Financial Times: Unfashionable megacaps await change in fortunes

EXTRACT: THE ARTICLE: BP and Royal Dutch Shell have been hit by lower oil prices, concerns over the future of their Russian operations and (in BP’s case) a series of problems in the US.

By Christopher Brown-Humes: Published: November 25 2006 02:00 | Last updated: November 25 2006 02:00

When it comes to investing in the UK stock market, big is definitely not beautiful. Mid-cap stocks have been outperforming the large-cap stocks for a long time. But even within the large caps there is a discrepancy; the real underperformers have been companies at the very top of the FTSE 100, megacaps such as BP, GlaxoSmithKline and HSBC.

This is an extraordinary turnround from the late 1990s, when companies such as Vodafone were driving the market higher and trading at a substantial premium to smaller companies. Today, it is the other way round. Citigroup notes that the top 20 FTSE 100 stocks – the FTSE 20 – are trading on an average 2006 price/earnings ratio of 11.9 times. The bottom 80 stocks in the FTSE 100 are trading on a p/e of 16.7 times, very close to the 17.0 p/e for the mid-caps. The megacaps also generate higher yields. The FTSE 20 is yielding 3.5 per cent, against 3.1 per cent for the FTSE 80 and 2.6 per cent for the FTSE 250.

There are specific reasons why some of the megacaps are out of fashion. BP and Royal Dutch Shell have been hit by lower oil prices, concerns over the future of their Russian operations and (in BP’s case) a series of problems in the US. GlaxoSmithKline and AstraZeneca have struggled because of worries about the quality of their drug pipelines.

But broader themes are also affecting the FTSE 20. One of the main reasons why they are out of fashion is that they are unlikely to be acquired in the ongoing merger and acquisition frenzy.

M&A activity has been concentrated in the FTSE 250 sector, but is also having an impact on the FTSE 80, where companies including O2, P&O and BAA have been bought and where Scottish Power and ITV are currently being targeted. Crucially, FTSE 80 companies are deemed tobe within striking range of private equity companies, whereas FTSE 20 companies – which all have market capitalisations above £20bn – are not.

There is evidence that pension funds have been selling out of megacap stocks and reinvesting the proceeds in areas like private equity, which then recycles the money back into lower reaches of the market.”If you go long of megacaps, you are going short M&A,” Citigroup notes.

There is a paradox here. FTSE 20 companies are cheap to acquire,but too big, while FTSE 80 andFTSE 250 companies are stillbeing bought in spite of being more expensive.

Another drag on performance is the weak dollar. Many of the FTSE 20 earn significant amounts of their revenues in dollars – either from direct sales or because they deal in dollar-denominated assets, such as oil and metals. Yesterday sterling hit an18-month high against the greenback at $1.93, putting further pressure on UK exporters.

Then there are worries about low organic growth and the price that the megacaps might have to pay to buy it. Some of them have still not been forgiven for the deals they did during the last M&A boom at the turn of the decade. Neither Glaxo’s merger with SmithKline nor Vodafone’s acquisition of Mannesmann has delivered value for the shareholders of those companies. The concerns linger: for example, Vodafone has been accused of overpaying for acquisitions in emerging markets and Royal Bank of Scotland has struggled to convince shareholders that it is not planning large overseas acquisitions.

A final factor may be that changes in investment styles are working against the megacaps. There is, for example, more emphasis today on absolute returns (as opposed to relative returns) as well as an increased emphasis on alpha – or returns not linked to the overall level of themarket. As a fund manager, youare likely to get more outperformance from your best-performing mid-caps than your best performing megacaps.

None of which is to say that mega-caps won’t come back into fashion at some point. The question is, what will be the catalyst?

A flight to safety might help, as some of the FTSE 20 stocks aredefensive, such as Tesco and British American Tobacco. Even this is not certain, as the biggest component of the FTSE 20 is banks. A change in the dynamic of the M&A market, whereby debt became more expensive or aleveraged buy-out went spectacularly wrong, would probably have a bigger impact.

Of course, megacaps can take actions of their own. Restructuring – selling off parts of the business, for example – might help. So might even bigger share buy-back programmes than we have seen so far. But thecatalyst for their return to favour may well be something outside their direct control.

Copyright The Financial Times Limited 2006