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The Observer: Good moment to pick up a heavyweight

EXTRACT: The bigger the empire, the more things can go wrong: BP has been dogged by safety issues in Alaska, trading problems in Texas and hurricanes in the Gulf of Mexico; Vodafone has faced write-offs against its British 3G licences and its German Mannesman acquisition, and has had to sell its Japanese business; Shell is still recovering from the debacle of the overstatement of its reserves.

THE ARTICLE

Heather Connon
Sunday October 15, 2006

Robert Parkes, UK equity strategist at HSBC, calls them the superheavyweights and it is an apt term for the 10 or so giants that dominate the FTSE 100 index. Each of them weighs in at least £30bn and the largest is worth more than £115bn; combined, the 10 – BP, Royal Dutch Shell, HSBC, GlaxoSmithKline, Vodafone, Royal Bank of Scotland, AstraZeneca, Barclays, HBOS and Anglo American – are worth more than £700bn, or more than 40 per cent of the total stock market.

You would expect that formidable financial strength would translate into formidable investment performance. In recent years, however, the opposite has been true: over the past six years they have lagged behind the rest of the stock market by almost a quarter. Indeed, their dismal performance has been one of the key reasons why the FTSE 250 (medium-sized companies) has done so much better than the FTSE 100 recently: the mid-cap has all but doubled in the past five years; the FTSE 100 has risen by only about 20 per cent.

There are a variety of reasons for this. The most obvious is the fact that the larger a company becomes, the harder it is for it to generate rapid growth. BP’s annual sales, for example, are more than £250bn. Increasing that by 10 per cent means adding £25bn of revenue, equal to a couple of dozen small and mid-sized companies. The bigger the empire, the more things can go wrong: BP has been dogged by safety issues in Alaska, trading problems in Texas and hurricanes in the Gulf of Mexico; Vodafone has faced write-offs against its British 3G licences and its German Mannesman acquisition, and has had to sell its Japanese business; Shell is still recovering from the debacle of the overstatement of its reserves.

The biggest companies also attract the most coverage by analysts: they, after all, are the companies likely to generate the most share trades for the banks that employ them. So they are far less likely to make unexpected announcements – like Cairn Energy’s spectacular oil discoveries – that can dramatically move shares. And they attract fewer bids than smaller rivals: the number of predators who can afford to pay £30bn, let alone £100bn, for an acquisition is small enough. The 250 index, on the other hand, has soared to new highs on the back of a wave of bids for retailers, builders, engineers, water companies and the like from foreigners and private equity companies.

The superheavyweights have also been undermined by general market conditions. Pension and insurance companies have been reducing their share holdings ever since the stock market crash in 2001 and, if you are selling shares, the biggest and most marketable are likely to be the first to go. As Ed Burke, who runs Invesco Perpetual’s UK Growth fund points out, the main buyers over recent years have been foreigners, and particularly US value funds, who are more likely to invest in bombed-out ‘value’ companies like Marks and Spencer or ITV than international giants like HSBC; or hedge funds. And hedge funds are more likely to be selling the index short – which effectively adds to the selling pressure on the giants – than buying into the likes of GlaxoSmithKline.

There are, however, signs that the tide may be about to turn in favour of the mega-caps. In Britain, the FTSE 100 index has risen above 6,000 for the first time since the spring; in the US, the Dow Jones, which includes some of America’s largest companies, has passed its all-time high while, as John Hatherly, a consultant to Seven Investment Management points out, the Russell 2000 index of small and mid-sized US companies has been underperforming recently. He thinks that is partly because investors have realised that private equity firms have raised so much money recently – and are getting together more to spend it – that no company is too big to be bought. Two years ago, a bid for BAA would have been unthinkable; these days, even Vodafone and BT – worth £66bn and £22bn respectively – are openly talked of as possible targets of break-up bids.

But the superheavyweights have more fundamental attractions. Mike Felton, who runs M&G’s UK Select fund, says the slowing global economy means earnings growth is becoming harder to generate, leading him to favour ‘companies which have more diversity in geography and production and a more secure base because of their strong balance sheets’. That means the mega-caps – and he has increased the FTSE 100 component of his fund from 58.2 per cent 18 months ago to 64.9 per cent, with the 10 top ‘mega-caps’ accounting for 38 per cent.

Years of lacklustre performance have also left the superheavyweights on attractive valuations: their yield, on average, is 40 per cent higher than the rest of the stock market with some, like HSBC and Royal Bank of Scotland, yielding almost 5 per cent based on expected future dividends – higher than you can get at most building societies and, unlike them, likely to carry on increasing.

Invesco’s Burke also points to many superheavyweights’ share buybacks – BP alone is generating so much cash flow that it is likely to buy back a fifth of its shares over the next five years – which should underpin share prices. While he still thinks there are plenty of attractive medium-sized companies, he thinks the likes of BP, Glaxo and HSBC offer ‘low multiples by historic standards’.

Anyone thinking of backing the superheavyweights should be aware that it means taking a punt on just four industries – banking, commodities, pharmaceuticals and telecoms – and not everyone is enthusiastic about these. While Stephen Whittaker, manager of New Star’s UK Growth fund, agrees that banks look attractive, he is more cautious about oil and commodity companies, as he believes that prices of these materials are likely to fall, dragging share prices down with them. Telecoms and drug companies also have structural problems which may act as a brake on earnings growth. But anyone looking for solid income should consider tucking away a few superheavyweights – or buying the funds run by Burke and Felton, whose records indicate they are good at judging when to back them.

http://observer.guardian.co.uk/cash/story/0,,1922007,00.html

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