They say the best things come in small packages. That's certainly been true in the UK stock market just lately. The FTSE SmallCap index delivered a total return of 33 per cent in 2013, closely followed by the mid-sized FTSE 250 index, which produced a 32.3 per cent gain. By contrast, the blue-chip FTSE 100 index managed a total return of 'just' 18.7 per cent.
Small- and medium-sized shares have also got the better of their bigger brethren in all but one of the last five years. After such a strong run, it clearly makes sense to ask if they can keep the upper hand in 2014. To answer this, we need to consider the current set-up in light of the history of the last few decades - and also ask the view of one of the country's most successful fund managers of recent times.
The long view
Shares in smaller companies have been a better investment over the very long term, as well as in recent years. A £1,000 investment that tracked the path of the Numis Smaller Companies index in 1955 would have become some £4.7m by the end of 2013, after reinvested dividends. By contrast, an investment in the blue chips of the FT 30 and FTSE 100 over the same period would have become just £0.62m.
Unsurprisingly, perhaps, smaller shares have had many more good individual years than big blue chips. The small- and medium-sized shares of the Numis index - formerly known as the Hoare Govett index - outstripped UK large caps in 46 of the last 58 years overall. So what is behind this vastly superior showing over time?
Returns sliced by size
| % | FTSE 100 | FTSE 250 | FTSE SmallCap |
|---|---|---|---|
| Total return (annual) | 9.7 | 12.6 | 9.4 |
| Volatility | 15.7 | 18.2 | 18.6 |
| Biggest drawdown | -48.5 | -50.1 | -59.0 |
| Years when best index | 39 | 21 | 39 |
Small- and medium-sized shares are riskier than blue chips, at least in absolute terms. As the above table shows, returns on the FTSE 250 and FTSE SmallCap index have been more volatile than those of the FTSE 100. And, small caps suffered a much bigger 'worst hit' during the period, down by more than 10 per cent more during the most serious part of the turmoil.
While small- and medium-sized shares often get lumped together in funds, their fortunes have been actually been rather different. Since 1985, the FTSE SmallCap index has produced a slightly inferior total return even than the FTSE 100 - but while running a lot more risk. It's actually been the FTSE 250 that's brought home the bacon, while incurring less volatility than the SmallCap index.
When it pays to go large
Although small- and medium-sized shares have had the better time of it over time, large caps do have their day in the sun. The prospect of slower economic activity has often boosted the big boys' performance against smaller caps - at least in the last quarter of a century. When the OECD leading indicator of economic activity for the UK has fallen, the FTSE 100 has often beaten the Numis index. At least for now, the OECD indicator is still signalling expansion ahead.
Outlook weakens, blue chips shine
Another key element is valuations. Some of the best moments for owning large caps over smaller caps have come when the dividend yield-gap between the two has been especially wide in favour of the FTSE 100. Specifically, some of the best annual outperformance has come after the FTSE 100's yield was at least 1.4 times as great as that on the Numis index. Just lately, the gap was 1.3 times, which makes large caps somewhat cheap rather than screamingly so.
Not yet at extremes
Simple price momentum is a further factor to watch. Once smaller caps become very stretched compared with larger caps - as captured by the monthly relative strength index - it can be a warning of an impending high. Currently, the reading is at similar levels to those seen before significant periods of large-cap outperformance in the past, although this does not rule out further upside for now.
Getting exposure
Buying into small caps cheaply and efficiently isn't nearly as easy as for large caps. Neither the Numis Smaller Companies index nor the FTSE SmallCap can be bought through a tracker fund. One alternative is to buy into an investment trust. Simon Elliott of Winterflood highlights Henderson Smaller Companies and Strategic Equity Capital as two of the worthiest plays in this area.
As we have seen, though, the best returns have generally been made on medium-sized shares rather than small caps. And FTSE 250 exchange traded funds (ETFs) are easy to come by. On 13 June last year - when that index was just below 14,000 - I said the index was likely to head for above 16,000, which it has since done.
Our tactical timing model (bit.ly/KgwJNg) - which has outperformed the index substantially - remains in 'buy' mode for now, so I will keep respecting the trend, despite my belief this is a 'late-stage' bull market.
Alan Miller warns: don't ignore large caps
The average UK equities fund has just under half its holdings in small- and mid-cap equities. Yet such stocks make up only around 16 per cent of the overall UK stock market. Mid caps blasted higher in 2013, rising by one-third compared with less than 20 per cent for large caps. This effect clearly boosted the performance of the average UK fund, given their skew to small and mid caps.
Of course, what this really means is that many of the best-performing UK funds owe their good showing to the size of the stocks they hold, rather than to the stock-picking expertise of their managers. Four of the 10 top-performing UK funds we've looked at in our research had no big blue-chip shares whatsoever.
Two often-quoted reasons for preferring mid caps and small caps over big blue chips right now are that they are more geared to the relatively buoyant UK economy and that they are less exposed to the troubled mining sector. All that may be true, but investors need also to think about valuations compared with the rate of earnings growth.
Last year, mid-cap earnings grew by 7 cent per cent more than blue-chip earnings, but the mid-cap FTSE 250 went up by 14 per cent more than the large-cap FTSE 100. The difference was exaggerated by the extreme underperformance of oil, gas and commodity sectors, which make up one-quarter of the FTSE 100 but less than one-tenth of the FTSE 250. Also, the strength of sterling dragged on blue-chip earnings, given that four-fifths of the typical FTSE 100 company's sales come from abroad.
My view is that sterling will gradually weaken from where it is now, especially against the critically important US dollar. Based on Purchasing Power Parity - a rough economic rule of thumb for determining the 'fair value' of a currency - the US dollar is currently 13 per cent undervalued against sterling.
What's more, the mid-caps' edge in terms of earnings growth may be fading. Analysts' bottom-up forecasts put the average earnings growth rate over the next two years at 12.3 per cent annually, which is only 2 per cent ahead of what the blue chips are forecast to achieve. For the privilege of this slightly superior earnings growth, investors are being asked to pay a premium of one-quarter, based on earnings multiples. I reckon that's demanding.
Bear in mind also that turbo-charged outperformance by the FTSE 250 isn't a constant phenomenon. In the 1990s, UK large caps actually beat mid caps by almost 2 per cent a year. And even during the 2000s, the FTSE 250's average outperformance was 6 per cent a year, which is much less than last year's runaway gains.
Today's mid-cap euphoria might just be another case of fund managers arriving at the party too late. It may well be time to look at the blue chips again instead.
Alan Miller is co-founder of SCM Private (www.scmprivate.com), a modern specialist ETF investment manager. He was previously one of the City's most consistent top-performing fund managers.
