March 2010
*For Sale: A one year old rally, no careful owners*
March 3rd 2009 marked the bottom of the UK bear market. One year later the FTSE 100 is up 51%. While that is pleasing it is outclassed by the FTSE 250 Index that is up 63% while the FTSE Small Cap is a staggering 69% higher. Have these gains arisen because profits in the constituent companies have risen by that much? Alas no.
In the case of the large companies profits have actually been pretty pedestrian over the last twelve months. Indeed, mining companies probably reported profits in 2009 that were about half the levels of 2008. Oil companies too all had much lower profits as oil prices fell. The saving grace for these global megacap stocks was their international exposure that enabled them to benefit from strong growth in emerging markets. Nevertheless, overall profits certainly did not rise by over a third.
In the case of the Mid Caps the performance was, if anything, even worse. This group of companies has a much stronger focus on the UK and includes sectors like house building, car retailers and many consumer facing industries. Most importantly over a quarter of the sector is financial stocks. Overall, they had a torrid time in 2009, and profits are, in many cases, sharply down on 2008. Finally, last but not least, the Small Caps are a mixed bag of companies that are much more sensitive to the economic winds because of their small size and can be best be described as the canaries of the financial world. They too had a tough time in 2009 and certainly did not increase profits, let alone anything like 69%.
So why then did the smaller companies do so much better in this rally than the big caps? The answer lies in the events leading up to the market trough. In 2008 the financial crisis led to a dramatic reappraisal of risk and it suddenly become important to price it correctly after years when it had been ignored.
Risk is associated with many things but an important factor is liquidity, the ability to get out of an asset when you want. Small cap stocks have famously been described as lobster pot stocks; easy to get into, impossible to get out of. As the true scale of the financial crisis became apparent at the end of 2008 the small cap and mid cap sectors cratered as investors exited the riskiest assets. A lack of liquidity meant brokers could not find buyers and prices were marked down sharply. The process continued in the first few months of 2009 and valuations of all equity markets, but especially small and mid caps, reached distress levels in the first week of March. It was then the Bank of England started its programme of quantitative easing. Although it had been flagged in advance the start of the programme gave investors the confidence to reprice stocks on a going concern basis rather than as basket cases only an accountant away from liquidation.
Over the next six months investors started to look at the whole market, but especially the small and mid cap stocks, on the assumption that eventually business conditions would normalise and that the recession would end eventually, even if no one knew when. So the market did what it loves to do, but is actually very bad at, which was to “vote” on all the beaten up shares and revalue them on expectations that they would return to profitability. All the evidence from long term studies on stock market returns, such as those from Barclays and Credit Suisse, show conclusively that the bulk of returns comes from reinvesting dividends and allowing the magic of compound interest to do its work. It does not come from chasing capital growth.
In the rally of 2009 all that was forgotten as investors clambered about car dealers and house builders in the expectation that profits would return to previous levels. However, by anticipating the recovery, the market has risen on valuation rather than earnings. It is the expectation of profits rather than actual delivery of earnings that has boosted share prices. Nowhere is that hope higher than in the mid and small caps.
This rally has been a painful experience for value investors who prefer the tangible evidence of dividends rather than the faith of recovery investors who expect balance sheets to deliver the same profits as before. The bounce has put the market on a much higher valuation than a year ago and has left more conservative investors behind. This is best measured by comparing the dividend yields of the three size categories. The FTSE 100 yields 3.4%, the FTSE 250 2.6% while the FTSE Small Cap yields 2.7%. It will take time for compound interest to work in favour of dividend paying stocks again. But there is no doubt it will happen and, as it does, funds with a value bias will start to close the performance gap on growth and momentum funds.