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Singing the blues

Chris Salih examines some of the factors that are helping mid-caps to consistently outperform the FTSE 100.

The bull market of recent years has favoured mid-caps and the performance cap with large caps shows no sign of closing, with the FTSE100 returning 14.43 per cent in 2006 compared with 30.21 per cent from the FTSE 250. The FTSE All Share returned 16.75 per cent.

T Bailey fund manager Jason Britton believes there are three major issues still holding large caps. He says: “The first problem facing the FTSE100 is that the falling dollar rate is still having a huge impact, with between 50 to 60 of those dollarbased companies suffering from the lowering valuation. This is something that the FTSE 250 does not have to deal with as it is a largely UK-centric index”There is also the ongoing issue that large caps are dominated by four main areas, namely, banks, oils, pharmaceuticals and telecommunications. All these are still under pressure in some shape or form, whether it is growth or cost issues, resulting in a malaise over all four markets.”

Britton also believes there are diseconomies of scale. He says: “As some of these companies get bigger, they begin to become less efficient as they spend lots of their time tackling bureaucracy, management issues, politics and general firefighting, all of which means the core business focus begins to become clouded.”

BestInvest head of communications Justin Modray says a problem facing large-cap managers is that they have a smaller universe to choose from than mid-cap managers. He says: “If a manager misses a trend in the FTSE 250, he can still outperform the market and his benchmark. However, investing in blue-chip companies is much harder as they are all well known and a lack of numbers makes it almost impossible to diversify.”

However, he disagrees with Britton that the “big four” sectors have held the FTSE 100 back. “Pharmaceuticals is the only sector that has really struggled. Banks have been good, oil and gas have been excellent until recently and telecoms have been average,” he says.

Achieving diversity in a FTSE100 fund is a major issue considering that the top five sectors – banks, oil & gas, pharmaceuticals, telecoms and mining – comprise 61 per cent of the index.

Rensburg UK mid-cap growth trust manager Paul Spencer believes that one of the biggest benefits that mid-caps offer over the FTSE100 is their lack of correlation to one another.

He says: “If you look at the sector weightings in the FTSE 250. The big five there are support services, travel and leisure, general financials, real estate and household goods. Together, they form 51 per cent of the index and they only form 7.9 per cent of the FTSE100.”

Spencer believes the main problem lies in the top 10 or 20 stocks in the FTSE 100 rather than the index as a whole. He says: “Some of these companies are so big that adopting a defensive option is the only way to ensure they perform to any standard whatsoever. If you look at P/E multiples for the FTSE80 and the FTSE 250 in 2006, they are fairly similar at 16.3 and 16.7 respectively. Compare that with the FTSE 20 where it is just 11.4.”

He says the theory that the mid-cap market is cyclical and performance is likely to tail off is nonsense because the turnover in constituent companies gives managers new opportunities and trends to work from.

He says: “If you look at the last 12 months, there were 96 changes to the mid-250 as companies were either promoted or demoted. For example, there have been some 16 takeovers that have resulted in companies being promoted to large-cap status. So it is a completely different market for managers to outperform in.

“There are just so many areas where the FTSE 250 is attractive, whether it is corporate activity, the evolving index, greater diversity, higher growth rates, more rating anomalies or the fact that business models are still less mature in their corporate development.”

New Star UK alpha fund manager Tim Steer believes there are a number of market trends that can benefit investors. He says: “More than half of my success was a direct result of high corporate activity, with the European buyout market particularly high and many of those companies being easier to buy in the FTSE 250 than the FTSE 100. Add to that record new private equity funding and strong competition among financial buyers reacting to high prices and the market does look good.

“Real estate has also been improving, thanks to an increase in overseas investors and the introduction of Reits into the market, while construction and materials continue to look strong.”

Steer believes increased aerospace and defence needs will also be a benefit to mid-cap managers. He says: “It is a trend that has been on the up since 2001 as we have seen 6 per cent growth in the US defence budget. They are happy to buy in the UK as many companies are linked to the US weapons programme. The US has increased its supplementary budget from $80bn in 2003 to $120bn for 2007.”


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