No trumpets for the FTSE 100
Just because the index has hit 5000 again, don’t be tempted to chase it higher, warns Matthew Vincent Mrs Parker Bowles has done the City a favour. Not by obliging the Prince of Wales to substitute a municipal hall in Windsor for a return visit to St Paul’s, but simply by saying ‘yes’. In so doing, she knocked news of the FTSE 100 index breaking the 5000 barrier off the front pages of all but the more republican papers (namely the Independent, although oddly the Financial Times covered both the marriage and the market, in a ratio of eight column inches to one). And this, City commentators might argue, is something of a blessing if it serves to distract over-exuberant investors. To invert the old vaudeville joke about Cleopatra remaining Queen of Denial: Camilla, by saying yes, reigned over — and reined in — the Square Mile. At the very least, those questionable news values put the UK market rally into perspective. On the day before, with the FTSE closing up at 4995.5, Jeremy Paxman accused Newsnight’s business correspondent of behaving like ‘a small boy on Christmas Eve’. All that actually happened on 10 February itself was a 0.09 per cent rise in blue chip stocks, led by banks and oil companies. Given that in getting to 5000 the index had risen 46 per cent since March 2003, Newsnight’s reporter was coming late to the party — which is exactly what investors should not do now in the hope of heady returns, because the last thing the market needs, or can muster, is a rally based on so-called growth stocks.
This is all the more important to realise if you’re still nursing a hangover from the last spree: the tech boom of the late 1990s. Much has been made of the market returning to its level of two and half years ago — but remember that back then the FTSE hit 5000 on its way down from 6900. Anyone who remembers the Gartmore TechTornado fund, launched in the heady days of February 2000, will know how destructive chasing growth can be. Those were the days when the Wall Street analyst Henry Blodgett was issuing ‘buy’ notes on companies comprising two geeks and a laptop, while privately describing them as ‘a piece of crap’. This time round, if you want a piece of the genuine action, you want something other than a ‘new paradigm’ growth stock.
My Investors Chronicle colleague Chris Dillow has declared that the IT, pharmaceuticals, media and telecoms sectors are now ‘exgrowth’. Research by fund managers at F&C also suggests that growth stocks haven’t so much ceased to be, as never were in the first place. They have worked out that while the FTSE All Share index returned 117 per cent in the ten years to 31 December 2004, most of that was due to surges in the wider market on just ten random days. Strip out those ten days, and the growth drops to just 44 per cent — or 3.7 per cent a year.
Not surprisingly, many managers of growth funds have changed their approach. James Thomson of Rathbone Global Opportunities Fund now holds stocks in companies with ‘a focus on cash generation, barriers to entry and sustainable demand’. No laptop upstarts here. Likewise, F&C suggests that high levels of corporate cash flow, combined with the general economic environment, ‘should provide benign support for shares’. But ‘benign support’ doesn’t explain the impetus for the rally — nor provide much indication of where future gains may come from.
For that, you may be tempted to look to the lower reaches of the UK market. It is here among the ‘mid-cap’, smaller capitalisation and Alternative Investment Market (AIM) stocks — that there has been more excitement of late. If the FTSE 100 stocks have been relatively sober adults at the party, then Crispin Finn, manager of the Credit Suisse UK Mid 250 Fund, sees mid-caps as the teenagers. He says: ‘The right “parenting” skills are vital for companies to transform them from “spotty youths” to “presentable adults” and realise their true potential.’ They have been growing up fast. While the FTSE 100 rose 10.9 per cent in the 12 months to 25 February 2005, the Mid 250 was up 15.7 per cent.
Smaller stocks have grown even faster. Over the same period, the FTSE AIM index has risen 22.9 per cent. Go back further, and small caps seem to be in a perpetual growth phase. Hoare Govett’s Smaller Companies Index report reveals that £1 invested in the smallest 10 per cent of UK stocks at the start of 1955 would, with dividends reinvested, have grown to £1,821 by the end of 2004 — more than three times what you would have made by investing in the UK market as a whole.
But does that make them growth stocks? Arguably not. Before you put your £1 into Diddlysquat plc, consider four small-cap caveats. Remember first that, when looking at market indices, there is an inherent survivorship bias: the companies that fail simply fall out of the index. Second, remember that this risk of failure explains the ‘small-cap premium’: it is a reward for extra risk. Third, be aware that returns in the sector are usually calculated ‘with dividends reinvested’: it is the steadily profitable, cash-generative small-caps that deliver most of the returns. Fourth — and most importantly — bear in mind that professional investors now disagree on the future prospects for smalland mid-cap markets.
Crispin Finn’s teenage hyperactivity thesis is countered by Jamie Hooper, director of UK equities at F&C, who predicts that this year will see a reversal of 2004’s sharp performance disparity between the FSTE 100 and the FTSE 250 indices. The Mail on Sunday also detects a speculative bubble on AIM, particularly among small mining stocks such as White Nile, about which Martin Vander Weyer writes here.
Finding pure growth stocks with the FTSE at 5000 and the AIM market bubbling is, therefore, a thing of the past. Investors’ belief systems in the last four years have had to undergo a change akin to physicists’ in the last 400. Just as Newtonian laws of predictable motion have given way to Heisenberg’s Uncertainty Principle, so the mid-1990s bullish view of market cycles has been replaced by the fractal risk theory of Benoit Mandelbrot. Markets today, like Heisenberg’s particles and Mandelbrot’s fractals, seem to change direction as soon as you measure them. The ABN AMRO/London Business School Global Investment Returns Yearbook 2004 reveals a series of unpredictable reversals: the worst performing stocks of 2002 gave the best returns in 2003 and vice versa; in 2004, some of these trends reversed again.
Faced with these uncertainties, cautious investors are concentrating on what they can be certain of: picking stocks backed by solid profits, sustainable dividends and strong cashflows. In other words, they are now seeking growth from traditional income stocks. George Luckraft, the highly experienced manager of the Framlington Income fund, sums it up: ‘Lower total returns from capital growth will mean that dividends will play a more important role ... reinvesting the dividends of such a portfolio should deliver higher total returns than that of the broader market.’ Where the FTSE 100 goes doesn’t matter. If there was a time to buy a FTSE 100 index tracker fund, it was when we went to war in Iraq in March 2003 — in line with Nathan Mayer Rothschild’s adage: ‘Buy at the sound of cannon and sell at the sound of trumpets.’ On the day the FTSE 100 hit 5000, the announcement of the royal wedding was met by neither. So now is not the time to chase the index higher.
Matthew Vincent is editor of Investors Chronicle.
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