If $30 (£20.82) per barrel of oil is the new normal, then further trying times can be expected for the explorers and producers of the FTSE 250, many of which have debt-heavy business models designed for low interest rates and a product trading at multiples of the current price.
Looking at the stock market as a whole, however, FTSE 100 earnings are weighed more by cheap oil than the mid-cap index. Whereas the energy sector is 2.88 per cent of the FTSE 250, the industry makes up 12.97 per cent of the FTSE 100, thanks to its concentration in behemoths such as BP and Royal Dutch Shell. Considering many of the loans to smaller oil companies (which are more likely to become distressed) will be from UK banks – a sub-sector that is itself 12.09 per cent of the blue-chip index – reasons to favour the outlook for the FTSE 250 are, at first sight, easily apparent.
In recent decades, the mid-caps of the FTSE 250 have been the main driver of UK equity market returns”
In recent decades, the mid-caps of the FTSE 250 have been the main driver of UK equity market returns. The chart, right, illustrates how total returns from stocks with a larger capitalisation have lagged, especially since the millennium. From January 1986, the compound annual growth rate (CAGR) for the FTSE 250 has been 11.24 per cent, comfortably beating the 8.04 per cent average return from the FTSE 100.
The natural assumption is that superior performance rewards greater risk. This is true to an extent, but the mid-cap index is only marginally more volatile than the FTSE 100, with a standard deviation of 17.8 per cent compared with 15.5 per cent.
Mid-caps outperform
Risk and reward for the FTSE 100 and FTSE 250 (31.01.1986 to 31.12. 2015)
| (%) | FTSE 100 | FTSE 250 |
| Annualised Total Return | 8.0 | 11.2 |
| Volatility | 15.5 | 17.8 |
| Largest peak-to-trough drawdown | -43.8 | -47.1 |
Earnings growth underpins the success of the FTSE 250 and, while several of the FTSE 100’s largest constituents have languished amid commodities strife, the profits of mid-caps have been markedly superior since 2014.
Rather strikingly, the earnings growth of much smaller companies (tracking earnings of the FTSE Small Companies Index) has been extremely patchy, although they have also done better than large-caps over the past two years.
Over the longer term, small-cap returns are roughly in line with those of the FTSE 100. This could imply the inferior earnings performance of small-caps has been unfairly rewarded, but is perhaps to be expected. After all, growth investors are likely to pay a higher multiple of earnings for small companies they believe have a bright future.
The payback on these investments may be seen once they have grown in size and belong in a higher market capitalisation bracket. Coupled with the higher likelihood of small companies failing or being acquired, the relatively weak earnings performance of the Small-Cap index as a whole, is less surprising.
Which index does the economic outlook favour?
The trend has been for total returns of the FTSE 250 relative to the FTSE 100 to improve when the outlook for the UK economy, according to the Organisation for Economic Co-operation and Development (OECD), is positive. One explanation for this would be investors’ risk appetites increasing as the economic picture brightens.
At a fundamental level, greater cyclical exposure to UK growth should see the relative earnings of the FTSE 250 strengthen along with the British economy.
This relationship still holds sway but has become less pronounced as immense pressure on commodities prices and emerging markets have hit internationally diversified large-caps harder than the more domestically-focused companies of the FTSE 250.
Relative earnings and economic outlook
ShareMaestro is calling a different tune to some of the big houses…
Despite a challenging macroeconomic environment squeezing the earnings potential of global mega-caps, there is no shortage of analysts who prefer the FTSE 100 to the FTSE 250. The house view of institutions such as BNP Paribas and Morgan Stanley is that the international scope of FTSE 100 companies will ultimately see them do better than the FTSE 250 if the UK economy faces its own headwinds; for example uncertainty over the UK’s promised referendum on EU membership.
For those of a cynical mind-set, there is a school of thought that ‘Brexit’ runs counter to the interests of international financiers, which is why many of the big players are talking up the potential negative impact for UK investors.
Putting politics and conspiracy theories aside and focusing on raw numbers, one tool for UK equity valuations that has proved very reliable is the ShareMaestro system. According to its algorithms, which estimate the intrinsic value of equity indices, the FTSE 100 is overbought and is not worth even 90 per cent of the current price. The FTSE 250, on the other hand, is undervalued by 15 per cent.
The ShareMaestro calculations include the impact of inflation and the minimum rate of return investors expect relative to gilt yields – in other words the required equity risk premium. Other important metrics are dividend yield and the dividend growth forecast.
The stark contrast in valuation is, in the words of ShareMaestro creator Glenn Martin, largely down to “the growth rate of FTSE 250 dividends knocking spots off the FTSE 100”. The predictive power of dividend yield, and what it is telling us now about blue-chips and mid-cap shares, will be considered in part two of this report.
SOURCE: www.investorschronicle.co.uk
