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Times Online: Mega-caps ready for resurgence but banks may still lag behind

EXTRACT: “…the likes of Shell and BP busy mopping up their own stock, selling out to the company’s broker has often proved the path of least resistance”.

June 9, 2007
Nick Hasell: Tempus

Big is back. After nearly three years in which the stock market’s largest stocks – the so-called “mega-caps” – have trailed their smaller peers, this week’s worldwide sell-off in equities produced the first signs that this trend may be beginning to unwind.

Four of the FTSE 100’s five biggest stocks – Royal Dutch Shell, BP, HSBC and Royal Bank of Scotland – have featured among the index’s best performers over the past five sessions. Vodafone Group, the one that did not, roundly outperformed the benchmark on being targeted by a rebel shareholder.

That showing contradicts what has recently become an unwritten law: the bigger the company, the worse it fares. While the FTSE 250 rose 27 per cent last year, the FTSE 100 could manage only an 11 per cent advance. Narrow that down to the large-cap index’s 14 biggest constituents – each of which are valued at more than £30 billion – and the gain was even worse: a meagre 4 per cent.

So why has big done so badly? First and foremost, mega-caps are perceived to be bid-proof – or, rather, private equity-proof. In a market preoccupied by spotting the next takeover target, the likes of a BP or GlaxoSmithKline have been deemed unassailable by even the most aggressive leveraged buyer. It is arguably only since the emergence this year of large-cap shareholder activism – characterised by TCI’s assault on ABN Amro, and Efficient Capital Structure’s tilt at Vodafone – that such a perception is starting to change.

Investec Securities suggests that the problem of portfolio concentration has also played a part. Roger Cursley, the equity strategist, points out that, at the start of 2005, when the mega-cap lag first became evident, the ten biggest companies in the FTSE 100 accounted for 51 per cent of the index, with BP alone speaking for more than 9 per cent. This posed a dilemma for fund managers who ran “actively managed” portfolios. Should they have wished to take an “overweight” position in BP, they risked breaching the rule stipulated by most pension trustees that they cannot hold more than 10 per cent of their portfolio in a single stock. And should they have merely sought to maintain a “neutral” position in the ten biggest stocks, that would have meant having more than half their portfolio doing no more than shadow the FTSE 100 – making it extremely hard to justify the fee premium that active managers charge over their index-tracking peers.

Finally, there is the recent popularity of share buybacks as a method of enhancing earnings: a strategy that has been most vigorously pursued by the mega-caps. With many pension funds having spent the past two years seeking to move money out of UK equities, and the likes of Shell and BP busy mopping up their own stock, selling out to the company’s broker has often proved the path of least resistance.

What has changed? Simply the realisation that, at a time when value is increasingly hard to come by, the only bargains are at the bigger end of the market. Of the UK’s 14 mega-caps, nine trade below the 12-month forward price earnings ratio of 12.8 times at which the FTSE 350 sits. That pattern is repeated globally. Of the world’s 7,600 biggest companies, Lehman Brothers finds that large caps are at a 13 per cent discount to their smaller peers, compared to an average premium over the past 18 years of 20 per cent. Couple this historic cheapness with the fact that the largest companies tend to have the highest dividend yields, the strongest cashflows and the highest return on equity, and the case becomes compelling.

So who will be the winners? This week’s slide has triggered a textbook rotation out of the most “expensive” large-cap sectors – property, personal goods, retail and general financials – into the most lowly valued: banks, oil and basic resources, mobile telecoms and pharmaceuticals.

Given the preponderance of the latter among mega-caps, a continuation of that trend will both help to narrow the valuation gap and protect the FTSE 100 from more severe falls. Yet it is likely to be the banks, the index’s persistent underperformers, that determine how far it runs. As our table shows, it is Barclays, Royal Bank of Scotland and HBOS that sit on the lowest mega-cap multiples.

Betting on a rerating of the banks in the short term is a brave call. M&A activity among banks may be expected to accelerate over the rest of the year, but their sensitivity to rising interest rates and concerns – warranted or not – that it is their cheap credit that is fuelling the leveraged buyout boom means that it is other mega-caps that are likely to lead the way.

http://business.timesonline.co.uk/tol/business/markets/article1907489.ece

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