Rising interest rates and concerns over economic growth have caused fund managers to start repositioning their money away from riskier smaller companies and back into quality large cap names.
Over 60 per cent of fund managers polled in March’s Citywire AAA fund manager survey said large-company stocks would comprise the best performing market segment over the next 12 months. Only 14 per cent chose small companies, while a similar proportion picked medium-sized firms.
The principal reason for the fund managers’ renewed optimism for large-cap stocks is that they believe they currently offer better value than other areas of the market.
The FTSE 100 index is trading on a price to earnings ratio of 12.6 – noticeably below the current p/e ratio of 14.2 for the FTSE 250 index of medium-sized stocks. In August of last year, the reverse was the case
“Whereas six months ago the p/e ratios for the large and small cap sectors were very different, this gap is now closing and we realise that the increased risk on small caps is no longer justified by higher returns,” says Leigh Harrison, income fund manager at Credit Suisse Asset Management.
Small and medium-sized companies have generally performed much better than FTSE 100 constituents since March 2003. While the FTSE SmallCap Index and the mid-cap index have provided a total return of 88 per cent and 105 per cent respectively since that date, the FTSE 100 index has lagged behind with a total return of only 61 per cent.
Going forward, some fund managers also argue blue chip companies will perform better in an environment of slowing corporate profits growth and a more subdued economy.
“Although economic growth remains quite robust, it has slowed right down from the very fast pace seen last year,” says Richard Prew, Axa’s UK Growth fund manager. “With interest rate rises seeming likely, investors are becoming increasingly nervous about the future path of the economy and corporate earnings.”
He says that the recovery that jerked into life in the days after the start of the Iraq war has since been undercut by the jittery housing market in the UK and the prospects of rises in interest rates.
Large cap funds concentrate most or all of their holdings in heavily researched FTSE 100 companies which means that finding undervalued stock can be difficult. But managers have taken the stockmarket’s subdued performance as a buying opportunity.
“I have switched from more economically sensitive smaller companies to a focus on defensive positions in larger cap stocks,” says Credit Suisse’s Harrison. “There’s more value in large caps over the last few months. Small and mid cap companies are exposed to the economic activity in the UK and with growth now slowing we have positioned the portfolio to take advantage of the new investment environment. We currently strongly favour non-cyclical healthcare stocks, due to their steady growth characteristics.”
Other fund managers believe the strong reasons for investing in UK larger companies include the growing UK merger and acquisition activity. Companies on average have been improving balance sheets since the excesses of the dotcom boom and, as borrowing is still relatively cheap, companies could gear up their balance sheets to make acquisitions.
“One reason for this change is global liquidity,” says Richard Moore, head of UK Large Cap at Old Mutual Asset Managers. “Flush with cash from institutional and individual investors, private equity firms have spent a reported $17bn on 124 deals in the UK since 2000. Purchases have included high street staples such as Debenhams and Selfridges. At the same time capital expenditure has remained muted, resulting in growing corporate cashflow and increasing the likelihood of M&A activity.”
Goldman Sachs estimates that M&A rumours currently surround about a quarter of the FTSE 100, accounting for almost a fifth of the index by market capitalisation.
“Clearly it is a flight of fancy to expect all of these to come to fruition, but it only takes one or two large deals to light up the market, particularly when these stocks are supported by attractive leveraged buy-out valuations,” says Moore.
He says that although this is not the first time that the market has been subject to a period of intense bid speculation, potential activity has previously tended to have a greater sector focus. In contrast this time, potential takeover targets are more diversified across sectors.
Moore currently favours oil and gas, which benefits from strength in the underlying crude price: “We also like aerospace which is a late cycle play; insurance where increased savings and pensions are leading to higher levels of business and beverages where other sector constituents are enjoying the spin-off effects of the Allied Domecq acquisition.”
In contrast, he says the less favoured areas include manufacturing, which is subject to a price squeeze; banks which are coming under pressure as consumer debt reaches record levels and retailers which will increasingly feel the impact of the slowdown in consumer spending.
He says the FTSE 100 also benefits from a historically high yield of 3.5 per cent (compared to 2.7 per cent on the FTSE 350 and just 2 per cent on the FTSE 250).
But how much of your portfolio you should have invested in large cap stocks and funds will depend on your risk profile.
Patrick Connolly, certified financial planner with John Scott & Partners, says large cap stocks are relatively low-risk because big companies tend to be financially stable. But he warns that opportunities to spot share price anomalies are relatively rare among big companies because they are thoroughly researched by analysts, meaning that information about their prospects is widely disseminated.