As fear rises and liquidity melts away, large cap stocks are the only place to defend capital and smaller stocks see hair-raising sell-offs, only for the situation to reverse as sentiment turns.
But which areas now look strongest in terms of valuations, income and geographic spread?
The performance of the three areas since the start of the year suggests that they are still following the risk on/risk off patterns of the past three years. Year to date, the FTSE 100 is up 1.69%, while the FTSE 250 is up 11.4% and the FTSE small cap is up 13.02%.
This has almost entirely been driven by a change in sentiment following the LTRO (long-term refinancing operations) rather than stronger earnings. For example, the price-to-earnings (PE) ratio on the FTSE 100 has moved from 10x at the start of the year to 9.6x now. In contrast the PE on the FTSE 250 has expanded from 15.3x at the start of the year to 18.3x now. The PE on the FTSE small cap has moved even further – from 17.03x to 20.84x.
These PE ratios would seem to suggest that small and mid cap stocks have run ahead and it is time to look back at large cap defensives. The overall picture, however, is distorted by the very low valuations of the banks and oil companies in the FTSE 100, a number of non-profit making companies in the small caps and the low point from which many small and mid caps started the year.
But, given there are arguments for distortions in each of the cap size groupings depending, for example, on the earnings definition used, how can investors determine which size of company is more likely to deliver?
One consideration here is the geographical exposure of each of the different market capitalisations. The relative UK-orientation of the mid and particularly the small cap sectors has been seen as a headwind at a time when the UK looked weak. As it is, the UK’s relative position has improved, but growth is still likely to be thin on the ground.
Certainly, the more international flavour of the large cap market may be an advantage for those companies directed towards the faster growing markets of the US or emerging markets.
The income available from the different areas is also a consideration, because markets have started to prize income more highly than previously. Some argue income is a more reliable guide to valuation than price to earnings ratios with the added benefit that a growing dividend also provides greater inflation protection.
If large caps no longer necessarily win out on their valuation, their geographic reach or their income, they certainly still win out on liquidity as, for example, small and mid caps will be more vulnerable to liquidity considerations.
In the short term the relative performance of the different parts of the market is likely to be driven by the situation in the eurozone. If the LTRO in the eurozone succeeds in persuading banks to extend more credit, this will benefit smaller companies disproportionately and vice versa.
The longer term is more difficult to predict: mid caps have had a strong run and now look well valued, but may see the strongest earnings growth; small caps will struggle if there is a further squeeze on liquidity, but have historic outperformance on their side; large caps no longer win out on income and geographic reach, but may just win out on liquidity. Investors will need to judge the environment first and pick their market cap accordingly.
