The Chinese market crash and the fall in commodity prices have not created an ideal environment for the biggest UK-listed companies to grow, but an increasing confidence in global growth is pushing fund managers to reconsider mega-caps.
Mega caps – companies worth more than $100bn – have underperformed, as evidenced by the fact the FTSE 100 index has lagged the mid-cap FTSE 250 index considerably.
In the past 12 months, the FTSE 100 total return was 2 per cent while the FTSE 250 was just over 17 per cent.
FE fund analyst Thomas McMahon says the poor FTSE 100 return has mainly been driven by the “terrible performance” of oil and gas companies, including Shell, BP, Rio Tinto, BHP Billiton and Glencore.
He says: “These sectors are highly sensitive to the global economy and to demand and supply dynamics from China in particular, and have been reacting in a volatile fashion to poor economic data.
“However, managers who have simply avoided the mining and oil and gas sectors would be up 6 per cent this year, so it has been relatively easy for active managers to outperform even the large cap area of the market.”
But Hermes Sourcecap European Alpha fund co-manager Martin Todd says this has started to change and over the past quarter the FTSE 100 has returned 5.17 per cent against the FTSE 250’s 1.92 per cent. “That made people realise there is some value there,” he says.
In a recent Money Marketing article, Old Mutual Global Investors chief executive Richard Buxton tipped the mega-cap sector to succeed. He said: “There is extraordinary value opening up in UK mega caps. This is both in absolute terms and relative to their smaller and medium-sized brethren.”
Valuation is a big part of the mega-cap story, with the rush to access small and mid-cap growth having driven up valuations in the sector.
Premier Optimum Income fund manager Chris Wright says many mid-cap stocks currently are at 25 to 30-year peak valuations, while mega-caps are providing “huge yields” and, in the quality names, big free cashflows.
JP Morgan Asset Management UK equities fund manager James Illsley says the scale of the “valuation disconnect” between mega-cap and small and mid-cap sectors poses an attractive opportunity for investors.
Thomas Miller Investments head of private investment management Andrew Herberts says if global growth comes through, then mega-caps will come back into fashion “if you can get the valuations right”.
He says: “A lot of managers have got a lot of their performance from the FTSE 250, and it’s the extent to which that bet stops paying off.
“If we see the weight of money move out of small and mid-cap and into mega caps, it becomes self-fulfilling. But I understand the rationale of locking in profits made in small and mid-caps and moving it to an area that has not done as well [in mega-caps].”
Some evidence of this has been seen as in the past few days resource and mining stocks “rebounded somewhat from extreme valuations”, says Illsley.
For example, Illsley says BP now has a yield of nearly 7 per cent and Royal Dutch Shell is yielding 6.63 per cent.
McMahon says if the valuation trend continues it should boost large cap-dominated funds, including many income funds that have bought into these stocks based on their high yields.
Investors are already shifting from small and mid caps to mega-caps. Experts say there is a clear rotation underway, partly in reaction to the valuation opportunity but also on hopes that the worst of the Chinese and emerging market slowdown may be behind us.
In the mega caps space, fund managers are betting on sectors such as banking, pharmaceuticals and telecoms and, despite recent underperformance of commodity-linked companies, some continue to hold positions in mega-caps such as Shell and BP.
Old Mutual UK Equity fund manager Simon Murphy currently favours pharmaceuticals, where the sector is in the middle of a “reappraisal” by investors and is going back into growth mode.
In his fund, Glaxo and Astra Zeneca make 4.1 per cent and 3.7 per cent respectively of the top holdings.
On the other hand, Allianz chief investment officer for UK equities Simon Gergel, who manages the Merchants Trust, also sees opportunities in the UK banking sector as lenders are “rebuilding capital”, including Lloyds which has just started repaying dividends. Lloyds, Glaxo, Royal Dutch Shell and HSBC make 20 per cent of his trust.
Illsley says longer-term winners in the mega-cap space are characterised by positive momentum, attractive valuations and high quality.
He says: “Names like BP will continue to do well as they are keeping costs down materially. We’ve also been positive on retailers such as Next, which have exhibited strong capital discipline, having bought back over 40 per cent of shares.” Illsley says another mega-cap name that stands out is defence company BAE Systems.
Experts say investors will want to be in the names able to perform regardless of China, but some challenges remain.
Gergel says one fear of holding many mega caps in a portfolio is they are “very different” and cover many industries and are at different stages of maturity, meaning they have different performance profiles.
Todd says one of the risks for mega-caps is also governments’ regulatory scrutiny. The largest names are also very well researched, meaning hunting value can be tricky.
“The biggest companies are also those who have the highest levels of analyst coverage, meaning these companies’ share price tend to reflect their value so it is difficult to find that hidden value in these large firms and, as a result, it is difficult to get a hedge on them.”