Archives for June 2014

UK Company Shares – Go Large

During the last 15 years, the UK’s largest companies (constituents of the FTSE 100 index) have delivered significantly lower returns than medium-sized companies (in the FTSE 250 index). We believe that this trend will now reverse over the next few years and the largest companies will outperform the medium-sized companies. We are therefore seeking to move portfolios towards funds with heavier exposure to FTSE 100 companies. 

Our analysis (as described in more detail below) shows that (i) the outperformance of medium-sized companies over this period has arisen from both falling valuations for larger companies, and faster earnings growth, (ii) the disappointing earnings of the larger companies has been due to specific weakness in key sectors, which are heavily weighted in the FTSE 100 index, (iii) these sectors of the market are now attractively valued, and (iv) there are good reasons to believe that these trends will reverse in future years, which (v) has implications for UK equity fund managers. The unusually large outperformance of medium-sized companies has allowed many of the UK’s equity fund managers to deliver extremely strong outperformance of the FTSE All Share Index over this long period. This is because they have a collective tendency to hold underweight positions in the largest companies and overweight positions in medium-sized companies, due to their belief in their stock-picking skills.   Given our analysis, we believe it will therefore be increasingly difficult for most UK equity managers to outperform the FTSE All Share Index.

The outperformance of medium-sized companies over larger companies

During the 15 years to the end of April 2014, the total return from the FTSE 100 index (the 100 largest companies listed and based in the UK) has been a compound annual rate of 3.6%, while the equivalent total return from the FTSE 250 (the 250 medium-sized companies after the FTSE 100) has been 9.9%. This is an astonishingly large differential (6.3% per annum) between different parts of the same stock market over such a long period. About half of this difference in performance has resulted from the change in the valuations between the two indices.  The decline in the forecast Price Earnings Ratio (“PER”) of the FTSE 100 over the period is from about 22.5 times to about 13.5 times while the forecast PER of the FTSE 250 is essentially unchanged (at about 15.5 times).   Over the longer term, valuations of these two indices can be expected to be broadly similar. Though the 40% premium seen in 1999 was exceptional, a move back to a FTSE 100 valuation premium is entirely possible in the next few years, particularly if, as we expect, Sterling declines against the Dollar, since the earnings and dividends of the FTSE 100 are very sensitive to movements in the Sterling-Dollar exchange rate, given the global nature of the very largest companies in the market. The other half of this valuation difference is accounted for by faster growth in expected earnings from FTSE 250 companies than from FTSE 100 companies. These stronger expected earnings occurred in two distinct phases; one from 1999 to 2003 and the second since 2011. The first period reflects disappointment that companies such as Vodafone and BT failed to live up to the wildly overoptimistic expectations that many analysts had during the Tech bubble, while the second period reflects actual earnings weakness due to economic problems following the banking crisis.          

The disappointing earnings of the larger companies in key sectors …

Several key sectors that are more heavily represented in the FTSE 100 than the FTSE 250 have endured particularly large declines in their expected earnings despite the economic recovery.  The prospective EPS of the FTSE 250 have grown by 5% during this period, but the FTSE 100 prospective EPS have fallen by 17%, led by declines in Food Retailing (28%), Oil and Gas (30%) and Mining (54%). Since October 2007, the prospective EPS of Banks have also fallen heavily (by 59%). Together these four sectors, which account for over 40% of the FTSE 100 index, but represent very little of the FTSE 250 index, and their very poor earnings performance, have been significant in curtailing returns from the FTSE 100 index in recent years.

… mean these sectors are now attractively valued …

Following this poor performance, these sectors are now attractively valued compared with the rest of the market – their prospective P/Es are between 10 and 12 compared with about 13.5 for the FTSE 100 

… and the performance trends are now set to reverse

We believe that all four of these key sectors (Banks, Oil and Gas, Mining and Food Retailing) offer attractive potential for future returns, based both on attractive valuations and on fundamental changes that management teams across these sectors are putting into place. They share a common feature in that previous management teams overinvested during the last decade. In Banking, the 2008 crisis showed this to be an error. In Mining and Oil and Gas, the end in 2011 of China’s enormous investment in infrastructure has reduced demand for, and therefore the prices of, commodities. In Food Retailing, the entry of Aldi and Lidl into a saturated UK market has led to a price war that has hit margins and profits. In each of these sectors, new management teams have been brought in, have cut investment and have refocused on cost-cutting and cash generation. History suggests these measures will lead to much more profitable times for shareholders than when managements emphasise growth over returns. Both earnings and valuations are likely to rise. With almost half of the FTSE 100 index undergoing this change, the prospect for future outperformance of the FTSE 250 appears strong.     Investing in markets is most profitable when growth expectations are low and are easily beaten, rather than when growth expectations are high, and thus hard to beat. For the FTSE 250 to meet its earnings forecasts over the next 12 months, earnings growth of about 27% is required, but for the FTSE 100 to meet its earnings forecasts over the next 12 months, earnings growth of about 2% is required. It should therefore be much easier for the FTSE 100 to beat investors’ earnings expectations than for the FTSE 250.

The implications for UK equity fund managers.

In developed world stock markets, numerous studies have shown that fund managers tend to underperform the benchmark index by about the amount of their fees – in other words that the fund management industry as a whole adds very little investment value to their clients’ portfolios. Indeed, since 1990 (to 31 May 2014), the IMA UK All Companies funds index has delivered a compound total return of 7.7% per annum, compared with 8.5% from the FTSE All Share index. However, since 2012 (to 31 May 2014), UK equity fund managers have outperformed their benchmark index – the IMA UK All Companies funds index has delivered a compound total return of 17.5% per annum, compared with 14.8% from the FTSE All Share index – a very strong and highly unusual period of outperformance.  The cause of this outperformance has been the generally heavy underweighting of large FTSE 100 companies by the IMA funds. A reversal in this trend of underperformance of FTSE 100 companies is likely to mean that UK fund managers will revert to their more normal pattern of underperforming the FTSE All Share index. The expectation of better performance from the FTSE 100 index means that, within our Model portfolios, we are seeking to switch UK equity exposures towards funds that have heavier weightings to FTSE 100 companies.