Panellists challenge ‘go large’ view

With a gloomy outlook forecast for developed-world companies that focus on domestic markets, many investors say the FTSE 100 firms have the best scope for growth. But not all IFAs agree.

Slowly the reality of the outlook for developed economies is sinking in. Last week data from America showing that the annual growth of real consumer spending slowed to about 1.5% in June backed up earlier findings in the Institute for Supply Management survey suggesting softening GDP growth.

Markets, however, remained relatively unmoved, giving rise to confusion in economic circles over why investors appeared not to be taking the threat of weakening G7 economies seriously.

Despite the shock of economists, investors had some sound reasons to remain positive last week. The poor news from America was counteracted by positive bank results that showed Lloyds swung sharply into a pre-tax profit in the first half of 2010, HSBC profits doubled to $11 billion (£7 billion) and Standard Chartered increased pre-tax earnings by 10%. (article continues below)

“The one word I would use for markets at the moment is volatile,” says Darius McDermott, the managing director of Chelsea Financial Services and an Adviser Fund Index (AFI) panellist. “The American figures have been poor but UK bank results were positive, so it’s a mixed picture.”

Where the picture is less mixed is over the types of companies being picked to outper- form, and for developed-­market companies focused on domestic demand at a time of below-trend economic growth, fiscal retrenchment and rising unemployment, the outlook is fairly grim.

The buzzwords of the moment, therefore, are “overseas earnings”, which in truth is a proxy for companies with a presence in rapidly expanding emerging economies.

Many investors argue that the large multinationals in the FTSE 100 index will be best positioned to exploit growth areas around the globe, investing in them on a large scale to maximise profits.

But not all AFI panellists are convinced.

The main driver of mid-cap growth, however, has been the pick-up in merger and acquisition activity that has begun to reignite hopes of major buyouts. With fiscal tightening curtailing economic growth prospects and credit conditions looking like remaining tight, much of this could prove wishful thinking.

Despite the uncertainty, there are still positive indicators. One gauge is the average price/earnings (P/E) ratio of mid-cap companies. On Aug­ust 6, 2007, companies in the FTSE 250 index had an average P/E ratio of 17.4, compared with a FTSE 100 average of 11.57, according to FTSE Group. Despite the weaker outlook, the average FTSE 100 company was trading on 14.49 as at August 4 while the FTSE 250 was on 16.09.

While this largely reflects destruction of earnings rather than price increases over the period, it suggests that the cost of opportunity for investing in mid-cap companies is more compelling that it was before the worst of the crisis.

“The large-caps are dominated by mining, oil and gas and banking, so you have to ask: where are you going to go for growth?” says Davies.

“It comes down to the ­age-old risk/return trade-off. You should expect mid caps to outperform large caps over the long term.”