It’s no secret that mid-caps have fared well in the past few years, particularly versus their giant- and large- cap peers. Morningstar’s UK Mid-Cap Equity category produced annualised average returns of 19.17% over the three years ended July 2007, while returns in our UK Large-Cap Blend category returned a meaningfully lower 16.76% over the same time period. As such, the varying degrees to which UK funds have held mid-c
ap exposure has been a key differentiator in how they’ve fared.
Brough is an opportunistic investor who looks for characteristics to drive appreciation such as superior pricing power, high turnover, strong franchises, and scarcity value. One of his top picks is consultancy Atkins (WS), where he held 3.2% of assets as of June 2007. Here, Brough sees good scarcity value via its employees: as the average age of engineers’ increases and the total number of engineers decreases, he thinks Atkins – the UK’s largest employer of engineers – will see high demand in the medium- to long-term. Pub operator JD Wetherspoon also caught his eye when we spoke to him earlier in 2007: He thought the firm could cash in on a lot more upside by increasing its pricing within its numerous pubs.
Although Brough’s bottom-up strategy has yielded exceptionally strong results so far, there are some reasons for concern. First, it’s worth noting that the fund’s performance relative to its benchmark has flagged in the past few years. From 2003 to 2006, it barely beat the index’ returns, trailed it by -1.22% in 2006, and has been lagging thus far in 2007. Part of the poor performance in 2006 may be due to his lack of exposure to specific names. Shares in the London Stock Exchange (LSE) and Corus, for example, did particularly well in the index, but Brough did not hold either during their major upswings (he used to hold LSE but replaced it with ICAP; he mulled over Corus, but ultimately stopped short of buying it).
But, the lagging performance also coincides with strong growth in the fund’s asset base. The portfolio held £2.8bn as of June 2007—a sizeable sum. Given this fund’s tight focus on mid-caps and fairly small ones at that, the fund’s girth makes it more challenging to run than would otherwise be the case. Brough states this isn’t a concern for him yet, and the fund’s portfolio turnover ratio is fairly low, which should help ease the burden of the fund’s big asset base. Still, given how quickly the fund has grown (its assets jumped by over £1bn between April 2006 and April 2007 alone), and the fund’s performance during this time period, we think it’s a worry.
Our second concern has to do with mid-caps as an asset class. They look richly valued relative to larger-cap issues on a historical basis, and the takeover boom that has in part fuelled their rise is coming under pressure as credit markets tighten. We don’t pretend to know if or when the mid-cap rally is going to wind down, but it doesn’t appear to be an especially attractive area right now.
Thus, although Brough has proven to have strong bottom-up stock-picking talent, the fund’s burgeoning asset size and the fact that the mid-cap boom is looking a bit long in the tooth makes us a little wary of this offering at the present time.
