Where should clients be positioned on the market cap spectrum?

The immediate aftermath of the UK’s vote to leave the European Union (EU) saw a rough and ready consensus develop among UK equity investors.

This was the notion that the fall in the value of sterling relative to other currencies would mean that companies with overseas earnings would benefit, and businesses with a focus on the UK domestic economy would, deservedly, fall from favour.

Such an approach pointed firmly to investments in the FTSE 100, where over 70 per cent of earnings come from large caps, compared with about 50 per cent in the FTSE 250.

Mid-cap momentum

Yet despite such data, it is the mid-cap market that has performed better over the past year, with the FTSE 250 index returning a negative 5.21 per cent, compared with a negative 5.91 per cent for the the large-cap index.

Such data has prompted Alex Wright, who runs the Fidelity Special Situations fund, to turn more of his attention to large-cap shares.

Mr Wright says a myth has developed among market participants that mid-caps have performed poorly, and this has prompted many investors to focus on that part of the market for value, when, in truth, large caps are where the underperformance has happened, and, in his view, this is where the value lies. 

We consider that investors should be careful not to have too much in the mega caps because this may lead to concentration within certain sectors such as oil, mining and pharmaceuticals.John Goodall

Simon Gergel, who manages the £693m Merchants Investment Trust at Allianz Global Investors, points out: “There are opportunities across the market cap spectrum. We have exposure to large mining, oil and pharmaceutical companies, as well as to small media and services businesses.”

Andrew Walker, portfolio manager at Walker Crips, explains the UK's looming exit from the EU has not changed how he manages the portfolios he runs for clients.

He says he has always used a multi-cap investment approach as this provides maximum flexibility, and he is persisting with this because he does not know what will happen to the UK market after Brexit. So a multi-cap approach means he is minimising risk by having a diversified portfolio.

Graham Bishop, investment manager at Heartwood Investment Management, says if there is a 'no deal' Brexit, then it is likely the value of sterling would fall sharply relative to other currencies, and, because of the overseas earnings of the larger companies, he would expect the small and mid-sized companies to perform poorly relative to larger businesses.

But Judith Mackenzie, who runs a range of small-cap funds at Downing, believes the advantage very small companies have - those she defines as having a market cap of less than £150m - is that those businesses tend to operate in niches which mean they don’t need strong economic growth to prosper.

Jamie Clark, manager of the Liontrust Macro Equity Income Growth fund, says: "Reordering the portfolio in anticipation of a singular event isn’t part of our approach. It would be short-termist and may leave the fund on the wrong side of a binary trade."

Noises off

But what to make of Brexit political noise?

"We’d suggest that ‘noise’ is the operative word," says Mr Clark. "The referendum gave an immediate fillip to UK equities with non-sterling earnings: consumer staples, tobaccos and pharmaceuticals thrived.

"Brexit was harsher on UK companies with material domestic exposure. Of the worst performing UK large-caps on the day after the vote, UK sales averaged more than 80 per cent of total revenues. Housebuilders, life insurers and banks bore the brunt.”

Mr Clark says he expects the share prices of domestic earning companies to recover as the market gets more clarity about Brexit. 

But it is worth noting that the companies he has invested in that derive the greater part of their revenue from within the UK are large-cap businesses, such as Lloyds and St James’s Place, rather than mid or small-cap shares.

Dan Whitestone, manager of the £536m BlackRock Throgmorton Trust, notes he has changed nothing as a result of Brexit, with the decline in the valuations of domestically-focused small-cap shares not tempting him.

Mr Whitestone says his portfolio continues to focus on companies with global earnings.

John Goodall, head of private client research at WH Ireland, suggests: “We consider that investors should be careful not to have too much in the mega caps because this may lead to concentration within certain sectors such as oil, mining and pharmaceuticals.

"It is still possible to pick out winners across the market spectrum and we do have a bias to overseas earners because they tend to offer superior growth prospects to the UK dependent on client requirements.”

david.thorpe@ft.com