Time to Ratchet Up The Market Cap?
Date Published: 13 January 2014
Our research shows that the average UK equities fund holds 48% in small/mid-caps vs. an index weighting of just 16%, with the mid-cap FTSE 250 rising by 33% vs. 19% for the blue-chip FTSE 100 in 2013; with many of the best performing UK funds owing their outperformance to their size bias rather than stock picking expertise. In fact four of the top ten performing UK funds analysed held zero in the largest blue-chips. Most fund managers or strategists have a love affair with these stocks extolling the attraction of their greater exposure to the UK or lower exposure to mining stocks. True, but they rarely mention the valuation relative to the growth rate.
Last year, the earnings from mid-caps was 7% more than the blue-chips, but they out-performed by 14% so their inherent valuation has risen. Arguably this growth differential was exaggerated in 2013 due to the extreme underperformance of the oil & gas/commodity sectors that account for 25% of the FTSE 100, but accounts for less than 9% of the FTSE 250. Also the strength of sterling in 2013 affected the blue-chips more given that the typical FTSE 100 stock has 81% of its sales overseas.
My view is that sterling will gradually depreciate from here, especially against the US$ which tends to be the key currency. Based on the current Purchasing Power Parity i.e. the exchange rate at which a ‘basket of goods’ would be the same price, according to OECD statistics, the US$ is over 13% undervalued against Sterling.
In addition, the degree of excess growth by the UK mid-caps appears to be slowing. Based on analyst bottom up forecasts, the average earnings growth for the mid-caps over the next two years will be 12.3% pa, which is just 2% pa above the same forecast for the blue-chips. This extra growth comes at a 25% valuation premium based on Price/Earnings ratios which I think is demanding.
Outperformance by the mid-caps is not a constant, in the UK during the 90’s the FTSE 100 actually beat the FTSE 250 by nearly 2% pa. And even during the next decade, the mid-cap outperformance averaged 6% pa, which was much less than the gains we saw last year. Interestingly at the start of 2000, they stood on an almost identical P/E to the blue-chips so investors received premium growth thereafter without paying a premium price. This is no longer the case.
The academics, Dimson and Marsh wrote in a 1998 paper called Murphy’s Law and Market Anomalies, ‘Many researchers have uncovered empirical regularities in stock market returns. If these regularities persist, investors can expect to achieve superior performance. Unfortunately, nature can be perverse. Once an apparent anomaly is publicised, only too often it disappears or goes into reverse.’
Isn’t the current mid-cap euphoria just another example of fund managers arriving at the party too late? Isn’t it time to focus on UK blue-chips again?