This opportunity – if that’s what it is – has arisen since March. It may have passed some investors by. On the face of it, this has been a fairly unexciting year for stocks: the average UK-listed stock is broadly flat year to date. But that masks a big so-called ‘rotation’ from smaller to bigger companies. As I pointed out a fortnight ago, since March the mid-cap index has underperformed the FTSE 100 by about 5 percentage points, led by the house builders and other housing-related stocks.
Why? One reason, clearly, is valuation. At the end of February, the valuation premium of mid-caps over large-caps was larger than it had been for at least a decade – note the chart below – and probably much longer. Active fund managers, who typically favour mid-caps, received substantial inflows in 2013. They may have used these to buy their favourite UK recovery stocks, generating so-called momentum. But eventually they could no longer justify the earnings multiples, prompting a buyers’ strike.
Another catalyst for the sell-off has been the prospect of rising interest rates, which has drawn closer as data have confirmed the health of Britain’s economic recovery. Loose monetary policy has been widely credited with driving up asset prices since early 2009, so it seems intuitive that tightening monetary policy will now weigh on markets.
Investors might favour blue-chip stocks as UK interest rates rise for two reasons. First, large companies are traditionally seen as safe havens, offering protection in stormy times. Second, they have less exposure to Britain than mid-caps, on average. If British consumers start having to spend more of their income on mortgage payments, they will have less to spend on clothes, food and drink, or new homes – goods typically sold by mid-cap companies.
Finally, the mergers and acquisitions (M&A) boom has not played out as expected. Mid-caps are often cited as takeover targets, but this year any mid-cap M&A activity has been overshadowed by blue-chip deals, or failed deals – notably Pfizer’s bid approach for AstraZeneca (AZN). Paul Niven, lead manager of the Foreign & Colonial investment trust (FRCL), reckons the April spike in Astra’s share price prompted fund managers – who are usually judged against the All-Share benchmark, of which Astra accounts for nearly 3 per cent – to reappraise their mid-cap bias.
So what now? The valuation case is now more balanced: mid-caps are no longer obviously expensive relative to large-caps. And earnings are more likely to come under pressure in the FTSE 100 than in the FTSE 250, which would make mid-cap stocks look cheaper still. That’s partly because emerging-market growth, which is key to blue-chip groups like Unilever (ULVR) and SAB Miller (SAB), has been disappointing, and partly because of the strong pound, which analysts have been slow to factor into forecasts. For example, Burberry (BRBY) warned in an update on Thursday that current exchange rates, if maintained, would reduce its profits by £55m compared to last year. Meanwhile, sterling strength plays into the hands of FTSE 250 importers like Dixons (DXNS) or Home Retail (HOME).
Much will depend how the market reacts to tightening monetary policy. Good news on the UK economy may be bad news for the more UK-focused stocks in the mid-cap index. Investors have had five years to get used to this paradox, but it remains as intractable as ever.
Source: Bloomberg
