Four quality UK mid-cap stocks

Professional investor Paul Spencer tips four high quality smaller companies with robust balance sheets and healthy cash flows.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Paul Spencer, fund manager of the Franklin Templeton UK Mid-Cap fund.

The recovery of the British economy has faltered and the incremental growth we saw in 2009 and 2010 has reduced to almost zero. To make matters worse, a still longer shadow has been cast over UK plc by the paralysis that has spread over the eurozone. Yet despite this erratic and uncertain environment, there are plenty of attractive opportunities in Britain's increasingly diverse range of mid-cap stocks.

The mid-cap sector has vastly outperformed the FTSE 100 in recent years. Over a decade the FTSE 100 has delivered a meagre 39% to investors compared with the FTSE 250's return of 120% over the same period. The breadth of the mid-cap sector and the fact that its firms have far fewer analysts covering them, compared with stocks in the FTSE 100, make it ideal territory for the active stockpicker who can take advantage of valuation anomalies.

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In these tricky economic times you need to have a portfolio that doesn't need to be chopped and changed. The key to success lies in not overreacting to the myriad economic headwinds. So our philosophy is simple: create a high-conviction portfolio of undervalued companies. But how do you go about doing so?

Firstly, we cast a sceptical eye over each company's accounts, business model and management track record. We like to achieve acceptable downside protection by eliminating those firms with unsustainable business models, ineffective management, or fragile finances. Any firm that passes this screening test should be higher quality, typically with a robust balance sheet, and healthy cash flows.

Most importantly, no matter how strong the company's fundamentals, it will still be a bad investment if you pay too much for it. The final criterion a company must meet is an attractive valuation. At the moment, valuations on a lot of mid-cap stocks are very tempting. We've used recent volatility to increase positions in stocks we consider have been unjustifiably weak.

For example, in the very volatile market conditions in September we added to our holding in Wood Group (LSE: WG), the oil and gas services company. The Aberdeen-based group continues to have positive cash balances despite returning more than £1bn to investors following the disposal of its well support division to GE Energy in April. Its management has a consistent track record of enhancing shareholder returns and the business has the scope to perform well on the back of robust trading in its core end markets. New additions to the portfolio included Howden Joinery (LSE: HWDN), which designs, manufactures and sells fitted kitchens to small local builders throughout Britain via its network of depots.

We have about 50% exposure to Britain, considerably higher than a lot of FTSE All Share portfolios, with our bigger holdings including the likes of Persimmon (LSE: PSN) and Travis Perkins (LSE: TPK). Both of these firms source 100% of their profits from Britain. Persimmon is a high-quality, volume house builder and Travis Perkins is a market-leading builder's merchant. Both have management teams that have done a great job of cutting their cost bases, improving efficiencies and preparing their businesses for very difficult market conditions.