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Mid-cap magic

Photo of Michelle Lopez By Michelle Lopez

min read

The Australian Securities Exchange is among the top 15 sharemarkets in the world, with a market capitalisation (value of all outstanding shares) of $A1.5 trillion.

Investors might not be aware how top-heavy it is. The largest 20 stocks (blue chips) account for 60 per cent of the S&P/ASX 300 Index, which constitutes the top 300 listed companies. Financial and materials (mining) companies make up more than two-thirds of the top 20.

It underlines how banks and miners have come to dominate Australia’s equity market. But looking ahead, we see a challenged operating environment for these companies.

Banks are now required to retain more capital on their books, crimping credit growth and putting pressure on returns. At the same time, interest rates are on a downward trend, which is negative for bank margins, and they will need to set aside more money in provisions for bad debts, which can only rise from historic lows. All this will cut into banks’ profitability.

Meanwhile, mining companies are being hurt by the decline in commodity prices and a slowdown in economic growth in China, which is Australia’s largest trading partner.

We see a stronger case for investing in mid-caps and small-caps in the remaining 40 per cent of the index. They provide greater investment options and derive their earnings from more varied sources. This is important, because investors do not want all their stocks exposed to the same growth drivers, nor their returns to be highly correlated.

As soon as you exclude the top 20 stocks – see the ASX 300 (ex-20) Index in Table 1 below – the weighting of financial companies falls from 59 per cent to 24 per cent. Immediately it is more balanced and diversified.

Table 1: Sector breakdown for ASX300 (ex-20)


Sector Top 20 ASX 300 (ex20)
Financials 58.8% 24.2%
Materials 10.9% 19.2%
Consumer Staples 9.2% 4.3%
Telecommunication Services 8.0% 1.8%
Industrials 5.2% 13.2%
Healthcare 5.8% 8.4%
Energy 2.3% 6.7%
Information Technology -- 3.1%
Utilities -- 6.1%
Consumer Discretionary -- 13.1%

Source: Aberdeen Asset Management, 31 May 2016

If we consider mid-caps alone, on the whole they have more developed governance and risk frameworks than small companies. Their cash flows tend to be more stable and replicable, and their share prices less volatile.

What is a mid-cap?
Defining what constitutes a mid-cap company is not an exact science. A good starting point is the S&P/ASX Mid-Cap 50 Index, which comprises all stocks listed on the S&P/ASX 100 excluding the top 50 – in other words, numbers 51 to 100.

But this is a narrow definition. Fund managers tend to have their own interpretations. At Aberdeen, we think of mid-caps more broadly as future leaders within their industry; those with the foundations to become the next blue chips. It is more about potential than position in an index.

This potential can be seen clearly in their returns. Over the past five years the ASX Mid-Cap 50 has consistently outperformed the larger ASX 100, 200 and 300 (ex-20) indices (see Table 2, below).

Table 2: Performance of large-caps v. mid-caps

  S&P/ASX Mid-Cap 50 S&P/ASX 100 S&P/ASX 200 S&P/ASX 300 (ex-20)
1 Year 10.03 -2.95 -2.38 7.58
3 Years (p.a.) 15.51 7.73 7.71 11.33
5 Years (p.a.) 9.45 7.93 7.54 7.33

Source: Bloomberg, 31 May 2016

Why mid-caps have outperformed
(Editor’s note: Do not read the following ideas as stock or sector recommendations. Do further research of your own or talk to a licensed financial adviser before acting on the themes in this story).

First, mid-caps have more capacity to grow than blue chips, which are constrained by their size in sectors they already dominate. Average growth in earnings per share for companies in the ASX 300 (ex-20) – as a proxy for mid-caps – is forecast to be 14.9 per cent over the next 12 months and 9.4 per cent in the following year, compared with 7.05 per cent and 8.9 per cent for the ASX 200, according to Bloomberg data.

Second, mid-caps have greater flexibility than blue chips to disrupt the industries in which they operate. NIB Holdings, which offers low-cost health insurance products, is competing against market leaders Bupa and Medibank Private, and its comparative nimbleness and lack of bureaucracy allows it to make quick decisions. This has enabled it to deliver above-average growth consistently and it is diversifying into new markets.

Third, compared to small companies, mid-caps have greater access to capital to drive their expansion. It means they can gain more exposure to larger and/or faster-growing economies, reducing their dependence on domestic earnings.

Good examples in the healthcare sector include Cochlear, Ramsay Healthcare, ResMed and Fisher & Paykel Healthcare. They are all mid-caps that derive a strong proportion of their earnings from outside Australia.
Cochlear, which makes implants for the hearing impaired, initially focused on infants domestically but has since broken into the market for adults and now sells products in more than 100 countries. It has become a global leader in its field.

Similarly, Fisher & Paykel Healthcare, which designs and manufactures products to treat sleep-disorder breathing conditions, has innovated constantly to extend its range of equipment. In a world of rising obesity levels, it now sells its systems in more than 120 countries.

As an active manager, a sector in which a company operates is not a factor that drives our investment decision-making. We want to understand if a business can generate returns in excess of its cost of capital.
That said, we are mindful of avoiding overlapping exposures in our portfolio and we prefer to invest in industries with strong tailwinds, as opposed to headwinds.

As a firm we are underweight industrials. Companies in the sector make up 9 per cent of the Aberdeen Ex-20 Australian Equities Fund, versus 13 per cent for the ex-20 index (see table 1).

Although we take a company-by-company approach, generally we see industrials as asset-intensive and carrying significant amounts of debt. Aurizon and Asciano, for instance, are leveraged to trading volumes that are driven by mining and agriculture, creating uncertainty for their cash flows.

At the same time, we can see sector titles as misleading. Consumer Discretionary companies, which provide non-essential goods and services such as entertainment and leisure, make up 13 per cent of the ex-20 index. Because they deal in discretionary goods, it is assumed demand will fluctuate. But Invocare is a mid-cap in this sector that provides funeral services, which we don’t see as discretionary at all.

In a similar vein, wagering and lotteries operator Tatts Group has produced consistent cash flows that have proven incredibly resilient across investment cycles.

It is this diversity that makes mid-caps such a fertile ground for active managers to find value. They have a wider dispersion of returns than blue chips, which gives more opportunities to uncover mispricings.

These companies do not have the inherent bias that comes with large index weightings, nor the perceived volatility you can expect at the smaller end of the market. There is a lot to like about them; not too big and not too small.

About the author

Michelle Lopez is a senior investment manager on the Australian equities team at Aberdeen Asset Management, @aberdeenassetAU, where she shares responsibility for company visits and portfolio management for small, mid and large-cap Australian equity funds. She joined in 2004 from Watson Wyatt and is a CFA charterholder.

(At 31 May 2016 the Aberdeen Ex-20 Australian Equities Fund returned 11.2 per cent over one year (after fees) compared to the S&P/ASX 300 (ex-20) Index return of 7.6 per cent. The fund was launched in August 2014 and since then has returned 18.4 per cent (after fees), beating the S&P/ASX 300 (ex-20) return of 10.2 per cent.)

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