When it comes to the stock market, the old adage “size matters” is very apposite. While there are more than 3,000 companies listed on the London Stock Exchange, it is only a tiny handful of “megacap” stocks that really move the market. The 10 biggest companies, for instance, account for some 40 per cent of the FTSE All-Share index.
But there is another reason why private investors should give these super-sized companies another look. While mid-cap companies are being courted by big institutional investors and private equity buyers, driving up their share prices, the biggest companies appear unloved by many fund managers, meaning there could be some real bargains to be had.
There is no hard and fast definition of a megacap, but in the UK it refers to a group of about a dozen companies at the top of the FTSE 100 index when ranked by their market capitalisation. This cluster of titans is dominated by banks, oil groups and pharmaceutical companies.
Two key valuation measures for companies are the price/earnings ratio and the dividend yield (see box). On both these measures, some megacap stocks like HSBC, Royal Dutch Shell or BP look cheap. The average p/e ratio for the biggest 10 companies in the FTSE 100 is 11.6, which is almost half the average of 20.4 for the other 90 companies in the index. The top 10’s high dividend yield also makes them look cheap – their average yield is 3.8 per cent, compared with 2.4 per cent for the other 90.
These higher dividend yields mean these stocks compare favourably with other income-generating assets such as government bonds and savings accounts. HSBC has a particularly juicy yield of 4.6 per cent [check against table]. This is not far off the 5.6 per cent rate offered today by the most competitive savings accounts and compares well with yields on 10 year government bonds (gilts) of around 5 per cent.
“This is the cheapest I’ve seen these stocks in the past decade,” says Martin Walker, who manages three UK equity funds for Invesco Perpetual. “P/e ratios are at a 20-year low relative to the rest of the market. All the value that makes the market cheap is in megacaps.”
Simon Gergel, manager of the Merchants Trust investment trust, points out that only 17 stocks in the FTSE 100 yield more than 4 per cent – and seven of them are in the top 10. He adds that although megacaps often have cyclical earnings, megacaps in certain sectors such as telecoms and pharmaceuticals are “defensive” stocks that reduce the risk of a portfolio. This is because their earnings are less vulnerable to economic downturns.
Fans of megacaps are also hoping that their value will rise as a result of share buy-backs, which are a way of distributing surplus cash to shareholders. Some are also hoping that the recent process of “de-equitisation”, which has seen money flow out of stock markets into other areas such as private equity, will reverse, bringing money back into the megacaps and pumping up share prices.
Walker adds that megacaps have a smaller proportion of debt on their balance sheets compared to other companies. This, combined with stable earnings streams and diversification across different regions of the world, makes them less risky than other stocks.
“There’s definitely an argument that megacaps should have taken on more debt than they have,” says Gergel. “They have inefficient balance sheets.”
This means that although their lack of debt makes them less risky because it reduces the likelihood of their going bankrupt, investors suffer from the flip side of low risk – namely, low returns. Gergel says share buy-backs are one way around this problem. “A lot are doing buy-backs, but not fast enough,” he says.
However, there are valid reasons why megacaps are cheap. The most obvious is the absence of takeover speculation. When a private equity firm or rival company buys a takeover target, it typically pays an additional premium typically about one-third of the target’s price before the takeover bid was launched. Takeover activity is frenzied at present, fuelled by huge amounts of money that investors are giving to private equity groups to invest.
Private equity groups are pursuing ever larger targets, pushes up share prices. But although a private equity consortium is buying Texan power company TXU for a record $45bn, analysts reckon the 10 biggest UK companies are still beyond private equity’s reach, and most of them are also too big for rival companies to swallow.
The defenders of megacaps argue that this makes them sounder investments, since their price is based on solid performance rather than takeover speculation. “If the high tide of private equity goes out, you need to be comfortable with valuations,” says Mr Walker.
But sceptics point to other reasons why megacaps deserve to be cheap. “I think they are more likely [than smaller companies] to underperform the index,” says Mark Lyttleton, a fund manager at BlackRock. “They deserve a lower valuation than the rest of the market because their earnings are more cyclical”. This is because they are in sectors such as banking, mining and oil where profits tend to swing up and down. Meanwhile, he says that megacaps in more stable sectors, such as pharmaceuticals and telecoms, face other problems such as pressure from competitors and tougher regulation.
If you still like the idea of megacaps, there are three main ways you can access them. The first is simply to buy their shares directly via a stockbroker or self invested personal pension (Sipp).
Buying and selling these shares is easy as the huge size of these companies means their shares are highly liquid. If you do not fancy picking individual stocks, you could simply buy the biggest 10 or 15 companies in the FTSE 100.
Alternatively, you could buy a fund that tracks the FTSE 100 index. Megacaps make up about half of the index, but the other half comprises shares that have lower yields, higher p/e ratios, and prices that often reflect takeover speculation.
Finally, you can put your money in a fund that has the bulk of its assets in megacaps. Income funds often fall into this category, since they buy stocks with high dividend yields. Or you can pick a fund manager who is keen on megacaps at present, such as Martin Walker at Invesco Perpetual, who runs a Children’s Fund, UK Focus Fund, and UK Opportunities Fund.
The M&G Recovery Fund is heavily invested in megacaps at present, but manager Tom Dobell says the fund has no inherent large-cap bias – it is simply a reflection of where he sees the best value at present. Three of the UK funds favoured by financial adviser Bestinvest have a strong tilt towards large companies – Rensburg UK Blue Chip Growth, Gartmore UK Focus, and Artemis Capital.
