28th February 2014
A lot has been made in recent days of the fact that the iconic FTSE-100 index is close to breaking its 14-year high, reached during the technology bubble back in early 2000 writes Edmund Shing.
Will the Footsie break through to a new multi-decade high? How much further can it go if it does? These questions are all well and good, but are not really the right questions to be asking.
Should you even be looking at the benchmark FTSE-100 index at all? The real value creation in the UK stock market has not been in these largest of companies, dominated over time by Banks, Telecoms companies and Oil majors. Instead, investors have been far better served by the mid- and small-cap segments of the UK market, not only over the past 14 years but even further back as well (Figure 2).
Including reinvested dividends over time, the FTSE-100 has given investors a mere 3.7% on average since the end of 1999 (the line in black on the chart – and that’s not counting management fees even in an index fund); compare this to the 6.5% pre-fees from the Small-Cap index (in green) and an impressive 10.2% pre-fees from the Mid-250 index (in red), nearly three times the average return from large-caps!
This was largely achieved through two key biases:
Let us not forget either that smaller companies generally also post higher growth rates in sales and profits too…
Despite this superior performance record for mid- and small-caps, you can’t even make the argument that mid- and small-cap companies are now systematically over-valued with respect to their large-cap counterparts: the estimated Price/Earnings ratio for the FTSE 100 is a little lower than for the Mid 250 index at 12.5x versus 14.6x, but it is not as low as for UK Small Caps, which trade at only 11x estimated end-2014 profits (Figure 3).
The only valuation argument that clearly favours the FTSE-100 over the other two size indices is dividend yield: the Footsie offers a prospective dividend yield of over 4%, while the other two offer 2.5-2.7%.
But then again, I can easily argue that this is just compensation for the lower growth rates on offer – you get more income today from Footsie companies, but over time the earnings and thus dividends should grow faster in smaller companies, so should approach the income from large-caps over time.
Another way that you could have outperformed an investment in the FTSE 100 was in embracing our European neighbours, i.e. by investing in companies based in Continental Europe. The FTSE Europe ex UK index in sterling today stands some 23% higher than its end-1999 level (in red in Figure 4), in sharp contrast the the FTSE 100 which remains some 2% below its end-1999 level, a difference not far from 2% per year on average…
Why might you want to invest in Europe while the consequences of the Eurozone sovereign crisis are still being felt? Well, because even the peripheral Euro economies like Spain, Italy and Ireland are actually starting to recover well. The bond market, for one, is certainly giving the thumbs up to the economic restructuring efforts being made in these countries, with the Spanish government now able to borrow money for 5 years at a lower interest rate than ever before (Figure 5), a mere 2% per year.
That way, you can invest in one of the world’s export powerhouses in the form of Germany, and also buy into the recovery in the peripheral Euro economies as well… Valuations for Europe ex UK are comparable to the FTSE 100’s ratios, so there is not much to choose between them on this basis.
Personally, I believe that international investors have continued to shun the Eurozone for many a year now as a result of the Euro sovereign crisis (which reached a peak back in 2011-2012), despite the varied austerity efforts of Euro governments and the sharp fall in interest rates in the region (Spanish 5-year bond yields, now under 2%, were as high as 6.3% in mid-2012!). There is thus still a value and recovery play to invest in here…
There is a myriad of different ETFs and investment trusts that you can use to get exposure to UK mid- and small-cap stocks, some of my preferred funds are:
There you go, a good selection of exchange-traded funds and investment trusts that have historically beaten the FTSE 100 index hands down. Of course, historic share price performance is not necessarily a good guide to future performance!