Large Cap Revival in UK and Europe

Morgan Stanley Investment Strategies (Europe):

In October 2004, we published a trade idea on the large cap sector in the UK and Europe. We believe that the case for a large cap revival in Europe still holds and is even more evident now. Our Equity Strategy Research Group highlighted to investors the relative attractiveness of investing in the UK and European large cap sector compared to the mid and small cap. In this report, we reiterate our recommendation, highlighting the key factors supporting our views using recent data, and suggest practical alternatives for investors wishing to gain the relevant exposure.

The case for switching to large caps from mid and small caps in the UK and Europe remains compelling. On various valuation measures, small and mid caps appear expensive, trading at 15-year highs relative to large caps. On a Price/Book Value (P/BV) basis, mid caps currently only trade at a 9% discount to large caps, versus a historical average discount of 25%, and small caps only trade at a 15% discount to large caps, versus a historical average discount of 39%. A Price/Sales (P/S) comparison provides similar results. On the other hand, the Dividend Yield (DY) of mid and small caps has been falling in the past 6 years relative to large caps. Furthermore, based on forward earnings valuation measures, the story remains the same. 2006 IBES Price/Earnings (P/E) is 11.9 for large caps versus 12.9 for mid caps and 17.3 for small caps. 2006 Enterprise Value/EBITDA (EV/ EBITDA) is also lower for large caps (6.2) than for small (6.4) and mid caps (6.4).

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Large caps also appear to be of a higher quality compared to small and mid caps, having higher EBIT, EBITDA and Net Income margins and returns on invested capital. Large caps have also consistently had better FCF margins and yields and generally have had lower leverage compared to small and mid caps. Trailing FCF yield is currently 6.1% for large caps vs. 1.6% for small caps. Multiple catalysts which have historically led to large cap outperformance are present now or in the near future:

• Growth slowdown coupled with cyclical bias of small and mid caps. A large portion of the small and mid cap indices are made up of cyclical sectors. In total, cyclicals account for approximately 48% of mid caps and 51% of small caps, compared to just 23% of large caps.
• Fed rate hikes large caps generally outperform in Fed tightening cycles. Small caps underperformed large caps by 10% in the 1994 tightening cycle
• Flattening yield curve in the US this correlates with large cap outperformance

So how can investors make the most of thisIn the UK - Investors expecting outperformance in the UK market of Large Cap stocks over Mid and Small Cap can gain exposure to the differentials in returns through going long the FTSE 100 (Bloomberg: UKX / RIC: .FTSE) and short the FTSE 250 (Bloomberg:MCX / RIC: .FTMC).

In Europe - Investors expecting outperformance of Large Cap stocks over Mid and Small Cap stocks in Europe can achieve exposure to the return differential through taking long exposure to the DJ STOXX Large 200 (Bloomberg: LCXP / RIC: .LCXP) and short exposure to the DJ STOXX Small 200 (Bloomberg: SCXP / RIC: .SCXP) or DJ STOXX Mid 200 (Bloomberg: MCXP / RIC: .MCXP).

Moreover, for exposure to Europe, three recently launched Exchange Traded Funds (ETF) based on the DJ STOXX Large 200, DJ STOXX Mid 200 and DJ STOXX Small 200 indices provide investors with the means to gain long or short exposure to the large, mid and small cap sectors in Europe. For the UK, there are ETFs on the FTSE 100 and FTSE 250 listed on various exchanges