For those happy to remain invested, where “should they put their money? Here my advice is to focus on large, good quality companies. Avoid at all costs smaller and medium-sized companies with weak balance sheets.”
Those are the thoughts of Anthony Bolton, the former Fidelity fund manager, when he was recently asked to give advice to investors on how to survive the bear market in one piece.
Bolton, like many active fund managers, has been shifting towards large caps for some time. And if you had followed the advice of the analysts at HSBC at the end of 2006 and piled into mega caps stocks of the FTSE 100 rather than mid caps, it would have saved you some pain. Since then the FTSE 100 has fallen 10 per cent, the FTSE 250 is down by 22 per cent.
Graham Ashby at Credit Suisse says: “Although of little consolation to UK equity investors, the relative outperformance of the FTSE 100 index is generally understandable given the lower exposure of many large companies to the rapidly deteriorating domestic economy.”
Tom Ewing, a colleague of Bolton’s at Fidelity admits that tracker investors will have fared better because if you “had £100 invested in a tracker, £57 would have tracked the 20 biggest stocks” and this does not include household names, such as Marks & Spencer or Barratt Homes, which have suffered badly in the economic downturn.
And while he doesn’t select stocks on the basis of market capitalisation, he is exposed to the so-called mega caps. “The mega caps are the biggest 20 stocks in the FTSE 100. The remaining 80 actually perform in line with the 250 index. The mega caps are the place to be. They are actually benefiting from some trends, such as the high price of energy and commodities.”
It wasn’t so long ago that a report by HSBC predicted a reversal of fortunes for the mega caps it dubbed “super heavyweights” because the stocks are much less cyclical than the mid caps, which would be an attraction in a slowing domestic and global economic environment. These super heavyweights are the ten biggest companies in Britain, and account for 40 per cent of the FTSE All-Share index’s market capitalisation.
They were BP, Royal Dutch Shell, GlaxoSmithKline, Barclays, HSBC, AstraZeneca, Vodafone, Royal Bank of Scotland, HBOS and Anglo American. The make-up of the top ten has changed somewhat – gone are the credit-crunched banks, but the mining and energy sectors, with Rio Tinto (representing 4.3 per cent of the FTSE 100), BG Group (3.1 per cent), Anglo American (3.1 per cent) and BHP Billiton (3 per cent) have provided a boost to the index.
The question is whether mega and large caps are the place to be in the months ahead, because in the past three months mid caps have fought back.
Over the past twelve months the FTSE 100 has fallen by 18.5 per cent. The FTSE 250 has fallen by 28 per cent. But in the year to date the gap has narrowed, with the blue chip index down 16.5 per cent and the 250 index down 20 per cent. Despite the change, HSBC is sticking by its guns and reckons that large caps will continue to outperform their smaller counterparts.
“Liquidity alone may be a positive attribute in this uncertain environment. We continue to prefer the large caps over the mid and small caps. Since the start of 2007 the large caps have outperformed the mid and small caps by 17 per cent and 31 per cent respectively. True, this outperformance has reduced the relative valuation attraction of the blue chips to some degree, but they still trade on a 13 per cent discount to the mid caps,” says Robert Parkes, equity strategist at HSBC. “The consensus forecasts point to a higher earnings growth rate in the large caps (both this year and next), with a higher yield also on offer.”
But the valuation argument can be a misnomer – there is currently little valuation differential on average between large and small cap stocks. Ten months ago the average price/earnings ratio for the FTSE 100 was 12.8, for the FTSE 250 it was 20.4. Over the summer the difference has narrowed as investors have warmed to large caps, with the FTSE 100 trading at an average of 10 times earnings and the FTSE 250 at 12. In other words, large caps are still cheap relative to their mid and small cap counterparts, but only just, and mid cap valuations are getting cheaper by the day.
Yet Mike Felton, fund manager of M&G UK Select, upped his weighting in mega caps two years ago and has no thought of altering this strategy in the immediate future. Given a global economic backdrop that continues to deteriorate, he believes it is still right to invest defensively, hence his full weighting to the top five stocks.
“Recently companies have been increasingly punished for being too indebted – Punch and Debenhams have been high profile examples – but it seems to have reached a crescendo of late as investors worry about the impact of the credit crunch and the ability of companies to service their debt,” adds Felton.
“With stronger balance sheets, as well as greater product and geographic diversification, mega caps are more likely to have better protection in difficult times. In general, these large companies have resisted calls from the wider community to ‘gear up’ their balance sheets in order to achieve an ‘optimal’ balance sheet structure.”
Felton cites companies such as GlaxoSmithKline (2.7 per cent of the FTSE 100) and Vodafone (3.1 per cent) as having had a measured approach to capital allocation, and believes this should serve them well in a downturn.
Richard Wilmot, manager at Newton Investment, also continues to favour larger companies because of their superior competitive position, stronger balance sheets and greater global orientation.
“A number of sectors where large capitalisation stocks dominate such as pharmaceuticals, telecommunications and utilities, enjoy defensive characteristics that should serve them relatively well should the difficult economic and equity conditions continue. Small and medium cap stocks do not offer as many safe havens and are in general more cyclically exposed. They tend to thrive when the domestic UK economy is buoyant and investor appetite for risk is increasing,” says Wilmot.
It is only in the past year or so that large caps have led the way. In the immediate years that followed the bursting of the technology bubble, large cap stocks proved to be material underperformers on a relative basis. A factor for the mid cap out performance over large caps in the immediate years prior to 2006 was the flurry of merger and acquisition activity triggered by private equity funds on the hunt for deals.
But the deals have dried up. If there are deals to be made they are being engineered by sovereign wealth funds – and they continue to build stakes in large international organisations, replacing private capital as the marginal buyer of equities.
However, the overseas argument for large caps is one that rankles with Andy Brough, manager of Schroder Mid-250. He argues that investors often fail to recognise that there are many UK midcaps with exposure to global economic trends.
“Car retailer Inchcape, for example, started out as a UK-focused supplier, but as a result of its international expansion, it is now the largest car dealer in St. Petersburg. Along the same lines, Carillion and Atkins are now just as dependent on fast-growing markets such as Dubai as they are on construction spend in the UK,” says Brough. “Despite these opportunities, investors still appear to see mid caps as the poorer cousin to large caps in a weakening economic environment. Yet (as of the end of April) there has been little difference in the performance of mid versus large caps since the beginning of the year.”
There are those that argue that the mega versus large versus mid cap versus small cap debate is futile. They reckon that a company’s size should never form the sole basis of an investment decision.
Less sophisticated investors tend to view size as a safety net, but there are some fantastic small companies and some very badly performing larger companies. Tim Steer at New Star argues that investors need only witness the recent destruction in value among some of our biggest companies, such as Royal Bank of Scotland or Marks & Spencer, to realise that economic circumstances can turn against any company regardless of size. “No company is too big to fail. Governments might prop up an ailing bank, car maker or airline but their concern is focused on employees and the economy, not the shareholders, who could be wiped out in any rescue,” adds Steer.
Steer – who tends to favour mid caps – admits the FTSE 250 companies have tended to suffer bad press because many of the poor-performing domestic-facing companies, such as house builders and retailers, are represented in the FTSE 250 index.
But he adds: “While this is true, so too are most of the specialist engineering companies, which are enjoying buoyant overseas sales, and the support services groups, which enjoy recurrent earnings.
“Similarly, banks are mainly large cap, yet their near term outlook is bleak. Conversely, there are plenty of large companies with strong overseas sales, such as Vodafone and BHP Billiton, which enable UK investors to reduce their exposure to a domestic slowdown. The key point is to look at the operating environment and fundamentals of a company, not its size.”
The mega caps are having their day in the sun, and will for a while yet, but the highest returns rarely come from stocks that are popular and long since discovered. Advisers reckon that over the longer term there’s better value to be found as one moves down the cap scale because of market inefficiencies. The key is to find a multi-cap fund with a shrewd manager at the helm. n
Adviser view
Stephen Marriott, senior research analyst, Bestinvest
funds in favour
We are currently overweight in large cap and within that space some of our favoured manager/funds include:
Rensburg UK Blue Chip Growth (Colin Morton) – The fund aims to maximise relative total returns through capital growth and income by building a portfolio consisting predominantly of FTSE 100 companies. The process uses longer-term macroeconomic themes to drive portfolio strategy, whilst bottom up relative valuations to guide the extent to which positions are over or under weight.
Standard Life UK Equity High Income (Karen Robertson) – The fund’s manager, Karen Robertson, follows a house process that aims to identify change ahead of the market. The process utilises this proprietary house model as well as incorporating the manager’s own skills. Investor’s should note that although there is a bias to large cap, around 25 per cent is invested in mid cap stocks.”
Adviser view
Mark Dampier, head of research, Hargreaves Lansdown Funds in favour
“Large cap is favoured but I think it’s more about investing in funds that invest in quality companies with little or no debt, good earnings visibility, pricing power and good cash flow. These are the companies that are less likely to have a profits warning and torpedo you.
“My choices include Richard Buxton of Schroder’s UK Alpha. He believes the market is likely to get worse before it gets better. In this environment, stock selection is even more crucial, and this fund’s performance has been aided by its exposure to the resources sector. While investors are right to be cautious, Richard Buxton believes some share prices do not reflect the companies’ long term strengths and that there are some great opportunities to be had.”
BlackRock’s Mark Lyttleton is also a favourite. While the UK market continues to be affected by events in the credit markets, his fund has held up very well compared to its peer group. Lyttleton does however expect to see further volatility in the short term due to inflationary pressures and a weaker consumer. In this environment, stock picking will be crucial and the fund’s focus on companies in the oil and gas sector over the banks, for example, should prove beneficial going forward.”