Mind the gap between small and large-cap valuations – it could be about to close
For investors, big hasn’t been so beautiful. The divergence in performance between firms in the FTSE 100 and smaller ones in the FTSE 250
over the past three years has been as striking as it has become perplexing.
Imagine you had the good luck – no doubt you’d portray it as good judgement – to have piled all your money into the FTSE 100 at the time of the invasion of Iraq in March 2003. You were fortunate/ canny enough to catch the market at its very bottom. Since then, you would have seen your investment rise 80% or so.
Satisfying enough, certainly. But what if you were even luckier, even smarter, and had put your money into the FTSE 250 at its nadir that spring? Then you would be showing a 150% gain. Remember: the FTSE 100 is still well below its dotcom-driven peak at the end of 1999. Yet, until the nervousness of the past four months took hold, the FTSE 250 had been setting record after record.
The divergence in performance has brought a corresponding gap in valuations. The price of a stock in the FTSE 250 is, on average, around 16 times expected earnings per share. For the FTSE 100, the ratio is a much more modest 12 times earnings.
There are partial explanations. The FTSE 100 is dominated by three sectors. Oil firms, banks and pharmaceuticals between them account for more than half of the index’s total capitalisation. Oils and banks are on lowly price/earnings ratios. That’s enough to drag down the average for the index as a whole. Among small- and mid-cap stocks, oils, banks and pharmaceuticals make up just 6% of total capitalisation.
Furthermore, well over half the earnings of FTSE 100 companies come from overseas operations. The current jitters about the medium-term health of the US economy are bound to weigh upon investors’ minds. And the price of oil companies implies that few believe crude will continue to trade at anything like $70 a barrel.
But surely this is not enough to explain the magnitude of the gap. By most conventional measures, it appears – at the risk of vastly over-simplifying – that big stocks are cheap. The best value to be had is among the top-liners.
Now turn to goings-on in the US.
We recently saw the world’s largest-ever leveraged buyout when healthcare group HCA willingly succumbed to a $33bn takeover by a consortium of private-equity firms. In nominal terms, this beats the previous record, the $31.3bn that KKR paid for its notorious takeover of RJR Nabisco in 1989. On this side of the Atlantic, Ferrovial’s acquisition of BAA was effectively a leveraged buyout and valued the airports operator at more than £10bn. That set a new UK record.
Research published this week by UK equity strategist Robert Parkes of HSBC asks a pertinent question: is any UK company safe anymore? All but 20 have a market capitalisation of less than the $33bn benchmark set by the HCA deal. A repeat of KKR’s takeover of RJR Nabisco would be worth $52bn today. There are only 14 UK listed companies with a higher market capitalisation.
In other words, to answer Parkes’s question, it seems there are very few companies that are now safe from potential leveraged buyouts. Venerable names such as BT, Diageo and BG all appear to be within the grasp of the new, friendlier, barbarians at the gate.
Of course, this is a simplistic calculation. It takes no account of a target’s corporate debt that any predator would have to inherit with its acquisition. It makes no allowance for the premium that a bidder would have to pay to secure control. But as a broad point, it is a good one.
We can no longer dismiss the idea that large FTSE 100 companies are beyond the reach of private-equity bidders.
By one calculation, the capital currently available to buy out funds now stands at around $300bn. And that, remember, is just the equity component. Potential borrowings are many times that number. The fire-power is enormous. Now, combine these two ideas – that large-cap stocks are relatively lowly rated and that the scale of funds that can be mustered for private-equity bids is becoming larger.
Maybe, just maybe, we are going to see the gap in valuations between top tier – for which read FTSE 100 – and second-line (FTSE 250) stocks – begin to converge. It seems logical.
And if that happens, it will, in part, be driven by the increasing influence of private equity. It is not necessary for bids actually to happen; the mere possibility should be sufficient to do the trick. If the stockmarket fails to appreciate the true worth of a company, then private equity will expose that failure – however big the target.
Freelance journalist Ben Laurance is former editor of Financial Mail on Sunday and The Observer Business section. Simon Nixon is away