Dull companies can be investment winners

1 December 2009

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.

Worst performers

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."

Dividend test

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.

IFA recommendations

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."

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