25/05/2007

Sizing Up The FTSE

The recent sustained out-performance of UK mid-cap over large-cap stocks is likely to narrow as a number of drivers start to exert themselves, according to research published today by leading investment house, Standard Life Investments.

In the latest edition of Global Insight, its monthly investment view, Standard Life Investments examines the drivers behind the recent mid-cap out-performance and whether this is likely to continue.

Richard Batty, Global Investment Strategist at Standard Life Investments, said:

"The outlook for UK larger FTSE100 companies relative to their medium sized FTSE250 counterparts has been hotly debated in recent years. Many of the drivers of large-cap stocks are becoming more prominent at the moment. The key question is whether these are likely to boost FTSE100 relative to FTSE250 stocks over the medium term.

"The high weighting of very large companies within the FTSE100 index – the top 10 make up 42% of the index – has been one reason why the FTSE100 overall growth outlook lags that of the FTSE250. This has been because these very large-cap stocks are expected to grow their earnings very modestly in the years ahead. In essence the market appears to be pricing these stocks as 'ex-growth stocks’, while the valuation of smaller companies within the FTSE100 and 250 appear to be justified by higher EPS growth expectations.

"Using our 'Focus on Change’ approach to look ahead, one driver that could differentiate performance between the two size indices is investor preferences for dividends and dividend growth. The top 10 largest stocks have forecast 2008 dividend yields of 4%, compared with 2.5-3.0% for the smaller stocks. While dividend yield on its own has recently been a poor driver of equity performance, dividend growth has typically been a more important driver of share price. Dividend growth is expected to exceed earnings growth over the next few years for larger UK companies. In addition, we anticipate investors will hunt out growth opportunities in the latter, more risky phase of the business cycle.

"Catalysts for pushing the share prices of very large companies ahead are changing. While valuations for the very biggest companies are becoming more of a lure for other companies and investors, recent relative under-performance has prompted management to start down the 'self-help’ route in order to extract value from the business. Alliance Boots is one example of a company taking itself private, HSBC changed its management structure in response to the problems at its US Household division, while RBS has joined with Fortis of Belgium and SCH of Spain in making a joint bid for ABN Amro, the Dutch bank.

"Rather than just focusing on the classical way of explaining differences in performance between size indices such as earnings, dividend and valuation differences, we have produced a statistical model to explain what other indicators cause large-caps to outperform or underperform mid-caps going forwards. The results suggest that large-caps would be favoured when our proxy for global industrial activity (US industrial production) picks up while at the same time investor sentiment regarding the outlook for risky assets falls away (here measured by the relative performance of US high yield relative to investment grade bonds) and the price of money rises (here measured by the US real 10 year bond yield)."