delivery, but they absolutely do.

DM: Abby, that’s really, really interesting. Thank you so much for taking the time to talk, just not just about some of the stock examples, but the whole asset class in general.

SW: abrdn UK Mid Cap Equity is a high conviction strategy which invests in medium-sized companies for the long term. It invests in businesses when they are well established, but still have a long runway of growth potential. For more information on the abrdn UK Mid Cap Equity fund visit fundcalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.

*The Z-score is a heuristic formula developed to estimate the chances of a company going bankrupt. The formula looks at working capital, retained earnings, and EBIT, all relative to a firm’s total assets. A Z-score above 3.0 signals good financial health, while a score below 1.8 suggests a high risk of bankruptcy. [Investopedia.com]