Midcap Equities Reflect Domestic Recovery in Britain

Record employment rates and robust consumer confidence make U.K. retail and other midcap stocks a promising buy.

London Stock Exchange As Stocks Fall On Italian Downgrade

Share price information is displayed on an electronic ticker in the main atrium of the London Stock Exchange Group Plc’s (LSE) headquarters in London, U.K., on Monday, March 11, 2013. European stocks fell from a 4 1/2-year high as Fitch Ratings downgraded Italy and China’s retail sales and industrial output missed forecasts. Photographer: Jason Alden/Bloomberg

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On July 25 the U.K. economy passed a milestone after a frustrating six-year journey: Its gross domestic product finally exceeded the level reached in 2008, before the global financial crisis erupted.

The country reached this milestone because of improvements in domestic demand — with exports, by contrast, depressed as a result of both poor prospects in the euro zone, the destination for more than half of the U.K.’s exported goods, and the sterling’s strength. Domestic demand is so strong that the U.K. economy has surged recently: The International Monetary Fund predicts that U.K. GDP will expand by 3.2 percent this year, faster than any other major advanced economy.

Responding to this lopsided recovery, some investors in recent weeks have shown renewed interest in domestically focused stocks in the U.K.’s midcap market and correspondingly less interest in large-cap stocks, which are often heavily exposed to international markets. London-based multinational educational and publishing company Pearson is one of many corporations listed on the FTSE 100 that have complained that the strength of the pound could hit their earnings.

Over the past several months, yield-hungry investors have shifted money into large caps with strong dividends in response to falling yields on U.K. government bonds. “The great switch out of midcap into large-cap equities has left many U.K. domestic stocks attractively priced,” says Steve Davies, a fund manager at London-based Jupiter Fund Management, which oversees £33.1 billion ($55.8 billion) in assets ($55.8 billion).

Consumer stocks are particularly attractive given the sharp rise in confidence among the U.K. public, which translated into a 1.6 percent leap in retail sales during the second quarter of the year. In its June 1 edition, the GfK monthly index of U.K. consumer confidence crossed into positive territory for the first time in nearly a decade (although it dropped slightly back into the negative in the July 1 report from market research firm GfK). Analysts attribute this newfound optimism to the U.K. employment rate of 73.1 percent, which ties a record high first hit in February 2005, as well as the dissipation of the sense of doom caused by the euro-zone debt crisis. Says Peter Dixon, chief U.K. economist at Commerzbank in London, consumer confidence “is certainly looking pretty punchy.”


The surge in consumer spending produces opportunities in a wide swath of sectors. Jupiter’s Davies favors Thomas Cook Group, the world’s oldest travel business. Higher household expenditures should translate into more minibreaks, increasingly exotic — and hence more expensive — destinations and higher spending while on vacation, Davies says. Jupiter’s investment in Thomas Cook is also a play on corporate recovery: Thomas Cook almost collapsed in 2011 and is still losing money, though not as much as before. Davies sees room for further efficiencies, including more online bookings.

He also likes consumer electronics chain Dixons Retail and cellphone retailer Carphone Warehouse Group, which are set to merge Thursday, when shares of the new entity will trade for the first time. Thomas Cook closed at £1.18 Tuesday; on their last day of trading as separate stocks, Dixons Retail was up 18 percent over the past 52 weeks at 53.5 pence and Carphone Warehouse was 40 percent higher at £3.42.

However, Davies advises avoiding certain domestically focused sectors, such as food retailers, given an ongoing supermarket price war in the U.K.

Investors think that consumer spending could receive another boost when a return to real wage growth — one of the missing pieces of the U.K. recovery — falls into place. Analysts say this milestone may not be that far off. “Wage growth has started to pick up,” says Gene Salerno, head of asset allocation and equities at London-based private bank Kleinwort Benson. U.K. employee earnings briefly edged ahead of inflation earlier this year for the first time since 2010, and economists expect real wage growth to have strengthened by the end of 2014.

Within U.K. equities Kleinwort Benson has had a bias toward midcaps and small caps over the past year or so, in part because of these stocks’ domestic focus. On the midcap front the bank has invested in Davies’s employer, Jupiter Fund Management. Jupiter has a strong brand among U.K. retail investors, whose improving economic circumstances are likely to have a knock-on effect on their interest in financial markets. “As retail investors’ confidence continues to rise and they continue to allocate additional funds to their investment portfolios, Jupiter is poised to perform,” Salerno says.

Some analysts, however, warn investors to limit their enthusiasm when it comes to domestically focused midcap stocks and small caps with a similar home-country bent. Commerzbank’s Dixon notes that a lot of smaller companies are in “less glamorous” labor-intensive sectors with low margins, such as cleaning and property maintenance. “They may be unable to generate big strong numbers unless the economy really does take off,” growing beyond the humdrum 2.5 percent a year or so that Commerzbank forecasts after this year’s surge, says Dixon.

For all the excitement generated by the recent strong growth in the U.K., Dixon calls on investors to remember that in the long term Britain is a low-growth economy compared with Asian emerging markets or even the U.S. Large caps are best poised to benefit from overseas growth, he says. “You don’t want to overweight the small- and medium-cap sector massively,” Dixon advises.

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