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As FTSE 250 hits new highs, small and mid caps still offer value for stock pickers

London’s mid-cap stock index, the FTSE 250, have this month pushed on to another all-time high having stumbled lower after blasting through the previous ceiling around 22,000 in April.
While many worry about inflation and other market watchers angst ab…

London's mid-cap stock index, the FTSE 250, have this month pushed on to another all-time high having stumbled lower after blasting through the previous ceiling around 22,000 in April. While many worry about inflation and other market watchers angst about share valuations that in many places look stretched, there remain many pockets of value on the stock market, of which UK and European small caps and the mid-caps that are found on the FTSE 250 remain two sources. READ: FTSE 250 hits all time-high - what it means for markets and the UK

These two particular pockets offer an "attractive entry point" for investors, according to UBS, following the biggest underperformance by European 'Smid caps' of US stocks for a decade. The Swiss bank noted on Wednesday that European small caps are trade at around 22 times full-year expected earnings, a premium to the long run average and also at a roughly a 20% premium to large caps, while US small caps are trading at a P/E ratio nearer 30 times. Richard Penny, a fund manager at Crux Fund Management, also suggests the UK remains a cheap stock market in which to invest.

Seeing UK stock returns set for double-digit growth, he says small cap investors have a prime opportunity to uncover hidden gems before everyone else catches up, especially as most big investment funds are not looking at companies valued below GBP500mln. However, when buying growth companies, both UBS and Penny stressed that careful stock picking is key and investors should think twice about investing with their heart rather than with their head. "The UK is cheap in absolute terms and relative terms," said Penny, who runs the TM Crux Special Situations Fund, as he spoke at the Cenkos and Proactive at the Growth & Innovation Forum on Tuesday.

"In absolute terms, the UK cyclically adjusted P/E [CAAP] is not far off where it was in 2009, which was a great buying opportunity," he said. The UK's CAAP, a measure that smooths earnings by taking the last 10 years of earnings and dividing it by the current market level, is at 11.9. "The US at 31.6 has only been higher twice," Penny pointed out, taking care of the relative terms.

"Now, why this is important is that cyclically adjusted P/E is a really good predictor of future returns. "If it works, as it has in the past, it's predicting double digit returns for the UK, whereas for the US, perhaps only two to 3% returns. "Post 2016 the UK went to a 50% discount against the rest of the world equities."

In terms of looking for growth and innovative stocks, while the UK may be at a 50-year discount, Penny said that global markets are "as polarised pretty much as they ever have been - with the most expensive stocks, the growth stocks, versus the value stocks are as spread as they have ever been. "So we have to be a bit careful when buying growth companies, there's quite a bit of exuberance out there." While his special situations fund has big names such as Aviva PLCPrudential PLC, Cranswick PLC, and Melrose Industries PLC, he also shared some of his UK small cap picks.

These include companies he calls "stealth compounders - you buy it before it's on the radar of the mainstream investors" such as Inspecs Group PLC (LON:SPEC), the eyewear frames and lenses maker with high gross margins and "really good cash conversion"; as well as Kape Technologies PLC (LON:KAPE), Essensys PLC (LON:ESYS), Gresham Tech PLC (LON:GHE), Induction Healthcare Group PLC (LON:INHC), Franchise Brands PLC (LON:FRAN) and Cake Box Holdings PLC (LON:CBOX). Another theme his team likes is 'crossover tech', where names include MaxCyte Inc (LON:MXCT) where "it was very overlooked but we've seen in the last year, American investors coming in. And over my career I've seen it being quite often the case that what is really strong in the US can often be overlooked in the UK and micro cap land". 

Other companies in this theme, he suggests, are Maestrano Group PLC (LON:MNO), CyanConnode Holdings PLC (LON:CYAN), First Derivatives PLC (LON:FDP), Dianomi PLC (LON:DNM), Arecor Therapeutics PLC (LON:AREC), Oncimmune Holdings PLC (LON:ONCI), Ebiquity PLC (LON:EBQ) and Fireangel Safety Technology Group PLC (LON:FA.). Over at UBS, analysts added Stagecoach Group PLC (LON:SGC) to the bank's Small and Mic Cap Conviction List and removed easyJet PLC (LON:EZJ), though it's fair to say these FTSE 250 companies would not make the small cap definition of many private investors The conviction list also includes five other London-listed companies: Avast PLC (LON:AVST), Berkeley Group Holdings PLC (LON:BKG), Electrocomponents PLC (LON:ECM), Melrose Industries and Smurfit Kappa Group (LON:SKG).

Stretching out to include continental cousins, the full list includes, Andritz, Bawag, EFG International, Georg Fischer, Grand City, Hella, Ipsen, Krones, Schibsted, SIG Combibloc, Securitas, Scout24, Talgo and Unicaja Banco. Stagecoach was recently initiated by UBS with a 'buy' rating and 125p price target, as analysts said they view the risk of large-scale shift away from buses as "limited" and forecast a "full recovery" in revenues to 2019 levels by 2023, driven by a recovery in passenger volumes to around 93% of previous levels. "We believe a strong cash-flow profile offers scope for dividend distributions above consensus expectations and in the longer term we see Stagecoach as the most levered to a positive modal shift if increasing environmental awareness leads to a material modal shift given c50% of revenues are linked directly to passenger volumes."

EasyJet was removed from the list as it has been downgraded to 'neutral', with more upside potential in other selections. UBS also set out the reasons for its continued optimism about equities. "Much of Europe was in some form of lockdown in Q1 and into Q2.

The US exited restrictions earlier and was boosted by the £1.9trn fiscal package in Q1. But Europe is now catching up and the change in the PMI New Orders supports equity market outperformance. "We think that it is too early to shift portfolios to a more defensive stance, both from the overall market perspective and also for the strategy within the market."

The question over whether it is 'time to move away from cyclicals' is being asked by many, the analyst noted. "To us the answer is 'not yet'. Europe just printed the strongest EPS momentum of the recovery so far.

In addition, this is only month six of upgrades (post-GFC the upgrade cycle lasted 20 months). "The UBS European Strategy team expects cyclicals to continue to drive those further upgrades. In this environment cyclicals should continue to lead, at least while base effects and operating leverage last but it no longer is a 'rising tide lifting all boats' and being selective becomes progressively more important."

Penny said he was "cautiously optimistic" as the UK is cheap but stressed that investors needed to keep their wits about them due to the stretched valuations growth stocks. "You've always got to be careful what you pay for an investment. Investment is always a balance between a narrative and the delivery of companies in terms of how much profits or revenues you're getting, versus what you're paying for it.

"If you're just thinking about how you feel about the business but you're not asking about the valuation, you might be missing something.

"I think people are people are to attuned to investing with their heart and not their head."

Penny said he learned the hard way, having been investing in an internet fund in 2000, before working at Legal & General Investment Management for a decade and half ahead of joining Crux.