Why small can be beautiful
Some of the best investment opportunities in the UK lie outside the FTSE 100.
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Investors in UK equities tend to focus on the FTSE 100. It’s the standard measure of how the UK stock market is performing and represents the performance of Britain’s biggest companies. But there’s more to UK plc than the FTSE 100, and some of the best opportunities right now lie elsewhere.
In the UK, the FTSE 100 is made up of the 100 most valuable companies listed on the London Stock Exchange. Most investors understand this index and it’s generally considered the yardstick of UK equity performance.
But there is more to UK equity than the FTSE 100, and we’re now looking with more interest at the FTSE 250, composed of the 250 largest UK companies beyond it. With a resolution to Brexit uncertainty on the horizon, and a no-deal result looking increasingly unlikely, we think companies in the FTSE 250 could benefit.
Good things can come in small packages
It’s generally accepted that because smaller companies are riskier than larger ones, investors should get compensated for that additional level of risk. The FTSE 250 has, indeed, outperformed the FTSE 100, returning 10% a year since 1994 compared to 5.5% for the FTSE 100 over the same period.
We think that size plays a much smaller role when comparing UK large and mid-caps than the nature of their underlying businesses. The FTSE 250 has a greater proportion of companies in so-called ‘cyclical sectors’, and a higher proportion of revenues generated domestically than the FTSE 100. This leads us to two important conclusions about the performance of the FTSE 250:
- it benefits from increased levels of economic activity
- it suffers less from a strong appreciation in sterling
These factors have been instrumental in our decision to increase our allocation to more domestically orientated, medium-sized UK companies.
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Smaller companies thrive when home fires burn brighter
Large-cap and mid-cap companies are significantly different in terms of sector composition. For example, the FTSE 100 has a higher weight in oil and gas and health care, while the FTSE 250 is more exposed to consumer discretionary companies.
What this means to investors is that the two indices will provide different levels of return at different phases of the business cycle. Because of its high exposure to cyclical sectors, the FTSE 250 can be significantly affected by changes in levels of business activity. In the meantime, the FTSE 100’s higher exposure to defensive sectors means it’s less sensitive to macroeconomic events, although the diversified nature of large global companies compared to smaller ones is a contributing factor.
A stronger pound: headwind for global companies, potential tailwind for domestic
Sources of revenue are another important factor. Intuitively, a UK company with costs incurred in sterling but revenue dominated by a foreign currency will benefit when the pound falls as overseas revenues get a boost. Companies more focused on the domestic market, on the other hand, could benefit from a rise in their home currency as the cost of imported inputs falls.
This intuition is backed up by research. Companies with a high proportion of non-UK sales do well when sterling falls, while companies more reliant on domestic sales outperform when the pound rises.
So, what does this mean for investors?
As we can see, the revenues for the FTSE 250 depend far more on the domestic market, while the FTSE 100 relies on overseas revenues.
The 20% fall in sterling in the months that followed the EU referendum vote in 2016 led to a strong appreciation in earnings for large international companies and a surge in the FTSE 100. Meanwhile companies in the FTSE 250 suffered from their stronger domestic exposure, as well as from the sharp slowdown in UK GDP growth amidst lower levels of investment and consumption caused by heightened uncertainty.
When Brexit uncertainty is resolved, we expect to see sterling strengthen and UK economic activity increase. This should favour FTSE 250 companies, with their greater exposure to the UK economy, and we’ve added to our exposure accordingly.
When investing, past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.
We have increased our investment in the FTSE 250 – the largest companies outside the FTSE 100.
We think these more UK-focused firms could benefit when Brexit is resolved as that should strengthen sterling and boost Britain’s economy.
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