The part of the UK stock market the pros are tipping as a big winner in 2023

Annual poll of fund manager expectations for the coming year has tipped this underperforming part of the market to bounce back next year.

After a truly horrible year, it seems the tide might be turning for UK shares housed in the FTSE 250 index.   

According to the Association of Investment Companies’ annual poll of fund manager expectations for the coming year, mid-cap equities are tipped as the best-performing asset class for 2023 by a table-topping 29% of respondents, far ahead of large caps (12%), renewable energy infrastructure and bonds (both on 11%). 

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The UK is identified as the most attractive market on a five-year view, followed by Europe, the US and emerging markets.

This year was particularly difficult for small and medium-sized businesses in the UK, and the funds and investment trusts that invest in them; analyst Stifel points out that some trusts’ net asset values (NAVs) almost halved in value from their 2021 peaks to their 2022 low points.

That’s because mid-cap companies are typically more dependent on the domestic economy than international-facing large-caps, and so have been badly hit by the UK’s toxic mix of soaring inflation - currently at 11.1% – and rising interest rates, which add to the squeeze on consumer and business spending.

Moreover, the UK’s big blue-chips have felt the benefit in the global markets – where 70% of their earnings are concentrated – as sterling has weakened against the dollar; it fell as much as 20% from January to late September before recovering to some extent.

A weak pound means British goods are more competitive abroad. Conversely, though, imports into the UK become even more expensive, putting further inflationary pressure on UK households and businesses.

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Looking ahead, the coming year is unlikely to be a walk in the park for businesses reliant on the UK economy. The Bank of England is predicting a two-year recession, the country's longest since records began.

Nonetheless, Richard Bullas, co-head of UK equities at Martin Currie is one who can see opportunities for recovery in 2023 emerging among the current barrage of UK negativity, short-termism and ongoing selling pressure.

“The issues the UK economy are facing are real, but next year we’re likely to see interest rate expectations peaking, inflation highly likely to fall from here and a manageable trading downturn,” he says. “We’re increasingly enthusiastic about some of the compelling opportunities we’re seeing within the mid-cap market which lay the foundation for future returns.”

Valuation is an obvious one, with the asset class one of the cheapest parts of an already undervalued region.

As Neil Hermon of Henderson Smaller Companies (LSE:HSL) investment trust explains, the UK market is now viewed as a real bargain basement: 2022 has come on top of years of being out of favour as a result of Brexit, political turmoil and Covid, which themselves hit domestically focused mid and small-caps hardest. “This has driven them to trade at a large discount compared to global peers,” he says.

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Bullas agrees. “We’re expecting earnings to come under pressure in the short term, but at this level of valuation discount a wide margin of safety is starting to be priced in. Currently mid-cap valuations are trading towards the lower end of their historical valuation range, along with attractive dividend and free cash flow yields.”

In addition to current exceptionally low valuations, there are other reasons why the sector looks so attractive. For a start, mergers and acquisitions are likely to increase as corporate buyers go bargain-hunting.

Second, these are innovative, growing and adaptable businesses. As Hermon observes, the pandemic pushed them to think laterally, with adoption of new technologies to enable remote working an obvious example. “Firms also adjusted their management practices and introduced new products and services to meet demand in the digital sphere,” he says.

After exiting a disruptive pandemic period in sound shape, not just financially but also operationally and competitively, many businesses and their future prospects have actually been significantly strengthened, agrees Bullas. “We believe the flexibility, strength and resilience engrained in many mid-cap companies is being underestimated,” he adds.

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Scouller also notes that even among the so-called smaller companies investment trusts, there are relatively high weightings to companies in the FTSE 250, including Henderson Smaller Cos with around 57% in mid-caps and Invesco Perpetual UK Smaller Companies (LSE:IPU), with around 45%.

Partly that reflects the growth of former small-cap companies, but he adds: “Many managers also disregard the FTSE Index market cap cut-off levels and believe their portfolios should have the ability to invest in broader UK mid- and small-cap companies.” He likes Mercantile (LSE:MRC), with over 70% in FTSE 250 stocks.

It is important to recognise that volatility could continue to undermine the sector for a while yet. As Hermon observes: “Historically, small and mid-cap stocks have always bore the brunt of market volatility when investors perceive the macroeconomic climate to be riskier, and this time is no different.”

However, Hermon emphasises that they also tend to bounce back much harder and faster as economies and stock markets recover.

For many of the professional managers responding to the AIC’s poll, clearly there is now quite an attractive light at the end of the tunnel for mid-caps.