Race for supremacy race

Anthony Bolton and Derek Stuart have the largest ever weightings in FTSE 100 stocks during the life of their special situations funds at Fidelity and Artemis respectively. Should investors be following their example? With mid-caps now trading at a premium to large-caps, it could be argued that on a selective basis the FTSE 100 offers better value.

Mid-caps have certainly had an impressive run since the technology bubble burst in March 2000. Between March 6, 2000 and March 7, 2005, the FTSE 250 index returned 24.5%, according to Standard & Poor’s. Over the same period, the FTSE 100 fell 9.9% against a fall of 3.1% by the FTSE SmallCap index.

What is even more impressive is that the FTSE 250 has outperformed large and small-caps in four of the five 12-month periods since 2000. Fund managers say the main drivers behind the outperformance have been increased merger and acquisition activity and the overselling of mid-caps. Some commentators also attribute the underperformance of large-caps to the net selling of equities by pension funds and insurers.

This phenomenon has not been confined to Britain. In the five years to March 7, 2005, the Dow Jones US Mid Cap index returned 11.5% compared with 5.7% by the Dow Jones US Small Cap index and a fall of 34.4% by the Dow Jones US Large Cap index. Mid-caps outperformed large-caps in each of the five 12-month periods from 2000 to 2005. Small-caps delivered higher returns than mid-caps from March 5, 2001 to March 4, 2002 and from March 10, 2003 to March 8, 2004, but mid-caps outperformed in the other three periods.

In Europe, the situation has been Aslightly different as small-caps have outperformed mid-caps over the past five years, although both have delivered higher returns than large-caps. Between March 6, 2000 and March 7, 2005, the DJ Stoxx ex UK Small index returned 15.4% against 5% by the DJ Stoxx Ex UK Mid index and a fall of 28.5% by the DJ Stoxx ex UK Large index. In each of the 12-month periods from 2000 to 2005, mid and small-caps out-performed large-caps.

Historically, Bolton’s Fidelity Special Situations fund has found most of its stocks among the mid and small-caps. But Bolton says his exposure to the FTSE 100 index is at its highest ever level at 36%: “The underperformance of the FTSE 100 has led to the opportunity to find some value among these companies. But among both the FTSE 100 and the small and mid-caps, the opportunities are on an individual stock basis rather than across the board. I have been increasing my exposure to FTSE 100 stocks over the past nine months.” This has included investing in some growth companies.

But, he says, the increased exposure to the FTSE 100 index does not mean he is more defensive about the outlook for the stockmarket in general: “I go where I find stocks that offer value. After the stockmarket returns of the past two years, it is sensible to be a bit more cautious. But I do not think we will have reached the top of the cycle until private investors start coming into the market in strong numbers. This has not happened yet.”

Derek Stuart says his Artemis Special Situations fund has its largest ever exposure to FTSE 100 stocks at about 40%: “There has been a whole rerating of the mid-cap index over the past few years. There is still value to be found in the mid and small-caps, but I am finding more opportunities in large-caps than for a long time. Even with this 40% exposure, however, we are still heavily underweight the benchmark.”

He does not expect there to be better rates of growth from FTSE 100 companies: “I expect large, mid and small-caps to perform generally in line with each other in the immediate future. There are investment opportunities in all three areas, but there are not the screaming buys of two years ago. Then you could buy stocks on 7x or 8x earnings. Now these stocks are on 12x or 13x earnings.”

The change in the market environment is illustrated by the fact that Stuart says there are no major themes in his portfolio: “I still like oil companies and have BP and Shell in addition to Cairn Energy. But in March 2003, there were stronger themes that I could point to in my portfolio. Themes included technology and media. It is not a question of investing in sectors now, but finding value in individual stocks. I do not have any strong views on the market at the moment.”

Stuart says that when investing in FTSE 100 stocks, as with other companies, he is looking for a catalyst to realise the value. This may be a high oil price, for example, but it is usually a change in management. He gives Scottish & Newcastle and Regis as examples of companies benefiting from a change in management: “If a company has a good franchise and bad performance, this is often the result of poor management.”

Simon King, co-manager of the Gartmore UK Focus fund, largely attributes the outperformance of mid-caps to M&A activity and says this will continue to underpin less attractive parts of the market: “Just recently we have seen a takeover of RAC. We felt the share price of RAC was fair based on fundamentals, but clearly Aviva is happy to pay a premium.

“Bids and takeovers have a ripple effect on the rest of the sector. If one stock is the subject of M&A activity, the share prices of other companies in the same sector will be supported. When RMC was bought for more than £2bn, it benefited the share prices of all building materials companies.”

What has characterised the past couple of years in M&A deals, says King, is the fact they have involved larger companies. “There have been deals for companies with capitalisations of £2bn. This started with venture capitalists and has moved on to larger companies bidding for mid-cap stocks. At one time, 10% of mid-cap stocks were under offer or had a received an offer.”

The dynamics of the market have been changed, says King, by the amount of money that venture capitalists have attracted. This means even FTSE 100 companies, such as Marks & Spencer and Sainsbury’s, could potentially be targets of venture capitalists: “One of the biggest drivers behind corporate activity is the cheap cost of debt at the moment. Recent hotel disposals by Whitbread and Inter-Continental were funded by debt. All the companies that we are seeing say it is cheaper to borrow than last year.”

There are a number of other factors in support of mid-caps, says King: “The yield curve is pretty flat, so it is hard to see interest rates rising by more than 25 or 50 basis points. There is reasonable economic growth, corporate balance sheets are in better shape and there is little new issuance.”

He adds that with companies buying back shares, there is a positive demand and supply ratio supporting share prices. King says he likes niche companies among cyclicals. He points to advertising spending edging up over the past two quarters, which will benefit media stocks.

Mark Hall, manager of the Rensburg UK Select Growth fund, warns against generalising when looking at the value offered by small, mid and large-cap stocks: “We can find investment opportunities in all three areas of the stockmarket. Over the past two years, the median stock in the FTSE All-Share has risen by around 50%.

“But companies that comprise a significant proportion of the index, such as Unilever, Shell and GlaxoSmithKline, have underperformed. Some of the larger stocks have shot themselves in the foot. Shell and Unilever have had profit warnings while HSBC overpaid for Household at the time.” He says, however, that some FTSE 100 stocks, such as Imperial Tobacco and AB Foods, have performed as well as mid-caps.

But Hall adds that he has also been increasing his exposure to large-cap stocks: “Over the past eight weeks, I have raised the fund’s weighting in the FTSE 100 from 32% to 42%. My mid-cap weighting has dropped from 32% to 22% over the same period.”

Hall says this reflects the sell discipline when stocks reach his target valuation and the fact he has been finding investment opportunities among the large-caps. Stocks, says Hall, have been quickly moving through his price targets due to the bid speculation among the mid-caps: “A good example is BBA, whose share price spiked up 12% or 13% in just one day. The £1.1bn takeover for RAC by Aviva is 10-15% above what we regard as the fair value. We sold RAC when it reached our estimate of fair value.”

Even some mid-cap fund managers are cautious about the immediate outlook. “Given the current climate, we believe we have seen the best of company newsflow. The market is currently trading on 13x earnings and is well supported at this level, but it is not likely to move significantly higher from current levels,” says Ashton Bradbury, manager of the Old Mutual Select Mid Cap fund.

“There are several other issues that are likely to impact the market this year. A sustained high oil price will result in slowing world growth. We expect the UK housing market to stagnate but not collapse, while within the equity market we anticipate continued high levels of corporate activity given the availability of relatively cheap money. The adoption of international accounting standards will mean changes in the treatment of items such as pensions and research and development, which will cause some uncertainty.”

Overweight sectors within the fund include “building materials as there is volume growth and rising prices; pubs because they are enjoying strong trading, good growth and are on low multiples; media, which is now attractively valued following a de-rating; water, which has had a favourable regulatory review and where yields are attractive; and property, where the investment market is strong, there is rental growth and improving tenant demand”.

Martin Cobb, manager of the Templeton UK Equity fund, which celebrated its first anniversary last week, takes a five-year view on the value of a stock and has been finding some value among the FTSE 100. His top 10 holdings, for example, include BP, Shell, Morrison and Centrica.

The fund has also invested in BSkyB, which is in the FTSE 100, as Cobb believes it has strong long-term earnings potential: “The market does not seem convinced by the new management and it has suffered earnings downgrades, but we believe it has great growth potential.” Indeed, Cobb believes large-caps could increasingly become targets of takeover bids, especially as the amount of money raised by venture capitalists increases.

Other fund managers are bullish about the outlook for mid-cap stocks. Nick Roe-Ely, manager of the Tilney American Growth fund, has a bias towards mid-caps in his fund, which is a result of his view that over the long term they offer the best potential to investors. Of course, the scale of mid-caps in America dwarfs the UK. There are about 1,400 mid caps in the US, each with a capitalisation of between $1bn (£520m) and $10bn (£5.22bn). In contrast, there are 300 firms with a capitalisation of more than $10bn.

“It is difficult to add value by investing in large-caps,” says Roe-Ely. “The majority of analysts and fund managers focus on the largest 200 to 250 companies. Each of these companies has an average of 40 to 45 analysts covering them. In contrast, small and mid-caps have almost no coverage. The advantage of investing in mid-caps is that they are more liquid and less volatile than the smaller companies. Yet mid-caps have the dynamism of small-caps.”

Roe-Ely also points to the outperformance of mid-caps between January 1926 and December 2004. Over this period, says Roe-Ely, the S&P 400 Mid Cap index returned 6,743.15% compared with 5,187.25% by the Russell 2000 index (small-caps) and 1,615.20% by the S&P 500 Composite (large-caps).

“The S&P 500 has an average growth in earnings of 6%,” says Roe-Ely. “But the average growth rate in our fund is 22% a year. While the average growth rate in earnings is more than three times higher for our fund than the S&P 500, the price/earnings ratio is just under 21x for our portfolio against 17x for the index. In effect, therefore, we are buying growth at a discount.”

He adds: “The US economy is increasingly dominated by medium-sized companies. They have a lower inherent risk than small-caps as they have passed the critical early stage of their business life cycles. Their business models and financial strength are also easier to analyse. The mid-caps are generally less burdened by defined benefit pension plans and healthcare benefit payments. Finally, mid-caps are potential acquisition targets.”

Given his long-term focus, Roe-Ely says he likes to invest in mid-caps that have a dominant position in their market so they can sustain their growth in earnings: “We like companies with relatively distinctive products or services, self-funding balance sheets with abundant cashflow and higher-than-average revenue, earnings, dividend growth rates, returns on sales and returns on equity.

“We also favour stocks that are under-researched by brokerage houses and which therefore have the potential to deliver earnings surprises, and those companies not burdened by large costs for pension plans and healthcare benefits.”

According to Roe-Ely, the fund can retain companies even after they are promoted to the large-cap index. An example is Harley-Davidson, which comprises 3.38% of the Tilney American Growth fund.

Even though mid-caps are now at a valuation premium to large-caps, Jeremy Wells, manager of the JP Morgan Fleming Mid Cap investment trust, is confident the momentum behind this part of the market can continue. “We believe mid-cap growth will remain strong throughout 2005 and 2006. This year, mid-cap growth is expected to run at about 12% compared with 8% for large-caps. The result of this is that, by 2006, mid and large-caps will trade on the same valuation.

“The mid-cap market enjoys a number of advantages over large-caps. Exposure to a declining US dollar is much less pronounced in mid-caps than among the multinationals of the FTSE 100 index, while the very size of mid-cap stocks means that venture capitalists consider this sector big enough to be meaningful but small enough to be digestible.”

The strong outperformance of mid-caps over the FTSE 100 might lead investors to be cautious about their future prospects. Even if M&A activity sustains positive returns, it could be argued that the risk is on the downside for mid-caps compared with the FTSE 100. With leading managers such as Bolton, Stuart and Hall increasing their weightings to large-caps, investors might be inclined to follow.

View of fund strategists
Mike Lenhoff, chief strategist and head of research of Brewin Dolphin Securities, says a major determinant of the future performance of mid-caps will be the movement in interest rates. If interest rates remain at their current level or are reduced, Lenhoff believes the mid-cap momentum could continue. But if interest rates rise, mid-caps are likely to underperform large-caps. Lenhoff attributes this to the greater exposure of mid-caps to cyclical stocks.

“The FTSE SmallCap and the FTSE 100 indices have relatively less exposure to cyclicals than the FSTE 250. Both indices have relatively more exposure than the FTSE 250 to various defensive and growth sectors, which have been underperforming cyclicals for the past two years,” he says.

“Over the past year, eight of the top 10 performing sectors are cyclical and the FTSE 250 has more exposure to each of these than the FTSE SmallCap index. The FTSE SmallCap has a higher weighting than the FTSE 250 to seven of what have been the 10 worst-performing sectors over the past year.”

But while small-caps and large-caps have trailed mid-caps, this could change, says Lenhoff: “Being under-exposed to cyclicals should prove advantageous when interest rates resume their upward trend. That is when cyclicals are likely to underperform, particularly the consumer-related cyclicals.

“A resumption of the upward trend in interest rates could bring a marked change for the better in the fortunes of technology and defensive growth sectors, and that would be good for small-caps. But it might be even better for large-caps. While the FTSE SmallCap index is light in cyclicals, it is not as light as the FTSE 100, nor is it as heavily weighted in defensive growth sectors as the FTSE.

“While small-caps may outperform mid-caps once interest rates start rising again, there is a case for thinking the large-caps could outperform the lot. There is also a valuation argument in their favour.”

Tim Price, senior investment strategist at Ansbacher, says that value stocks are looking expensive while growth companies look more attractively priced: “One of the big issues in the markets now is the fact that value has outperformed growth for several years, arguably to the point at which value now trades like growth and with something akin to growth valuations. Value, in other words, looks a bit toppy. Growth stocks, by the same rationale, now seem altogether more fairly priced.

“The FTSE 100 now yields around 3.6%, which I still find attractive, while the FTSE 250 yields about 2.9%, which I do not find so attractive. I think you could fairly approximate the FTSE 250 with growth, given the lower yields available and the fact that some of these companies will undoubtedly grow larger, whereas the FTSE components essentially have everything to lose and obviously cannot grow to the sky.

“Investors, therefore, need to be flexible and pragmatic. We remain biased to defensive characteristics and yield but are happy to consider opportunistic plays in sectors like oil and resources. Several years of frothy monetary conditions have blurred the distinction between a wide variety of asset types, such as growth and value stocks, and this means the trick will be to retain disciplined risk control by immediately cutting stock holdings when they start to disappoint significantly.

View of fund strategists
Mick Gilligan, director of fund research at Killik & Co, says that it started moving its exposure from mid-cap funds to multi-asset funds six to nine months ago: “After the outperformance of the mid-caps over the large-caps, we wanted to put money with managers who had more flexibility over where they could find investment opportunities.

“Mid-caps have continued to do well but we have benefited from investing with Neil Pegrum at Cazenove and Nigel Thomas at Framlington. We felt it was better to leave it to the discretion of such managers to move across the cap sizes to find value. Two of the funds we own, Mark Lyttleton’s Merrill Lynch UK Dynamic and Thomas’s Framlington UK Select Opportunities, have increased their exposure to large-caps, as this is where they are finding opportunities.”

Tim Cockerill, head of research at Rowan & Co Capital Management, says large-caps need a couple of catalysts to outperform: “Large-caps need the dollar to turn upwards, as around 45% of profits from FTSE 100 stocks are dollar-related. If the value of the dollar rises then the profits of FTSE 100 companies could increase significantly.”

Some commentators argue that part of the reason why large-caps have under-performed is because pension funds and life companies have been net sellers of equities. A sizeable proportion of their equity holdings have been large-caps and therefore their selling has particularly affected the FTSE 100. This process may need to stop for large-caps to outperform, says Cockerill.

He adds that Rowan & Co does not usually invest in large-cap funds and prefers managers who have flexibility to invest in any part of the market. Cockerill argues that it is hard for large-cap managers to add value: “It is hard for them because of the sheer size of some of the stocks in the FTSE. The 10 largest stocks comprise more than 50% of the index. BP is around 10%, HSBC 9%, Vodafone 8% and GlaxoSmithKline 6%. When Shell combines its UK and Dutch listings, it will be 8.6%. It is hard for managers to take overweight positions in these stocks.”

Craig Heron, co-manager of the New Star Asset Management funds of funds, says that because of the relative amount of research conducted into different parts of the market, there is a strong case for arguing that managers can add greater value among small and mid-caps than large-caps.

Heron adds that it is difficult for multi-managers to gain a neutral weighting to the FTSE 100 or All-Share: “The problem is that the largest stocks in the FTSE 100 comprise such a large part of the index. Most managers, therefore, are overweight small and mid- cap stocks.”