Save, make, understand money

Experienced Investor

FTSE 100 fights back: why 2016 could be the year of the large cap revival

Kit Klarenberg
Written By:
Kit Klarenberg

Is the multi-year outperfomance run by small and mid cap stocks about to come to an end?

Since the year 2000, mid-cap stocks – FTSE 250 constituents, valued between £500m and £2.5bn – have become increasingly popular with investors.

Mid-caps are perceived as agile, dynamic businesses able to flourish in both booms and downturns, that offer more opportunities for growth – and returns – than their larger FTSE 100 counterparts.

This perception is supported by data from Interactive Investor, which shows that between 2002 and 2012, the FTSE 250 returned around 150 per cent, over three times the 45 per cent delivered by the FTSE 100.

Simon Gergel, manager of the Merchants Trust, which invests mainly in higher yielding UK FTSE 100 companies, attributes this outperformance to the tendency of large-caps to suffer disproportionately during downturns.

“The relative underperformance of large cap stocks since 2000 is unsurprising, given this timeframe has played host to the dotcom bubble, the financial crisis and the end of the commodities super cycle,” he says.

The fightback begins

Moving forward, Gergel believes large-caps are set to recover in the next few years and he believes the current market offers investors a number of buying opportunities.

“Large caps have spent so long unloved they’ve become cheap – the 100 index now trades on an average price to earnings ratio of 14.3 times, compared to 16.4 times for the 250,” he explains.

“The returns are better on the FTSE 100 too, with an average dividend yield of 4.3 per cent, compared to 2.9 per cent on the 250.”

Certain features of the macro outlook may indeed support a large-cap resurgence, and a shift away from the middle ranks of the market.

Large-caps are internationally orientated, and with the US economy growing increasingly stronger and mainland Europe recovering to varying degrees, stocks with exposure to those regions are set to perform strongly in the years ahead.

Mid-caps, on the other hand, tend to be more domestically focused. The UK economy may not be as supportive of mid-caps in the mid-term, with impending interest rate rises and an expected increase in inflation potentially impacting consumer spending power and household budgets.

Among the large-cap stocks he tips, Gergel cites BP and Royal Dutch Shell, HSBC, and GlaxoSmithKline.

“Their valuations are modest, they offer dividend yields of around six per cent, and their investment stories are only going to improve,” he says.

A challenging market 

Other experts, however, question whether future events will support large-caps. Stephen Bailey, co-manager of the Liontrust Macro UK Growth fund, believes the next few years will be challenging for every capitalisation, but particularly the FTSE 100.

He says: “The [100] Index is dominated by a number of sectors we’d flag as risky, particularly in respect of dividends, and I’d approach that element of the market with caution.

“Take oil majors. Based on current projections, oil will remain beneath $50 per barrel throughout 2016. The longer it stays at that level, the longer profits will decline, and the more likely dividends will be cut.”

Gergel responds that while oil major returns are undoubtedly under pressure, the industry isn’t sitting idly by. Capital expenditure has been slashed in response, and production slowed significantly.

“The last time prices were so low, in the mid-80s, the industry managed to maintain dividends despite the loss of revenue,” says Gergel.

“The majors know high and sustainable dividends are a fundamental part of their investment case, and they’ll do what it takes to maintain them as a result. These businesses are cash-rich, and can afford a few years of pain. Shell recently announced they would maintain their dividend, for instance.”

If oil majors don’t hold out, the FTSE 100 will be negatively impacted. Natural resources stocks – including major energy and mining companies – account for around a third of the Index.

Mining stocks also have their own issues to deal with, including ever-falling commodity prices and a major mining disaster in Brazil denting market confidence.

Rio Tinto and BHP are suffering severe cash flow problems, and they’ll be reviewing dividends soon – payments aren’t being covered by genuine free cash flow at the moment,” says Bailey.

Financials, which account for around 25 per cent of the 100 Index, have been restructured, recapitalised and more strictly regulated since the financial crisis, and many have increased or restarted dividends.

Despite this, Bailey believes the sector still faces significant challenges, and there are better opportunities among challenger banks, such as the FTSE 250 listed Virgin Money.

All creatures great and small

These misgivings aside, Bailey believes investors are best served by a multi-stock approach driven by themes, rather capitalisation size. His view is supported by Matt Hudson, manager of the Schroder UK Alpha Income and UK Opportunities funds.

“The period of relative mid-cap outperformance is fading, but there are still some fabulous opportunities in the mid-cap space,” he says.

While mid-caps currently trade at a premium, meaning investors pay more for lower yields, Hudson believes their valuations will fall in time.

“At the higher end of the market, investors generally look one to two years down the line – future damage to FTSE 100 earnings are consequently priced in today. The same isn’t generally true of 250 stocks, which are less well-researched,” he explains.

“Industrial stocks account for around 20 per cent of the FTSE 250. Their performance is falling, and there’s more downside to come. When that happens, these stocks will become attractive again, as higher discounts will be applied.”

At the same time, Hudson believes large-cap stocks will be necessary portfolio constituents as the UK economy moves further along the business cycle.

“Liquidity is much better the larger you go, and when we enter a business slowdown, investors will need to hold more liquid stocks,” he says.

“Still, investors should remain selective, focusing on FTSE 100 growth stocks with good dividend yields and recovering earnings. Currently, I like Sage, Carphone Warehouse, and tobacco stocks such as BAT, which are great yield stocks available at a discount.”