Analysis of small, mid versus large cap stocks

Threadneedle Investments - Mega caps are mega cheap. There has been a massive shift in the valuation profile of the UK market over the past few years. Seven years ago the top 15 companies in the index were trading on a forward PE of more than 20 times while, outside the FTSE 100, no tier traded at more than ten times. Now, the top 15 are on 11 times and none of the tiers below the 100th stock trade on less than 15 times.

There are two main drivers of this shift in valuations: the superior earnings growth of mid and small caps and the wave of takeovers and buyouts that has swept through the lower tiers of the market.

Of these drivers, the first is still in place. The Mid 250 is generating 15% earnings growth versus around 7% for the FTSE 100. But is this growth mismatch sufficient to justify such a gulf in valuations? I don’t think so.

Whether the second driver remains in place is more of a moot point. Much has been made of the wall of private equity cash waiting to be deployed. What is interesting is that the number of private equity deals has plateaued but the size of those deals has crept higher. With the level of gearing being applied to deals still some way below the peaks seen in previous cycles, there is the scope for some big names to come into play.

Meanwhile, the market has made terrific progress in recent months and I suspect that investors may be underestimating the threat of stubborn inflation and higher interest rates. Thus, a more defensive stance may be appropriate in the short term.

With these factors in mind we have been reducing mid and small cap exposure and moving further overweight in mega caps in recent weeks. Key holdings for us include BT, GlaxoSmithKline, BP, Shell, Vodafone and BAT. Am I holding these stocks because I think they are all takeover targets? Of course not. But would I be surprised if something in this area of the market was bid for? No, I wouldn’t.