Will mid-caps continue to outperform the FTSE 100? They have done so hugely for almost three decades. Since January 1990 the FTSE 250 has outperformed the 100 by an average of 2.5 percentage points per year in total return terms. That means you would have made twice as much from mid caps during this period as you would if you had stayed in the FTSE 100.
What’s more, this outperformance has been astonishingly consistent. Except for the late 1990s, 2008-09 and a few small blips, the 250 has steadily beaten the 100 since the mid-1990s.
This fact implies something intriguing. If mid-caps outperform so consistently, then this outperformance must be quite immune to changes in economic conditions.
For one thing, valuations are not hugely important. If we take the three-year change in the FTSE 100 relative to the 250 the correlation with the difference in dividend yields on the two indices three years previously is only 0.28. This suggests that while the 100 should do relatively well after it has been relatively cheap, the tendency is not a very powerful one. Low yields on mid-caps relative to the 100 are often a sign of superior growth prospects rather than of overvaluation.
Also, mid-caps' relative performance isn’t as sensitive to other things as you might imagine. For example, you might think that mid caps would suffer relative to the FTSE 100 when sterling falls. After all, the FTSE 100 is dominated by global companies that should see the sterling value of their overseas earnings rise when the pound falls. In fact, though, the correlation between annual changes in the two indices and changes in the dollar/sterling rate since 1990 has been only minus 0.1. That’s weak.
There might be a good reason for this consistent outperformance. It’s that big funds have a bias towards big stocks. One reason for this is that it is only these that are liquid enough to allow them to take reasonably big positions. If a £2bn fund wants to hold 50 stocks, its average position is £40m. It’s hard to get such a holding in smaller stocks; it is over 3 per cent of the median FTSE 250 stock’s market cap. Another reason is that if a big fund wants a big dividend payer then it is limited to a few stocks: HSBC, Royal Dutch Shell, BAT and so on. Larger equity income funds thus have a bias towards FTSE 100 stocks. This bias towards the FTSE 100 causes it to be overpriced relative to mid-caps – hence its steady underperformance. (There’s an analogy here with the reason for the historic underperformance of high-beta stocks: investors who cannot borrow use these as a geared play on the market rising, which causes them to consistently over-own such shares with the result that they are usually overpriced.)
All this poses the question: under what circumstances might we see a reversal of mid-caps long outperformance?
One would be a severe financial crisis. It’s no accident that the FTSE 100 outperformed during the 2008-09 crisis even though it contained some hard-hit banks. In times of acute stress, investors prefer familiar stocks, and this favours mega-caps over mid-caps.
This point, however, cuts the other way. It gives us a reason to expect mid-caps to outperform in normal times, simply as a reward for taking on the risk of them doing really badly in a crisis.
There is, though, something else. It might be no accident that the long and consistent outperformance of mid-caps has come at the same time as another long, consistent trend – for gilt yields to fall.
In fact, the negative correlation between the 100/250 ratio and 10-year gilt yields isn’t evident only in the trend. It’s also statistically significant if we take annual changes in the two.
There’s a good reason for this. When gilt yields fall the present value of future cash flows increases: this is basic maths. This raises the price of growth stocks relative to others because they (by definition) offer more future cash flows. Because the 250 has traditionally been biased towards growth stocks – which we know because its dividend yield has generally been lower – it therefore outperforms when gilt yields fall.
Which raises an obvious danger. If or when the long-term downtrend in gilt yields stops, so too might the outperformance by mid-caps.
There’s another danger. To see it, recall the fate of small stocks in the 1980s and 1990s. In the mid-1980s investors noticed that these had out-performed large ones for decades. So they piled into them: many small-cap funds were launched for this purpose. That drove their prices up even further – so much so that they became so overpriced that they underperformed big stocks for most of the 1990s.
This episode warns us that investors do sometimes wise up to successful strategies and in doing so cause prices to move so much that the strategy stops working.
It’s hard to say for sure that this is about to happen to mid caps. But if we add to this danger the fact that mid-caps are sensitive to gilt yields, and do tend to outperform in really horrible times, then we have reasons not to bet everything on them. We should not write off big stocks completely.
