Mid-sized UK firms poised to create profits

Kathleen Brooks
WHO would have thought that the FTSE 250 – often considered a better reflection of the UK economy than the FTSE 100 – would have outperformed the larger index?

Even after the swings in the financial markets at the end of last week, the mid-cap 250 index is currently 5 per cent higher than it was at the start of the year. This compares to the FTSE 100, which has fallen 5 per cent.

Research from Charles Stanley Securities puts the FTSE 250’s strong performance down to two things: firstly a recovery in earnings in the first quarter of the year and secondly a re-emergence of takeover activity.

But rather than dive straight in and take a long position in the mid-cap index, Charles Stanley recommends that investors be more selective. It has found that 30 companies look overpriced on a historical price-to-earnings (P/E) basis. These include Victrex, whose current P/E ratio is 93 per cent higher than its 10-year average. Other stocks that look over-valued on the same historical basis include Durex condom maker SSL and Internet Securities.

On the other hand, IG Group, the trading company, still looks very cheap relative to history and is currently trading on a 37 per cent discount to its historical average P/E ratio.

But apart from price, what else is driving interest in the UK’s mid-cap index? Primarily it is growth potential, according to research from Charles Stanley. Mid-cap companies have hunkered down during the recession, re-structured and cut costs, which has left them poised to benefit from the economic recovery. This has already helped profits at some companies in the first quarter and should continue to do so throughout this year.

Domino’s Pizza, Homeserve, Telecity and International Personal Finance are some of the most attractive stocks in the index and should perform strongly over the next few months, say Charles Stanley analysts.

They are particularly hopeful for Domino’s Pizza: “Given a consumer that remains cash-strapped, but yet still keen to enjoy the occasional food treat, the group’s underlying sales growth should remain robust,” it wrote in a note to clients at the end of last week.

Analysts point out that the company is close to opening a new production plant and, unlike a restaurant complex, Domino’s Pizza requires fairly low levels of investment to boost sales.

This means that even during a period of expansion its balance sheet remains in fairly good shape. In the current economic climate that should be attractive to investors as it gives the company more flexibility to scale up its business if demand for its pizzas remains elevated.

Since the start of this year there has been a flurry of takeover activity and this has been no different in the FTSE 250. Arriva, Shanks Group, VT Group, Forth Ports and Chloride have all received bids this year. If offers continue at this rate then 2010 will be the most prolific year for mergers and acquisitions in the mid-cap index since 2006, according to Charles Stanley analysts.

So while the UK’s political establishment tries to figure out who will govern the country, spread betters can earn profits by investing in Britain’s mid-size businesses.