I spend most of my time hunting for exciting small company shares. One of the joys of investing in this corner of the stock market is that our returns are largely down to the performance of the company itself. It’s a very simple proposition. If our business grows rapidly, then its shares will respond to the higher profits. Usually this will happen regardless of the broader market conditions.
In contrast, very large stocks – the sort of household names that populate the FTSE 100 – will find their financial performance is much more influenced by the economy. Good management can make a difference; but an innovative new product or a big contract win will be unlikely to change the prospects of a £5bn company whereas it can be transformational with one valued at £50m.
But what happens when the stock market is due a sharp correction? Bucketloads of ink are spilled speculating on this question. And it’s not all wasted: if we can spot those key turning points with some success (sell in 2007 and buy back in 2009), then we will make a huge difference to our investment returns.
But as far as I’m concerned that’s just the wrong way to invest. Let me explain why I believe that.
The FTSE is a very confusing beast
The usual thing for investors to focus on when talking about equities is the valuation of ‘the index’. The big problem is that the answer to this valuation question can be highly misleading. It’s misleading not just because there are many ways of calculating ‘value’ (p/e, cyclically adjusted p/e, yield, Tobins Q, Fed model etc etc). The bigger issue is that ‘the index’ itself is a confusing beast.
Take the UK market as a classic example. Most pundits focus on the FTSE 100 which is a market-cap weighted index. That is to say that its level and valuation are heavily influenced by the biggest companies – indeed the largest ten stocks account for a whopping 43% of it. In fact, half your investment will be in two broad sectors: oils and basic resources (35% of the FTSE 100) and banking (15%). These are lowly rated sectors for obvious reasons: they are not growing very quickly and they consume lots of capital.
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They are also responsible for pulling down the valuation of ‘the market’. According to Deutsche Bank, the FTSE 100 trades on a price/earnings (p/e) of 13.2 times this year’s earnings. This looks much cheaper than the Mid 250 index on 16.1 times and the Small Cap index on 18 times. So we might conclude the FTSE 100 is the place to be since it’s so much ‘better value’. Wrong! That apparent cheapness is down to its huge exposure to some struggling sectors.
If you want to think about valuation for the typical UK stock, then it’s best to look at the Mid 250 where the p/e is higher, but so is the growth rate. Deutsche have this falling to 14.5 next year, followed by 12.8 using 2015 profits. In other words, you get more for your money. And despite being more expensive, the Mid 250 has risen by 21% this year compared with the ‘better value’ FTSE 100 up just 11%. Small companies have done better still, up by almost 25%.
A cautionary tale from Russia
Russia, my old stamping ground, is the most extreme example of this index composition problem. A lot of pundits are recommending Russia because “the market is cheap”. After all, they say, it’s on a ridiculously low p/e of only five. What can go wrong? Now I am not arguing that they are mistaken to like this market; but it is well worth looking a little more closely behind the numbers.
We might think such a bombed out rating means that investors hate Russia to the point of irrationality and that everything is being given away far too cheaply. The best listed company in Russia by a long chalk is a supermarket retailer called Magnit (MGNT on the LSE’s International Order Book). It’s a great stock and was my long-standing favourite. It trades on a p/e of 27 times 2013 earnings according to VTB Bank and is up 44% this year. So much for rock bottom valuations!
However if you buy into a Russian index you’re not getting much Magnit. You are getting lots of lowly rated oil and gas. Kremlin controlled oil and gas comes even cheaper! Gazprom is a much bigger company than Magnit and trades on a p/e of just three. Of course, you can make money by trading Gazprom shares but they offer a pretty unappealing prospect for long-term investors.
The lesson is: be careful when looking at the valuation of a market. Focus on exactly what is in the index you are buying into, rather than just its valuation. Finding exciting individual stocks is much more straightforward proposition. And is usually more rewarding.
• This article is taken from our free twice-weekly small-cap investment email, The Penny Sleuth. Sign up to The Penny Sleuth here.
Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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