How efficient is the UK market? Passive investing depends on share prices correctly discounting all there is to know about company prospects. Or, at least it should not be worth the fees of an active investment manager to spot the errors. But, for 30 years UK mid-caps have outperformed the FTSE 100. Why does this persist?
Companies in the FTSE Mid 250 range in size from £500m to £5bn. Alongside them, some of the largest businesses listed on the Alternative Investment Market are also as big as those at the lower end of the FTSE 100. Medium sized is a relative term – many of these are big businesses. But, despite the much larger number of medium sized businesses, these tend to be under the radar of the major investment banks and fund managers. The largest three companies listed on the London market – Royal Dutch Shell, HSBC and British American Tobacco – add up to more than the combined value of all 250 mid-cap businesses. It is understandable that more research effort is put into the most liquid shares, where dealing commission is more easily generated.
This can mean that a mid-cap company might only be researched by two or three broking analysts, whilst their bigger FTSE 100 counterparts are covered by 20 or more. With much less trading going on in mid-cap shares, which is what pays for research, they are a neglected area of the stockmarket. The economics of broking make it more likely that the market is efficient in the big stocks. That limits the value added for big active institutional managers, and supports the case for passives. If the prices are “right”, buying an index could make sense.
But, where coverage is lower, mispricing is more likely. And, that is what the data points to. Over periods of three years and more - up to the entire 30 year life of the FTSE Mid 250 Index - medium sized companies have outperformed. And, even taking risk and volatility into account, the extra reward still looks worthwhile. But, investment banks and stockbrokers do not see research in this area as worthwhile, given how hard it can be to deal in the stocks. However, research alone does not justify the inefficiency. In most markets, opportunity would be arbitraged out. For mid-caps, it seems that performance is not a secret – but it is hard for large funds to take advantage. The better growth in mid-caps is not being competed away. It is much harder for big institutional funds to participate in mid-cap growth, given the difficulty of building-up portfolio positions.
Typically, the best opportunity to buy into businesses as they grow, is when they float or raise further capital. But, the trend for some of today’s big winners to grow without additional funding, makes this difficult. Companies with scalable business models can often expand without additional investment. Fevertree Drinks, for example, is a marketing business that has developed a strong brand in a niche that other drinks firms had neglected. Contracting out manufacture means leveraging management capability rather than capital is its main challenge.
This capital-lite model is a key characteristic of disruptive businesses. Typically they must move quickly if they enter a new area, taking business from a longstanding incumbent. After initial listing, these companies may offer limited opportunity for institutional entry. Businesses such as Fevertree and online retailer, ASOS, are listed on AIM, but they may never move out onto the main stockmarket. With limited additional capital needs, they are not compelled to find new investors.
The Mid 250 is being boosted by the disruption that new technology brings. The Index contains more technology and high growth businesses, often attacking much bigger companies, and undermining long-standing brands and services. In this turbulent environment, major global businesses are no longer safe. Indeed, the biggest listed companies – oil, mining, banks, pharmaceuticals and tobacco – tend to be driven by the global economy. This puts them more at risk from trade frictions and currency volatility, and can mean they are less in control of their own destiny. Once, FTSE 100 companies were able to build moats around their businesses, using unique structural advantage, intellectual property or scale to protect margins. That has changed, and few investors talk now about blue-chips.
Investors need to re-assess business risk in the context of rapid technological change. Research and investment may be better channelled into mid-cap companies – an area where active managers can gain an edge. It may point to a world in which actives and passives can co-exist, each within their own areas of strength. Cost might drive investment in the biggest companies, but the Mid 250 could be the place for performance.
Disclaimer: SVM Asset Management Limited, its clients and/or employees hold positions in Royal Dutch Shell, HSBC, Fevertree Drinks and ASOS.
A version of this article was published on Trustnet on 15 November 2017