FTSE 100 reaches for 7000 mark but are there better places for your money?

28th February 2014

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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.

 1. FTSE-100 Inching Closer to the 7000 level

Source: Bloomberg

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.

In the Stock Market, Size is not Everything!

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).

2. FTSE Mid-250 and Small-Cap Indices Far Outstrip the Footsie
 Source: Bloomberg

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:

  1. A bias towards domestic economic exposure, which is greater in the mid- and small-cap segments of the stock market. In contrast, FTSE-100 companies tend to be global by nature, and indeed often have little to do with the UK per se (look at the Miners, for example).
  2. Low weightings in hard-hit sectors, such as Banks, Insurance, Telecoms and Oil Majors. All of which have come a cropper either during the recent Financial Crisis, or before that post the 1999-2000 Tech bubble.

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).

3. FTSE 100 Cheaper than Mid-Caps, But Small-Caps Cheaper Still

Source: Author, Bloomberg

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.

Embrace Your European Neighbours

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…

4. Continental Europe Has Beaten the FTSE 100 By a Decent Margin

Source: Bloomberg

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.

5. Spanish 5-Year Bond Yield Falls To Below 2%, a Historic Low

Source: Bloomberg

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…

Which Funds to Use?

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:

  1. iShares FTSE 250 UCITS ETF (code: MIDD), which tracks the performance of the FTSE Mid-250 index including dividends. Expense ratio: 0.40% p.a.
  2. iShares MSCI UK Small Cap UCITS ETF (CUKS), which tracks the performance of the MSCI UK Small Cap index. Expense ratio: 0.58% p.a.
  3. Herald Investment Trust (HRI), which is an actively managed  closed-end fund focusing on smaller technology and media companies. Annual expense ratio: 1.1%, current discount to underlying net asset value (NAV): 11.8%.
  4. Henderson Smaller Companies (HSL), again an actively managed investment trust investing in UK small cap companies. Over the last 5 years, it has delivered an annual total return of nearly 39%, compared with under 26% for the MSCI UK Small Cap index.
  5. iShares MSCI Europe Minimum Volatility ETF (IMV), which invests in European large-cap companies with the lowest historic stock volatility, with the aim of limiting the investment risk taken in the overall fund while maintaining performance. Annual expense ratio: 0.25%.
  6. European Assets investment trust (EAT): this closed-end fund investing in European small caps and managed by fund group F&C. This fund has risen an average 26.5% p.a. over the last five years, trades in line with current NAV and has a higher-than-average 1.7% annual management charge.
  7. JPMorgan European Small Companies (JESC): another European small cap investment trust, which has gained an average 21% p.a. over the last 5 years and which trades today at an 11% discount to underlying NAV.

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!

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