Mega-caps for moody markets

HSBC defines mega-caps as the very largest stocks measured by market capitalisation in developed market indices. "These companies are typically household names and bellwether stocks within their respective industries," says Dean Turner, investment strategist at HSBC Private Bank.

Although the bank does not put a figure on what qualifies as mega-cap, it says that the top 10 shares in the UK's FTSE 100 fall into this category, as would the top few in each developed market.

Largest FTSE 100 companies

Source: HSBC Private Bank/Bloomberg as at 23 August 2012. *'A' and 'B' share classes combined.

HSBC recommends that you should have a portfolio of at least 20 mega-caps as some experience wider volatility than the wider market, hence the need for an international outlook. UK, Europe and the US are HSBC's preferred regions because the aim is lower volatility and greater safety than the wider market. Emerging markets mega-caps can be volatile while the bank has concerns about Japan.

"Mega-cap stocks typically perform well in periods of elevated uncertainty as investors tend to perceive them to be lower-risk investments," says Mr Turner. "Indeed, given their size, mega caps tend to be able to withstand periods of economic weakness. On the whole, therefore, they tend to have earnings that are less volatile than the wider market and are usually lower-beta investments."

Mega-caps have outperformed recently and Mr Turner believes they could continue to do this.

"Mega-caps have historically enjoyed higher net profit margins than other segments of the market; moreover, the current levels are appreciably above long-term averages," he says. "Mega-cap companies tend to enjoy diversification across products and geographies and therefore should be able to capitalise on their brand positions to maintain an adequate level of sales by focusing on growing markets. In addition to this, given the weakness of labour markets and low inflation globally, these companies should be able to continue to successfully manage their costs. Finally, with monetary policy likely to stay at emergency levels for some time, the quest for yield is compressing yields on high-quality corporate debt to record lows. Thus, many mega caps have seen their borrowing costs fall to historically low levels. All of these factors suggest that the margins outlook for mega caps may continue to be better for that sector relative to the rest of the market. Companies that can maintain decent profitability are likely to be rewarded by investors in periods of sub-par growth."

The dividend yield on the 50 largest US companies is approximately 10 per cent higher than the wider market and Mr Turner thinks companies able to pay and grow their dividends should continue to be in demand. Their valuations are also attractive, compared with the market as a whole. "Moreover, the healthy cash position that most mega caps enjoy suggests that dividends and share buy-back programs should be sustainable, potentially bolstering total shareholder returns," he adds.

But size doesn't always matter

However, many large caps also have these attributes, although the very largest companies tend to be the most liquid. HSBC says the 50 largest US shares have started to outperform the wider market and that should continue for some time. Its analysis suggests that the majority of mega-cap stocks have done an impressive job of generating and retaining free cash flow since the financial crisis first hit. The ability of mega caps to continue to generate decent levels of free cash flow is unlikely to be diminished in the near term, which suggests access to liquidity for day-to-day operations should remain adequate.

But Rob Burgeman, divisional director in private client investment management at Brewin Dolphin, says: "There is not much difference once you get above a certain size, as large companies share a lot of characteristics. Both large and mega caps have the ability to survive - for example, not many companies could pay out what BP did following its spill in the Gulf of Mexico. Size is one key thing to look out for when seeking a company for these conditions. But in different economic environments the right company in the right industry can deliver growth."

Simon Brazier, manager of Threadneedle UK Fund, does not just look at large caps, when assessing business risk . "Some of the largest companies by default in the UK market are defensives - for example, tobacco, utilities and telecoms. But I am not concerned if I sell some FTSE 100 shares to buy FTSE 250 ones and I've been structurally underweight the FTSE 100 in my fund because I think you can find good companies elsewhere as well."

Colin McLean, managing director of SVM Asset Management, says a lot of large-cap European-listed global businesses, including some mega caps, are still attractive and offer value. "The trend to re-rate credit quality is only part way through, and large-cap European defensives still offer value: tobacco, some pharmaceuticals, food and consumer staples. Our portfolios include stocks in these sectors such as British American Tobacco, AB Foods, Kerry Group, Swedish Match and Roche."

But he adds: "Some UK consumer businesses will be survivors, such as Whitbread and (FTSE 250 listed) Debenhams."

Aviva Investors' head of equities, David Lis, expects high-quality franchises to be positively re-rated, so companies that are able to grow revenues and cash flow in subdued economic conditions will be highly prized. His holdings in this category include FTSE 250 cash-and-carry wholesaler Booker, and FTSE 100 large-cap support services company Compass.

Equity income

Larger companies tend to be able to distribute income even when markets are not doing too well, so their total returns hold up better. Many companies have weathered the financial crisis well and protected their businesses by cutting costs, strengthening their balance sheets and improving their cash flow, enabling them to sustain and grow dividends. "Companies that pay dividends in the UK, for example, tend to be less sensitive to the economic conditions as they are more defensive in nature, covering sectors such as utilities and healthcare where there is good cash flow and constant demand, thus the dividends are more reliable," says Jason Hollands, managing director at investment adviser Bestinvest. "Equity income over the past few years has produced superior returns for less risk."

But attractive yields can be found across the market - and in the UK are twice covered by company cash flows, which is above the historical average of 1.8 times, although overall FTSE 100 stocks are higher yielding than mid- or small-caps at 4.1, 3.6 and 2.9 per cent, respectively.

"In part this is because very large businesses are more mature, with established cash flows and earnings that are generally geographically diversified," continues Mr Hollands. "It also reflects the make-up of the indices. Approximately 18.6 per cent of the FTSE 100 is represented by oil and gas, where average yields are around 4.2 per cent. Utilities account for 4.2 per cent of the FTSE 100 - historically one of the highest yielding sectors, where yields are currently a thumping 5.4 per cent."

Even if you are focused on growth, dividend reinvestment can significantly boost your returns. "Over the long-term, dividends have made up a significant proportion of the overall return on equities," explains Mr Hollands. "Markets have been volatile over the last 12 years with the stock market struggling to make new highs. £100 invested in the FTSE 100 index would have sunk to £89.97 since 1 January 2000, while with dividends reinvested the value would have risen to £138.29."

But paying out income is not always a prerequisite for a good company. "Historically, dividends have been less of a feature in the US market than the UK and the average yield on the S&P 500 is only around 2.2 per cent," says Mr Hollands. "Leading companies such as Apple only started paying dividends again recently for the first time in 17 years, with a yield of less than 2 per cent."

This is the case with a number of large US technology companies which largely remain in good shape. "Technology and tech-enabled sectors of the S&P 500 have grown three times as fast as US GDP over the three years ended 31 December 2011 (6 per cent versus 2 per cent) and are projected to continue expanding more rapidly than global GDP for the foreseeable future," says William Paternotte, senior client adviser at investment manager Brown Advisory. "No matter what the environment, there are always a few management teams (within the tech sector) that demonstrate a unique ability to create new products or services to gain competitive advantage and drive revenues and earnings at a superior rate."

UK mega-cap Diageo only yields around 2.42 per cent but has enjoyed good share price growth over the past few years, adds Mr Burgeman.

And Mr Brazier likes to look at cash flow to equity, a measure of the dividends that could be paid to shareholders, rather than what is actually paid out. "Experian and Pearson reinvest," he says. "This means Pearson has the largest online education platform while Experian has set up Indian and Australian credit businesses. I am happy if companies reinvest appropriately, but you need to watch for ones that spend their cash poorly."

Downsides

Mega and large caps tend to grow less than smaller companies in better market and economic conditions, and will get left behind in an upswing (read more on smaller companies). Their ability to grow can be restricted and it can take some time for a very large company to change direction.

If an individual company is in an industry in long-term decline it will not necessarily hold up. Banks, for example, are among the largest companies but have experienced severe problems since the financial crisis, while unexpected events can beset a company such as BP, even if they are in a stronger position to deal with it.

Large companies also suffer when investor appetite for risk falls, although probably experience less downside than smaller companies.

"At a global level there is a preponderance of technology, financials, and oil and gas businesses at the top end of the market cap spectrum, so negative unforeseen events for these sectors could proportionately move the dial," says Mr Hollands. "Mega-cap stocks are more exposed to levers such as movements in the US dollar and the oil price than smaller more domestically focused businesses."

Not all large companies are defensive because there are also cyclicals at this end of the market, while these are vulnerable to global economic trends which at present are cautious.

Read more on Funds For Uncertain Times