Dull companies can be investment winners
If you hold any funds invested in the UK stockmarket, the chances are that a good chunk of your money will have ended up in blue chip stocks such as HSBC, Vodafone, BP and Unilever – the biggest, and traditionally, the safest, most reliable companies in the country.
Typically, the term 'blue chip' refers to the FTSE 100 – the top 100 companies in terms of market value, which together account for around 80% of the total value of the UK market. However, that single index covers quite a spread.
"The FTSE 100 is really several indices – the top 10 'megacap' companies alone account for almost 50% of the market," comments Darius McDermott, managing director of IFA Chelsea Financial Services. At the other end of the index, the bottom 50 companies together make up just 12% of the total.
So what kind of performance can we expect from the biggest companies in the UK? Large stocks are basically mature businesses that have already expanded enormously (although those companies at the lower end of the FTSE 100 may still have good potential to grow further). They're therefore fairly steady and safe investments.
However, as Colin Morton, manager of Rensburg UK Blue Chip Growth Trust, points out, there's a trade-off for safety. "You won't get flashy performance. Over the long term large caps are the worst performers, followed by mid caps; small companies are the best performers [because they have the potential to double or triple in value rapidly from a small base if things go well], but the riskiest."
Over the 10 years to 8 October 2009, for example, the FTSE 100 was up just 23%, while the FTSE 250 index (which tracks the next 250 companies by value) gained 121%.
But the past year has been a deeply traumatic time for many blue chips. "2008 proved that blue chip stocks weren't all as high-quality as investors thought – particularly in the banking sector," says Jackie Beard, director of UK fund research at fund analysis company Morningstar.
Over the 12 months to 5 October 2009, the FTSE 100 index was up less than 5%, in contrast with the FTSE 250, up 15%, and the FTSE Small Cap index's 20% bounce. But the past year can be divided into three distinct phases.
At the end of 2008, as markets collapsed globally, large stocks (which tend to be easily sold) lost less than less well-known small and medium companies, which saw a lot of forced sales at stupidly low prices because buyers were so hard to come by.
Early in 2009, the market was still pretty grim overall – but blue chips suffered worst. "Banks were still being avoided as it wasn't clear whether they would be nationalised (taking shareholders' holdings to zero value)," adds Beard.
Since the market trough in early March, the whole market has strengthened, but especially the small caps that were decimated last autumn. The Small Cap index is up a whopping 78% since 9 March, compared with the FTSE 100's 50% gain.
Clearly, then, large stocks are not always the safe havens they are assumed to be – and given their tendency to produce unexciting returns over the long term, you might be wondering why it's worth bothering with them. Well, they are still relatively stable, secure investments, very unlikely to go bankrupt. And they do have other important characteristics, attractive to investors.
One benefit, as we've seen, is that they are highly liquid – easy to sell – so you are less exposed if you want to get out in a market downturn. Another is that blue chips in general, and the global megacaps in particular, provide broad exposure to international markets, with around 60% of the total FTSE 100 profits generated outside the UK.
Full force protection
So investors get protection from the full force of UK economic slowdown, as they're automatically diversified into a range of other markets with different economic cycles. Mid and small cap companies, in contrast, tend to be much more focused on the UK economy.
However, against that advantage, McDermott suggests that currency movements may damage profits in the short term (though they will benefit at other times, when the currency movement is in the other direction).
Another key strength of these well-established companies is that they have traditionally paid out steady or even growing dividends year after year. That makes them a great choice for income-seeking investors.
Moreover, as Morton observes: "If you're receiving a decent dividend, share prices don't need to rise at all for you to be better off than if your money were in a deposit account."
But dividend payments too have been put to the test by the turmoil of this year. Morton focuses on rising income in his Rensburg Equity Income fund. He has achieved dividend growth averaging 10% a year in the 14 years he's been running the fund.
"This year has been difficult because companies in difficulties have been cutting dividends. Banks and miners (which account for around a third of the top 100) are now doing best in capital growth terms, but they're paying no dividends at all since life got tough.
"The fund's dividend will probably be down around 9% on last year, though that's better than the 17% drop in dividends across the market as a whole."
However, it's not all bad. Morton sees "very good opportunities to buy high-quality companies with good dividend yields above cash or government gilts, at prices 25% below two years ago".
Mick Gilligan, head of research at Killick & Co, is also inclined to buy into the large cap sector at present. "Generally we're in favour of a broader spread that will capture the growth potential of the small and medium cap firms, but on a three-to five-year view we like blue chips," he says.
That's because although he believes the market will continue to rise for the next year or so, he sees more problems further ahead as governments globally struggle with their enormous quantitative easing debts.
"At that time we want to be holding bigger companies – global leaders paying good dividends. We quite like the look and undemanding valuations of a number of large caps over that timeframe," he explains.
How much exposure?
So how much blue chip exposure do you need, and how should you get it? This is the area where even people who don't buy individual shares are most likely to have one or two holdings – perhaps denationalised utilities or demutualised building society shares.
But if you want to build up a core portfolio it's best to use a fund or investment trust that will give you an instant spread of investments, no matter how little cash you put in.
Martin Bamford, managing director of IFA Informed Choice, suggests that most of your UK equity exposure should be in large cap stocks for relative safety: "By investing in these companies you should get a good level of exposure to overall market returns," he says.
Then medium and small cap funds can be added round the edge, to boost returns. Mike Horseman, managing director of IFA Cockburn Lucas, recommends that defensive investors should have 80% of their UK equity holdings in large caps; however, he suggests limiting UK exposure to around a quarter of the equity portfolio, as he favours the greater diversity of global funds.
One popular route into the FTSE 100 is via an index tracker such as those from Legal & General or HSBC, or an exchange traded fund such as Barclays iShares. These cheap passive funds involve no managerial decision-making – instead, they mirror the make-up of the index.
Gilligan says that if you really want to get full exposure to the very biggest companies, trackers make sense: "Very few active All-Share fund managers will have 80% in the FTSE 100, in the way an
All-Share tracker would."
A place for trackers
There's also an argument that it's difficult for stock-picking active managers to add much value in large cap stocks because they're so well researched. Certainly, says Bamford, "there is little sense in paying more for an active fund that is effectively a 'closet tracker'. This means looking for active fund managers prepared to take contrarian views".
"Trackers have a place if you just want to capture UK plc at a low cost," agrees Colin Morton. "Indeed, over the last three years you'd have been better with an FTSE All-Share tracker than with my income fund.
But over a reasonable period we can add value." Over 14 years since he took the helm at Rensburg, the Equity Income fund is up 234% and the All-Share index is up 167%.
Ultimately, funds focusing on blue chip stocks are unlikely to set your portfolio alight. But they're an ideal core holding: broad-based, stable, paying dividends that can be reinvested if you don't need an income, and – on most occasions anyway – providing a less volatile ride than the wider market when things get rocky.
The FTSE relegation battle
It's important to understand that the FTSE 100 is a changing beast – it's updated on a quarterly basis, at which point companies that have lost value and slipped down the table may be relegated and replaced with others that are doing well.
At the last review in September, Rentokil and Whitbread replaced Balfour Beatty and the waste management company Pennon Group. ITV, IT company Logica and sugar manufacturer Tate & Lyle are among those waiting in the wings. So the border area is a rather grey area for blue chips.
• Martin Bamford, managing director of Informed Choice, says:
"Majedie Asset UK – UK Equity is a good choice from a boutique fund manager. It contains just over 200 holdings, with around 40% in the largest caps. There is a multi-manager approach with four managers taking responsibility for different mandates. Only 10% is allocated to smaller companies."
• Mick Gilligan, head of research at Killik & Co, says:
"At the moment I like tracker funds on a three- to five-year view. I would use the Barclays iShare FTSE 100 ETF for cheap blue chip expsosure. Alternatively, Neil Woodford at Invesco Perpetual is very much into large caps, which has held his acclaimed Income and High Income funds back over the last six months but I think could pay off in the longer term."
• Peter McGahan, managing director of World Wide Financial Planning, says:
"We like Aegon UK Equity – its managers adopt a practical, flexible and dynamic approach to identifying and acting on good investment opportunities. The fund, which typically holds between 70 and 90 stocks, is not tied to one particular style and the managers may change the portfolio to suit market conditions at any given time."
• Darius McDermott, managing director of Chelsea Financial Services, says:
"We prefer all-cap funds where the manager has flexibility to adjust the weighting between large, medium and small cap holdings. Artemis Special Situations is one we like: it is mainly mid-cap but moved around 60-70% into large caps for protection in 2008."
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Named after a high value gambling chip, the term is used for an investment seen as solid and whose share price is not volatile. Blue chip companies are normally household names and have consistent records of growth, dividend payments, stable management and substantial assets and are the bedrock of a pension fund’s portfolio.