As investors attempt to make sense of record high stock markets and political uncertainty, the question of ‘quality’ has become increasingly prominent. Debates around quality are framed in several ways, but more recently the discussion has concentrated on the apparent decoupling of large stocks and their smaller counterparts. This phenomenon is best illustrated in the U.K. where mid-caps, as defined by the FTSE 250 index, have outperformed the large-caps, the FTSE 100, by more than 100% over the past 15 years.
Many have concluded that a size premium genuinely exists in the U.K. because the companies underlying the FTSE 250 index grow earnings at a superior rate to large companies. But to conform to this theory, it is worth re-iterating what is meant by the size premium and to investigate the underlying composition of the index.
Question the Size Premium
The size premium was described by Nobel laureate Eugene Fama and his fellow researcher Kenneth French who identified the fact that smaller companies consistently provided higher returns than large companies over long periods of time. This insight has become one of the most widely used inputs into the asset allocation process and accounts for the fact that most equity funds have a structural bias towards smaller companies.
While we respect the foundations and logic that underpin this body of research, as investors, it is important to note that not all performance is attributable to a ‘single factor’. Just as French and Fama have since found that there are at least five factors that influence performance; size, value, market risk, profitability, investment, we can’t explain all the performance by any one factor.
Equally, as investors, we need to look beyond simple mathematical relationships and understand the fundamental drivers of these results. This understanding is embedded in Morningstar’s ‘building blocks’ approach to estimating returns. Rather than simply estimating a total return of an asset class, we divide asset returns into the key fundamental drivers and scrutinize each of these individually.
By doing this, we believe that we gain a better estimate of the overall return of the asset class and are less dependent on historical relationships and heuristics. It is this approach that causes us to question the superior performance of mid-cap on the basis of size alone.
FTSE 100 versus FTSE 250
We find that the outperformance of mid-caps in the past decade, especially in the U.K. but also in Europe and to a lesser extent the U.S., has been mostly attributable to the difference in earnings.
When we think about the drivers of earnings, it is necessary to go beyond the headlines and look at whether the profitability is being driven by revenue growth or profit margins, as the latter tends to have a tighter baseline and is harder to sustain as a competitive advantage. What we find is that the attribution in the U.K over the past 15 years weighs heavily in favour of profit margins, which have diverged dramatically relative to revenue growth.
Perhaps due to this profit margin growth, we have also witnessed valuation measures such as the cyclically-adjusted price-earnings ratio and price to sales ratio increase at a faster rate than their large counterparts as investors increasingly price in a continuation of this trend into the current price.
In order to justify these higher prices, we would typically expect the underlying companies to have a superior business model and consequently be of higher ‘quality’ than its peers. This is something value investors need to be mindful of, as a bias towards low margins could lead unaccustomed value investors to favour poorer quality companies. In an ideal world, we want to be informed by quality, with the assessment of ‘fair value’ acting as a hurdle rate and accounting for the greater stability of cash-flows.
Knowing that we should adjust for quality, it may be possible to explain the mid-cap superior earnings growth by looking at the sector exposures of the FTSE 250 and comparing this to the FTSE 100. If the mid-cap superiority would be explained in this chart, we would see a clear bias in sector exposure towards ‘higher quality’ industries. However, as we can see below this is only marginally the case.
The question in a forward-looking context is whether the FTSE 250 could be expected to deliver superior performance going forward.
What we find is a situation that is not so clear cut. While the FTSE 250 has delivered superior earnings growth over the past 15 years, the fact a large portion of this has been derived by stretching profit margins is of some concern, especially given the ‘quality’ element is not particularly convincing based on our initial findings. We also have the issue about Brexit, especially as the pound sterling experiences abnormal volatility and influences bottom-line earnings.
As only 25-30% of large-cap revenue is derived onshore, a rebound in sterling would hurt the FTSE 100 far more than the FTSE 250, which obtains approximately 50% of its revenue domestically.1 Of course, the same applies in reverse. In addition, there are concentration issues that must be understood by investors. As one such example, the top 10 holdings in the FTSE 100 account for approximately 43 per cent of the exposure versus just 11 per cent for the FTSE 250. Therefore, mid-caps provide greater diversification benefits at a stock selection level.2
What Lessons can be Applied?
To make the analysis simple to absorb, we can boil any outperformance advantage to a few key variables in a forward-looking context. In order for the FTSE 250 outperformance to be repeatable and the apparent size premium to be maintained, we would need to see:
a) Profit margins continue to expand (highly unlikely);
b) The pound sterling to rebound (potentially likely, albeit with further drawdown risk);
c) Cyclically-adjusted price-earnings multiples to further expand (unlikely); or
d) An alternative ‘factor’ influence pricing.
It is worth disclaiming that our team are undertaking further fundamental digging at a sub-industry group level, for example, mid-cap financials are very different to a large-cap bank, as well as the continued work around pound sterling valuations amid Brexit. Withstanding the above, the early evidence is unconvincing that the mid-cap space will continue to act as a superior investment on the basis of size alone.
