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Daily Telegraph: Investment column: Recipe for ongoing recovery? Or ‘mega’ cheap for a reason?

By Tom Stevenson
Last Updated: 12:32am BST 17/04/2007

BP’s annual meeting last week provided the usual unedifying, if democratic, spectacle of soap-box ranters haranguing the board. It confirmed that shareholders will put up with a great deal if their shares are going up, but woe betide a chief executive who is seen to be feathering his nest while the ordinary investor is losing money.

The shares have perked up a bit in the past month but over the year under review at the agm they have been a dog. They have fallen around 17pc while the FTSE 100 as a whole has risen 7pc. At their worst they were down by a quarter. Forget oil spills, delays at the Thunderhorse platform and safety, what is really needling the BP faithful is lack of performance.

BP is not alone. Britain’s so-called mega-caps, the giant corporations that dominate the top of the FTSE 100, have never been so out of favour. They are cheaper compared with earnings today than they were when the market hit bottom in 2003, relentlessly losing ground to the rest of the market over the past four years.

Strong earnings growth has disguised the de-rating and the FTSE 100 has doubled in four years, but the FTSE 250 has trebled over the same period. For the biggest companies the gap has yawned even wider.

The lack of investor interest means Britain’s biggest stocks, the bluest of blue-chips, are not just cheap compared with their own history. They are also an apparent bargain when measured against the rest of the stock market and against rival assets such as government bonds.

The price-earnings ratios of the top 10 companies range from the reasonable, if unexciting, 14.1 (GlaxoSmithKline) to the apparently dirt cheap (HBOS’s p/e of 9.7). Also in single digits are Royal Dutch Shell (9.9) and Barclays (9.8).

It is not until you reach Tesco, Britain’s 11th biggest company, that you get a half-decent rating. It trades at 18 times this year’s expected earnings. Most of the next 10 blue-chips are cut-price too. Lloyds TSB trades on a p/e of 11, BHP Billiton and Xstrata are both rated at less than 10 times earnings.

Martin Cobb, who runs Templeton’s UK Equity fund, says: “There are sector and stock specific reasons for the sluggish performance of the mega-cap stocks, notably doubts about the sustainability of recent high earnings for energy and financial stocks and concerns about pricing and product pipelines for the pharmaceutical operators. Nevertheless, the degree of undervaluation is remarkable.”

He points out that the forecast dividend yield for the 10 biggest Footsie companies is close to that available from the fixed income of long gilts.

When you consider the rate at which equity dividends have grown over the years, that is curious.

By comparison, the biggest FTSE 250 stocks range in valuation from British Energy’s 12.1 to Admiral’s 25.5. The average of the top 10 mid-caps is a price-earnings ratio of 17.8. Five of the 10 biggest Small Cap companies trade on more than 20 times expected earnings.

The smart money is banking on a revival of fortunes for the mega-caps. Richard Buxton at Schroders said recently: “The stock market is fickle. The appeal of quality four years ago has completely unwound and today the appetite is for faster growth, higher debt and quite probably lower quality. Taking advantage of the unloved and undervalued now, in advance of the inevitable change in sentiment, seems like common sense.”

It can also be argued that mega-caps are favoured by the fact that private equity, with money burning a hole in its pocket, is looking further up the size scale.

With so much cash waiting to be deployed, there simply are not enough opportunities outside the FTSE 100 to make a difference. And with ratings now so high in the mid-cap arena, the paybacks are too long and the rates of return too low to be worth the bother.

So far, so logical, but in the wake of private equity’s failure to bag J Sainsbury at what looked a pretty generous price, and with politicians and unions snapping at the heels of the financiers, the game looks less and less worth the candle.

As Templeton’s Cobb says: “An assault on a large and well-known company would have to be seen as an uncomfortably high profile and high-risk venture. The private equity houses might prefer to look for opportunities abroad rather than in mega-caps.”

Or they may simply accept that higher valuations are a price worth paying for deliverable deals that do not upset too many sensibilities. Either way, mega-caps stay in the shadows.

If the biggest companies cannot benefit from the takeover premium that has fuelled the out-performance of the market’s lower reaches, they must rely on investment fundamentals.

Here I suspect that, while income will provide support, in other respects the dismal ratings of the mega-caps are justified.

Among the FTSE 100’s top 20 companies the only apparent mismatch between valuation and growth expectations is among the miners. There, single-digit multiples jar against still-buoyant growth expectations – Xstrata’s earnings are expected to increase by 40pc this year and Anglo American’s even faster.

For the others, it is an uninspiring picture of single-digit earnings growth or even declining profits. Those high-teens multiples in the Small Cap arena may look punchy by comparison but you can at least expect decent growth and a consequent margin of safety if things slow down a bit.

Martin Cobb’s conclusion – and I find it hard to disagree – is that smaller stocks have run ahead of themselves while many of the mega-caps are cheap for good reason. That is not a recipe for the recent market recovery continuing over the summer. Sell in May, anyone?

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