UK small and mid-caps have lost their appeal compared with what blue chips are now offering, according to Lazard’s Alan Custis (pictured). 
The co-manager of the Lazard UK Omega fund has been rebalancing his portfolio over the last few months towards stocks listed on the FTSE 100, due to their attractive dividends and relatively cheap valuations.
Since the start of the year the FTSE Small Cap and FTSE 250 indices have delivered a strong performance, providing returns of 10.18 and 15.78 per cent respectively, compared to the FTSE 100’s return of 1.66 per cent.
Performance of indices in 2015
Source: FE Analytics
As shown in the graph above, the indices only began to diverge substantially following May’s general election, which resulted in a stable Conservative majority government.
As a result, many investors sold out of global-oriented large-caps to reap the benefits of the UK economy’s new found strength and bought into smaller, localised stocks, which is why the smaller indices saw a boost in performance during May.
However, the huge sell off in UK large-caps between May and the end of June was arguably triggered by the uncertainty surrounding Greece, according to Custis, as global stocks were more likely to be affected by a European break-up.
“Obviously Greece has now been temporarily resolved, albeit kicked into long grass, and we’re not suggesting that won’t reappear in the future, but certainly for the time being with banks opening up in Greece it seems to have gone down in the priority of concern list from a market standpoint,” he said.
“What is interesting is that we had this post-Greece bounce [see above graph], so we’ve seen that macro concern come off large-caps and have therefore seen some of the valuation characteristics start to come back to the fore. Therefore the value as we see at the moment remains in large-cap relative to small.”
There are other macroeconomic factors aside from Greece that have contributed Custis’ decision to rebalance his portfolio, such as the fall in oil price over the last year.
The FTSE 100 has a 13.61 per cent weighting to the oil & gas sector, which means the index has inevitably suffered as a result – the poor performance of mining stocks will have also delivered a blow to performance.
Performance of indices in 2015
Source: FE Analytics
“To get more constructive towards large-cap you have to be more constructive towards sectors or some of those sectors going forwards, and we are certainly getting more constructive towards mining and oil & gas, which in aggregate still represent 15 per cent plus of the FTSE 100,” the manager said.
“We are getting to valuation levels that we think are starting to get quite compelling. If we look at the dividend yields of Rio Tinto at around 5.5 per cent, BHP Billiton at 6.3 per cent, they’re obviously high-yielding stocks now in the context of the stock market overall.”
Some investors would argue that the dividends may not be sustainable as a result of cash flow pressure caused by the low oil prices.
However, the analysis conducted by Custis and his team suggests that there is very little likelihood that mining giants such as Rio Tinto or BHP Billiton will be cutting their dividends.
“When you look at the dividends yields relative to the STOXX 600 we’re back to something we last saw in the latter part of two decades ago in the late 90s, at which point the mining sector performed very well off that last dividend,” he pointed out.
Source: Lazard Asset Management
“The last time we saw this sort of dividend yield relative [see above graph], we were at the point at which we saw some fairly strong share price performance, and you can say the same for price-to-book, which is again getting back to the levels we saw 20-odd years ago.”
Another reason Custis believes now is the time to buy into large-cap commodity stocks is that sector prices are in the first and second quartile of the cost curve, which means the production of most commodities is no longer profitable.
As a result, the manager expects companies to cut production levels, therefore re-balancing prices.
“The other factor that’s relevant is that the sector actually performs very well on interest rate increases and obviously we’re looking at the US tightening, most likely this year,” he added.
“The sector performs very well because, normally, we have interest rate increases because the economy is looking better and with the economy generally looking better, one would expect a degree of support to come in for commodities.”
“I think there are some interesting points now at this level with where commodity prices are, and obviously resources have been a drag on the market. As we move into the second half of the year, we may see more support of the backdrop to the market there.”
However, it cannot be ignored that the FTSE 250 has outperformed the blue chip index by more than 10 times over the last year, and is continuing to deliver a strong performance.
Performance of indices over 1yr
Source: FE Analytics
Custis says that mid-caps are far more sensitive to interest rate increases than large-caps, however, which could provide a major headwind for medium-sized companies in the near future.
What’s more, the national living wage increase that was announced in the emergency Budget earlier this month is likely to put a strain on industries where low-cost workforces are prevalent, such as restaurant and pub industries.
A further headwind to mid-caps, according to Custis, is the strength of sterling, which could make UK domestic companies less competitive compared to their European and global peers.
“You have a lot more of those domestic stocks represented further down the market cap spectrum,” Custis explained.
“Also, you’ve got the FTSE 100 yielding 4.2 per cent and the mid 250 yielding 2.9 per cent. I know interest rates are going up and therefore perhaps the race for income will be less pronounced going forwards, but as [Mark] Carney said, interest rates are going to peak at about half the previous peak, which suggests something like 2.25 per cent.”
“If I’ve got a company that I think is going to continue to pay 6 per cent, surely that still remains an attractive option for people? I think that yield attraction has to a degree been overlooked, and if we think that mid-caps are more UK-orientated and some of the welfare changes are going to take money out of people’s pockets, does that make those companies slightly less attractive?”
“I think it’s interesting to air the debate. But we do need stability and commodities, which we think we’re now getting down to a very low level. We are looking at a combination of the current economic backdrop and those attractive yields that we believe are sustainable.”
Over the last five years, Lazard UK Omega has returned 79.21 per cent, outperforming its sector average and benchmark by 11.33 and 22.01 percentage points respectively.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
The £83m fund has also managed to outperform both its sector average and benchmark over one, three, five and 10 years. It has a clean ongoing charges figure (OCF) of 0.96 per cent.
