The sector managed to generate strong investment returns at a time when large caps weren’t performing, as well as providing diversification to equity portfolios, and many investors fell in love with the asset class.
However, we are now seeing signs of a turnaround. Described by some as a “large cap renaissance” and by others as the “revenge of large caps”, investors are starting to return to investing in larger stocks, and the trend is set to continue.
According to a recent report by Morgan Stanley Investment Strategies, Europe is enjoying a large cap revival, with more investors moving away from the small and mid cap sectors into large company stocks. Various valuations and fundamental measures make large caps look attractive relative to small and mid caps and therefore, the report recommends that investors should consider taking profits and switch to large stocks.
Widening spreads
Graham Secker, UK equity strategist at Morgan Stanley, gives two main reasons why they should do so: “First, the relative performance of mid caps over the past five years has closely followed corporate bond spreads and when these spreads go tighter, mid caps start to outperform. But corporate bond spreads are widening out, which tells us that investors are rationing down risk expectations and mid caps should come under pressure.”
The second reason for moving into large company stocks can be found in the current slowdown in the economy, which particularly affects this asset class. Mr Secker explains that in the UK, for instance, 20 per cent of the FTSE100 is cyclical – but this figure goes up to 63 per cent in the case of the FTSE Mid 250 index.
“If you plot the Mid 250’s relative performance versus something like the UK Leading Indicator over the past 20 years, there is a quite a close relationship, up until the last year when the Leading Indicator has been falling and mid caps have continued to outperform,” he says.
Mr Secker explains that a lot of what he describes as ‘hot money’ has been going into the mid cap arena over the past few years, but now things have started to change.
“We have seen a lot of hedge funds going into that area and now they are coming out. Over the past month or so, we have seen massive traded volumes in mid caps as some of these hedge funds are trying to get out.”
Both a slowing economy and reduced risk appetite from investors are putting pressure on the current valuation of small and mid caps. “In the UK, mid caps are trading at about a 15 per cent premium to large caps. A lot of investors have been increasing their mid cap exposure over the past three or four years because of the strong performance that we’ve seen in that area. Now they suddenly realise they have too much exposure and are trying desperately to turn it around quickly,” Mr Secker says.
This phenomenon is not confined to the UK but can be seen across different European countries and the US. “Underperformance and valuation discrepancy in the US is not as wide as it is in the UK, but it is still there. It is natural that as economic growth starts to slow down, people will go more for large caps in whatever country you are in.
Fundamentals first
“Basically you should choose to invest in companies based on their fundamentals rather than their size,” Mr Secker adds. “But at the moment, if you are investing in some good quality companies in the mid or small area for liquidity reasons, you may find that, over the course of the next three to six months, their share price comes under pressure.”
For those wishing to move away from the small and mid cap sectors into larger stocks, he explains there are different strategies to follow including the use of futures, total return swaps, certificates and exchange-traded funds.
It is apparent that small and mid caps are not as good value as they were in the past and many commentators are confident that in terms of returns, large caps are going to do better in the near future.
A study by UBS in the US shows that, by examining the relative performance of large caps versus small caps compared with the market and broad economy conditions, small caps perform best when equity markets are surging.
In particular, UBS found that the relative performance of small caps is highest when the S&P500 index is up more than 10 per cent in any given year. Since UBS expects this index to be range-bound for the next 12 months, it believes large cap stocks are likely to outperform small caps this year.
However, returns and valuation aside, small caps still offer an important tool of diversification in investors’ portfolios and opportunities for long-term growth.
Dan Hanbury, an equity fund manager responsible for the Investec Small Cap Fund, believes pension funds that are investing in equities need growth and that the best growth in terms of earnings can be found in small companies. “Long-term performance of smaller companies is very strong and that suggests that any pension fund with a long-term view should consider smaller companies in their asset allocation,” he says.
Hanbury: take the long-term view
Overextended
“We have had a terrific run for the past couple of years, with smaller companies performing really strongly. As we went through that period, I think investors were progressively taking on more and more risk as they grew more confident and, in a way, they got overextended. As a consequence, you are not seeing more risk aversion,” Mr Hanbury comments.
He agrees that large caps will do well for a while, but highlights the importance of taking a long-term view. “If you look at the long-term track records of smaller companies you will see that historically they have done very well,” he says. “The discount in the UK market has probably gone in terms of the valuations but there are probably superior earning rates to be found in the smaller companies area for investors looking for growth opportunities.”
Demand, he says, is coming from both institutional and retail investors. “We are seeing good inflows on the retail side and opportunities to pitch more mandates on the institutional side, which is encouraging. But what I really find encouraging is when I look at surveys from multi-managers and see that most of them are still relatively negative on small caps. Until everyone is bullish about small caps, it’s too early to come out.”
This view is shared by Baring Asset Management, which believes European small companies are still an attractive sector for investors looking for growth. Nick Williams, manager of the Baring Europe Select trust, believes that continued restructuring, balance sheet strengths and sensitivity to economic growth have helped small caps to grow at a faster rate than large caps.
Mr Williams says the under-researched nature of smaller company stocks means that opportunities exist for active investors to find undervalued companies and he reckons there are more than 1500 in Europe to choose from.
“Opportunities exist to find undervalued and under-researched stocks,” he says. “Unlike larger companies, small cap share prices tend to react more readily to their own news flow rather than macro-economic and market-related events.” This, he explains, makes this asset class very useful for portfolio diversification given the dull economic backdrop of the Eurozone.
Baring expects the business services sub-sector to benefit particularly from growing adoption across Europe of outsourcing, public-private partnerships and temporary employment growth.
As investors renew their confidence in the large cap sector, we will continue seeing more interest in increasing exposure to the sector. However, now investors have tasted the potential benefits of investing in small companies, it is unlikely that good performance in large caps will result in a diminution of interest in smaller stocks. The general view among managers is that both large and small caps have a role to play in investment portfolios and should be used depending on investors’ specific needs regarding their individual risk profiles and long-term liabilities.
