Why large is back in charge for FTSE stocks

After five years during which small and mid-cap stocks raced ahead, large cap stocks are coming into their own again. Could they help the FTSE set a new record over 7,000?

A major stockmarket trend of the past few years "could finally be breaking down", says Chris Brown-Humes in the FT. Small and medium-sized stocks are no longer racing ahead of their large counterparts. Since markets hit a low for the year on 5 March, large caps have had the edge in Europe, Japan and the UK, while in the US large caps outperformed in June.

In Britain, the FTSE 100 has gained around 10% and the FTSE 250 mid cap index is up 8.8%; this index slid by almost 5% in June, with 40 stocks tumbling by more than 10%. The FTSE 250 is down by 0.5% over the past three months, says Clare Francis in The Sunday Times, while the blue chips are up by more than 4.5%.

"Large is back in charge," reckons Goldman Sachs. Note that small and mid caps have been looking very pricy: across Europe, mid caps reached the top of their valuation range of the past four years, while large caps remain in the middle of their ranges. Moreover, small and mid caps do well in a rising market and when risk tolerance and global liquidity are high.

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But now earnings growth is slowing, which is likely to dampen returns from stocks, and higher short- and long-term interest rates are set to undermine liquidity and appetite for risk. Finally, mergers and acquisitions (M&A) have given smaller firms a fillip, but with many now expensive the number of suitable targets is dwindling. "It is telling", says Robert Parkes of HSBC, that in the UK M&A activity has moved from "the second liners to the FTSE 100". Lehman Brothers expects investors' preference for quality large caps to help the FTSE 100 set a new record above 7,000 this year.

The composition of the FTSE 250 also points to an uphill struggle for mid caps from here. It is more exposed to the domestic economy than the FTSE 100, with 54% of its sales stemming from Britain, compared with 40% for the blue chips. And five rate hikes in a year have buffeted the 250's retailers and house builders, says Francis.

The FTSE 100 is on a p/e of 12.5 compared with 19 for the 250 and 25 for the FTSE Small Cap Index, and the best opportunities are in the "megacaps", the very biggest firms, says Richard Buxton of Schroder Alpha UK Plus. They are now "cheaper than they were during the bear market".