Where does the rotation into large caps leave the smaller caps?


UK equities have become a tale of two indices in the period following Brexit. Within a week of the vote the FTSE 100 was up 5.4 per cent while the FTSE 250 was down 3.6 per cent, a gap of 9 per cent. 

The preference for large caps turns a 15-year love affair with mid caps on its head. Research from The Share Centre says net profits in the FTSE 100 over that period fell 34 per cent compared to a 7 per cent increase seen in the FTSE 250.

Weak sterling and a flight to safety have boosted the large cap index since the EU referendum. Twenty-one per cent of revenues in the FTSE 100 come from UK operations compared to 59 per cent in the FTSE 250, says iShares. While sterling has made gains since falling below $1.30 on 5 July, it is still more than 10 per cent lower than its pre-referendum level of $1.48.

So should investors join the crowd in the FTSE 100 or pick opportunities in the FTSE 250? William Meadon, portfolio manager at JP Morgan Claverhouse Investment trust, says strategically investors should favour the FTSE 100, but be prepared to find opportunities in mid caps. “Many of our portfolios will be tilted towards blue chips, but we’re going to be tactically aware that when some mid caps do get completely overblown we will take advantage of them.” 

The investment trust sold out of domestically sensitive mid caps in the lead up to the Brexit vote, including housebuilders, as well as bakery chain Greggs. The fund also took its gearing down from “around 10 per cent to 3 or 4 per cent”. It has also been building reserves and hopes to continue its track record of increasing dividends.

Gervais Williams, manager of Miton’s UK Multi Cap income fund, says he sold Persimmon, Taylor Wimpey, ITV and EasyJet the day Brexit was confirmed in the anticipation consumer discretionary spending will go down with the weak currency.

The banks, insurers, oil and mining stocks that dominate the FTSE 100 are not the most appealing mix, because it needs an economic fair wind worldwide to really thrive, says Russ Mould, investment director at AJ Bell. However, he adds: “In the short term if the market was to be frightened of a UK downturn, I think the FTSE 100 would continue to outperform and you’d find people would huddle for safety under those circumstances.”

The upcycle has been hard for active managers to outperform, says Mould. “There’s been a lot of whipsawing, it’s been a very macro driven market, correlations between different sectors and different assets have been very high.” He says investors who are confident the markets are going to rise should look at passives in order to keep costs low. iShares reports it saw a “clear rotation” out of mid caps into large caps post Brexit. There was $62m in assets that flowed into UK large cap ETF products and $117m that came out of UK mid caps.

Worst performing small cap funds over Brexit periodFS_010716_009.pdf

For the long term, Chelsea Financial Services senior research analyst James Yardley says the FTSE 250 has quality companies and is now a lot cheaper than it was a month ago. But he adds the last time sterling dropped by a significant amount, in 1992, the FTSE 100 outperformed for a long time. 

Yardley says he would pick an active manager for the FTSE 100, who can avoid sectors such as banks and miners. His preference in this space is the Evenlode Income fund or JOHCM UK Opportunities. For the FTSE 250 he again favours active managers like the Franklin UK Mid Cap or Neptune UK Mid Cap, but says investors wanting exposure to the whole market could choose the HSBC FTSE 250 tracker.

Chris Mayo, investment director at Wellian Investment Solutions, says he prefers active over passive and instead of double guessing what the markets are going to do and trading around short-term events, he advocates a buy and hold strategy.

Have valuations of FTSE 100 companies been pushed? Gerrit Smit, portfolio manager for the Stonehage Fleming Global Best Ideas Equity fund, says they do not make much provision for sterling to recover. 

Best performing small cap funds over Brexit periodFS_010716_008.pdf

Williams points out that if trouble arises in Europe sterling could start to look like a safe haven. “But longer term, unless we start saving more as a country and we don’t rely on overseas investors to buy UK assets, I think we have to assume the UK is generally going to be a weakish currency.”

Smit points out that blue chip Unilever’s price-to-earning ratio is 25, more than two standard deviations away from its 10-year average, leaving “little room for error” in earnings delivery. In contrast, packaging mid-cap Essentra’s price-to-earnings dropped two standard deviations from its 10-year average following a profit warning.

Value managers who bought into mining and oil stocks have probably done well from entering the FTSE 100 when it was out of favour prior to the Brexit vote, says Mould, and now have more opportunities in the FTSE 250 where it would have been difficult to find value a year ago. 


“You’ve got that expensive tag hanging around a few of the defensives’ necks at the moment. It will be interesting to see if we see the revenge or return of value.” Mould says Legal & General UK Special Situations or M&G’s Recovery fund, run by Tom Dobell, could be ones to keep an eye on.

The assumption that all small caps are domestically focused is incorrect, says Williams. The fund has underwritten a rights issue at 35p for small-cap stock Sepura, which makes mobile handsets for emergency services and recently made an acquisition in the US. 

“As a recovery stock, it’s a beautiful stock. It’s not dependent on whether people are buying houses or whether interest rates are going up. It’s absolutely dependent on whether the fire service needs to upgrade its tetra network,” Williams says. The stock was 77.5p on the day of the vote, having already fallen from 197.5p in March due to high debt.

The composition of the FTSE 100 may be forever altered if companies decide to relocate operations to the EU, according to Williams. “There will be a lesser inclination for multinationals to have large parts of their operations in the UK and anyone thinking of coming to the UK may now choose to go to the EU.”

But what’s bad for the UK economy isn’t necessarily bad for shareholders, says Meadon. “If companies pull out of the UK or move a lot of their operations overseas, if that’s the right thing for that company then you still want to be a shareholder in that company. It may be bad for the British economy, it may be bad for the people that work there, but it doesn’t stop that company being a bad investment. From a strictly selfish shareholder point of view it could be the best thing that company could do.”

Williams says if multinationals start moving operations to the EU the political leadership will have to place more emphasis on small quoted companies. “The UK has always had a strong small cap sector. I think we’ll see policies like stamp duty being removed for the Aim stocks.”

However, Meadon says the uncertain environment means his portfolio will not take a view on the direction of Government policy. “We have quite a thick fog, constitutionally, economically and politically. That fog is not going to clear for quite some time.” 

In this uncertain period Meadon says investors will focus on international companies with “fortress balance sheets, experienced management, diverse products, barriers to entry and strong budgets”. And, he adds, they will be willing to pay a premium for it.