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Financial Times: Oil and gas heat a smaller pot for investors

By Charles Batchelor
Published: February 11 2006
Like an athlete on steroids, the London stock market has been pumping itself up on oil and gas industry profits. Record-breaking numbers from BP and Shell in the past two weeks have highlighted the impact that a soaring oil price is having on the industry's profitability.
At the same time, the seemingly insatiable demand for copper, zinc and other metals by the booming economies of China and India has made mining one of the fastest-growing sectors in the FTSE 100. It now accounts for just under 7 per cent of the FTSE 100 index compared with just 1.6 per cent 10 years ago.
In the nearly three years since the market touched bottom on March 12, 2003, the FTSE 100 has risen a respectable 75.6 per cent. A revival of takeovers has fuelled some of this increase but much has come from an upsurge in energy and commodity prices.
The FTSE 100 oil and gas sector has added 83 per cent, while mining – a far smaller sector in terms of market capitalisation – has raced ahead by 189 per cent.
But for all the euphoria over these developments – BP plans to return up to $65bn to shareholders over the next three years – there are concerns that the growing dominance of the oil and gas sector is leading to an undue concentration of risk and making it harder for investors to “read” the trends.
“By buying a FTSE 100 tracker you are hostage to the fortune of a handful of companies,” says Phil Wagstaff, managing director for retail marketing and investments at New Star Investment Funds. “If these companies fail to perform, you are stuck with them – and a poorly performing fund.”
The oil and gas sector now accounts for just under 21 per cent of the FTSE 100 index, a similar figure to the banks and followed by pharmaceuticals with 9.2 per cent.
These three sectors account for half of the top 100 stocks by value and dominate an increasingly polarised index. The recent rise in the oil price has had a big impact but the market's increasing concentration represents a long-term trend.
Ten years ago the five largest sectors – banks, pharmaceuticals, oil and gas, telecommunications and media – comprised less than 50 per cent of the index and there was far less bunching at either end of the index. In 1996, 10 sectors had a share of 3 per cent or more; today only seven sectors exceed this threshold.
Some long-established sectors of the market have shrunk almost to invisibilityover the past decade. The steepest declines were achieved by general insurance,which has gone from a 2.4 to a 0.26 per cent weighting in the broader FTSE All-Share index and automobiles, down from 0.83 to 0.16 per cent, according to Fidelity, the fund manager.
“I am slightly concerned that the FTSE is such a distorted index,” says Tom Walker, manager of the Martin Currie Portfolio Investment Trust.
“If you have a large percentage of the benchmark in BP and Shell, that is a lot of absolute risk. I am still feeling positive about oil but having more than 5 per cent in any one stock increases your risk if anything went wrong.”
Investment trusts are prevented by legislation from putting more than 15 per cent of their assets into any one stock but many impose much lower internal limits on their managers so they would be prevented from going overweight on BP, which accounts for about 9.6 per cent of the market, and Shell whose shares account for 8.9 per cent.
The limits on open-ended funds such as unit trusts are even lower, with these funds prevented from holding more than 10 per cent of their portfolio in any one stock.
But for many managers the issue is not one of increasing their exposure to a particular stock or stocks but of reducing their risk. “There are people with half of their money in the top 10 stocks,” says Richard Marwood, an investment manager at Axa.
“People are saying: 'We won't take our full exposure to the benchmark, we will cap it at 5 per cent.' We are managing money on that basis.” Axa has a limit of 4.5 per cent exposure to any single stock on some of the money it manages, he adds.
FTSE, the index provider that is part-owned by the Financial Times, has responded to demand for an index that takes account of the increasing concentration of value in a small number of stocks.
It launched the FTSE Cap 100 5 per cent Index and the FTSE Cap All-Share 5 per cent Index last June. Four stocks – BP, HSBC, GlaxoSmithKline and Royal Dutch – have all had absolute weightings in the FTSE 100 above 5 per cent recently. But within the capped index, BP was 5.12 per cent (the index is calculated quarterly and can exceed the cap temporarily), Royal Dutch was 5.1 per cent, HSBC was 4.96 per cent and Glaxo was 4.79 per cent.
But launching indices that attempt to modify market developments is not without its problems. “We take the view it is good to have simplicity and clarity,” says Walker. “It is no good having benchmarks that no-one can relate to.”
The flipside to the strong performance of oil, gas and mining stocks is the relative weakness of some other sectors. The whole market has benefited from a recovery of investor confidence in equities but stripping out oil, gas and mining shows a 68.8 per cent rise in the market since March 2003, compared with a 75.6 per cent rise before this adjustment.
“The retailers and the banks were underperformers last year,” says Richard Hunter, head of UK equities at Hargreaves Lansdown. “Some of the retailers did well at Christmas and we are just getting into the banking reporting season proper. If they can show they have turned a corner that will be two negatives that have been removed.”
The telecoms sector, too, has struggled to maintain its early excitement and even the mobile telecoms companies are increasingly being seen as cash-rich utilities.
Cable & Wireless and Vodafone have performed poorly over the last 16 months. Food producers have also underperformed the wider market.
Change in the composition of the stock market is nothing new and reflects technological developments and wider economic trends. For instance, at one stage in the 19th century, the market was dominated by railway companies.
Even the dominance of the oil and gas stocks is not new. “In the late 1960s the sector accounted for 30 per cent of the market,” says Simon Ward, investment strategist at New Star.
Other, admittedly much smaller, regional stock markets have been dominated by a handful of large stocks. Nokia, the mobile phones manufacturer, makes up the largest chunk of the Finnish stock market.
A problem for long-term investors in the UK stock market is that they may still be clinging to the idea that its constituents are dependent on the fortunes of the UK economy. But not only are large stocks such as the oil majors increasingly subject to global developments, more companies with very little UK connection are making their appearance. Tougher US regulations are making London the listing of choice for foreign companies.
“There is an old-fashioned perception that the FTSE reflects the UK economy,” says Frederic de Merode, senior strategist at Fidelity International. “An investor might see GDP growth or consumer activity slowing and decide to sell out of his UK stocks. In fact foreign earnings could mean that the company was performing better.”
And while the purchase of a fund that tracked the FTSE 100 would expose the investor to global economic trends, it might limit his or her exposure in terms of the sectors covered.
For a broader coverage, the investor would need to invest, either directly or through funds, in overseas markets.
“By only investing in the UK market, you gain protection from currency movements but you would need to diversify more to take advantage of trends across Europe and the world,” says de Merode.

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