Mid-caps, big returns The outlook for the FTSE 250 index

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1 Dominic Picarda CFA, CMT Mid-caps, big returns The outlook for the FTSE 25 index Contents The FTSE 25 s record 2 What drives the mid-caps 3 Valuations today 7 Tactical investing in mid-caps 9 Outlook for the FTSE thinkstockphotos Overall: Bullish Valuation: Bullish Momentum: Bullish The FTSE 25 has had a terrific run and not just lately. At its recent highs, the mid-cap index was up by some 171% from its credit-crunch lows of 28, compared to just 98% for the FTSE 1. The mid-cap index has also been a much better investment than the FTSE 1 over the last decade and more. As such, the FTSE 25 is not especially cheap right now, either in its own right or compared to its bigger brother. In this report, I examine the drivers of the index s success and consider whether it s still worth buying, as well as the best moments for getting in and out of the market. I also explore a trendfollowing approach that has produced more than double the return of buying and holding the FTSE 25 over time.

2 The un-squeezed middle Mid-caps have been a better bet than large-caps over time Medium-sized stocks in the UK have been a cracking investment over time. Since its creation in 1985, the FTSE 25 has trounced the FTSE 1. In price terms, the mid-cap index went up by almost 9% between December 1985 and May 213. The FTSE 1 was up only 366% over the same period. Mid-caps win the day FTSE FTSE Assuming the reinvestment of all dividends, the FTSE 25 s return was 246% since 1985, while the FTSE 1 s was %. The mid-caps dominance really started around 1999, since which time the FTSE 25 has beaten the FTSE 1 in ten years out of fourteen. 2

3 The drivers of the mid-cap index It s not just a matter of size - style factors are also at play How do we explain the FTSE 25 s superior returns over time? Financial theory suggests that medium-sized stocks should earn more than their large-cap brethren because they are riskier. Defining risk as volatility, this does appear to be the case. The standard deviation of the FTSE 25 s average annual total return since 1985 has been 2.8%, compared to 16.2% for the FTSE 1. However, if size were the only factor involved here, the FTSE SmallCap index which contains even smaller-sized stocks than the FTSE 1 and FTSE 25 would logically come out on top of the heap. In fact, though, its total return since 1985 has been similar to that of the FTSE 1, but with even more risk than the FTSE 25. FTSE 1 FTSE 25 FTSE Small Cos Average annual total return (%) Volatility (%) What else might help explain mid-caps superior showing? Over time, there is a wealth of academic and practical evidence that suggests that buying value stocks beats buying growth or dear stocks. Perhaps, then, the FTSE 25 contains more value stocks than its peers. 3

4 If this were the case, though, we might expect the index to do especially well at the same times when value stocks are beating growth stocks. This black line on this chart shows the performance of the MSCI UK Value index versus that of the MSCI UK Growth index. The red line is the FTSE 25 s performance versus the FTSE 1. Unclear ties: value and the FTSE Value v Growth FTSE 25 v FTSE The mid-cap index has tended to do better than its large-cap counterpart during many of the same times that value was beating growth. However, the relationship is not particularly consistent over time. Indeed, it has appeared to have reversed just lately, as well as at other key moments in recent history. 4

5 While value may be part of the story here, it is far from the only factor. The economic cycle also appears to influence the FTSE 25 s performance. Specifically, mid-caps typically strengthen as the economic outlook improves, as measured by an upswing in the OECD s leading indicator for the UK. Improving outlook, rising mid-caps 8 6 OECD UK LI, 12m% v 1, 12m% Economic recoveries such as in the early 199s and after the credit crunch meltdown have seen the FTSE 25 outpace the FTSE 1. One possible explanation here is that the mid-caps are made up of more cyclically-sensitive businesses such as industrials and consumer-discretionary firms - and fewer defensives. Another explanation is that an improving economic outlook emboldens investors to buy riskier, medium-sized shares over safer, larger ones. We can cross-reference this theory by examining the FTSE 25 s relative performance to the FTSE 1 compared to that of defensive and cyclical equities. 5

6 The cyclical and defensive indices shown here are of my own construction, consisting of equally-weighted positions in a selection of objectively-determined cyclical and defensive sectors. Mid-caps are more cyclically-orientated 8 6 Defensives v cyclicals FTSE 1 v FTSE Mid-caps have done better compared to large-caps at the same time when cyclicals have beaten defensives. It is therefore worth our watching defensive and cyclical valuations for clues about where the mid-cap index may be heading next. 6

7 Mid-cap valuation today The dividend yield is the key metric to watch The FTSE 25 has risen very strongly indeed from its depressed lows of October 28, gaining more than 171% over the five-and-a-half year period. The natural suspicion after such a powerful uptrend is that the index might be somewhat expensive. Since the data began in 1993, the FTSE 25 has traded on an average multiple of 19.4 times trailing earnings. Today s multiple of 21.6 is almost one standard deviation above the long-term average. Mid-cap multiples s.d. dear average 15 1 s.d. cheap Trailing PE has not been a meaningful guide to future returns in the mid-cap index, however. 7

8 In statistical terms, today s PE has explained around 2% of subsequent twelve-monthly returns. I usually prefer looking at the dividend yield in these situations. Dividends are an actual cash payment to shareholders, and a critical part of the total return, whereas earnings are merely an accounting concoction. FTSE 25 s dividend yield over time s.d. dear 1 s.d. cheap The dividend record for the FTSE 25 also extends back to the index s birth in 1985, giving us a much fuller picture of the trend. This valuation metric has been a much more helpful predictor of price performance in the index than the price/earnings ratio. The level of the yield has explained around 1.6% of subsequent twelve monthly returns. This rises to almost 17% over a two-year investment horizon. Since 1985, the average dividend yield on the FTSE 25 has been 3.3%, compared to a reading at the end of May of 2.6%. While somewhat expensive more than one standard deviation below average - this need not trouble us unduly. 8

9 Heading into the big top of 27, the dividend yield got down to as low as 1.9%. A yield such as today s has on average given way to a capital return of 1.4% over the next twelve months, with the index rising slightly more than three-quarters of the time. Tactical investing in the FTSE 25 Mechanical trendfollowing has beaten buy-and-hold in the mid-caps Although important, valuation has its drawbacks when used for tactical investment purposes. Deployed in isolation, value-based investing risks can cause us to exit a dear but strongly rising market, thereby foregoing potential profits. Likewise, it can persuade us to re-enter a falling market before a genuine low is in. For this reason, it is worth taking momentum into account. I have therefore developed a straightforward trend-following model for tactically investing in the mid-cap index, whose signals would have handsomely beaten buying and holding the FTSE 25. Riding the mid-cap waves 9

10 The model seeks to catch strong uptrends in the FTSE 25 and to get out of the market during downtrends, wherein proceeds are invested in cash at a LIBOR rate of interest. Simply buying and holding the mid-cap index would have produced an annualised total return of 12.3% a year since the FTSE 25 s creation in The strategy proposed here would have produced an annualised return of 16.5%. Put another way, a 1 investment in the index held throughout the period would have become 2424 by the end of May 213. The same 1 invested in the system proposed here would have become What s more, this vastly superior performance was achieved by taking on much less risk. Buyandhold System Annualised return Volatility Sharpe ratio The standard deviation of returns from buy-and-hold was 17.2 per cent, compared to just 12.4 per cent for my approach. The model has not demanded heavy trading activity, having generated some 25 round-trip trades in the period. Of these, 14 were winners and 11 were losers. The average winner racked up a profit of 28.8%, while the average loser was just 2.1%. An overview of the trades is shown here. This model is ideal for tactical investment via an exchange-traded fund or other tracking product and we will update its signals and performance going forward. 1

11 Summary of trades Average trade return (%) 15.2 Average trade (weeks) 4 Best trade (%) 14.7 Worst trade (%) -4.2 Average winner return (%) 28.8 Average loser return (%) -2.1 Winners (%) 56 Losers (%) 44 Win return/lose return (X) 13.9 Average worst drawdown per trade (%) -4.3 Most consecutive losers (#) 3. Longest period out of market (weeks) 138. Average out-of-market (weeks) 13.2 Outlook for the FTSE 25 The prospects for the coming twelve months are modestly bullish While the FTSE 25 has had a terrific run since its lows of October 28, neither the strength of the gains nor their duration should worry us unduly. The mid-cap index s last bull run was even greater, taking the market up by 225% versus only 171% today. Technically, it is less stretched, especially since it had a substantial dip in 211, which was not the case during The valuation today as measured principally by the dividend yield is much less stretched than that of the last major high in 27. There is probably further scope for the index to head up to a new record high above 16,. My model s last buy signal was in June last year and the uptrend is well intact for now. My aim would be to use the end of the summer correction in the market to go long, even absent another buy-signal from my model. 11

12 The Financial Times Ltd 213. Investors Chronicle is trademark of Financial Times Ltd. Financial Times and FT are registered trademarks and service marks of the Financial Times Limited. All rights reserved. No part of this publication or information contained within it may be commercially exploited in any way without prior permission in writing from the editor. Material (including tips) contained herein is for general information only and is not intended to be relied upon by individual readers in making (or refraining from making) any specific investment decision. Appropriate independent advice should be obtained before making any such decisions. Financial Times Business Limited does not accept any liability for any loss suffered by any user as a result of any such decision. Do remember, particularly if you are new to stock market investment, that the prices of shares and other investments can fall sharply. You may not get back the money you originally invested. Past performance is not necessarily a guide to the future. In comparing the investments described in this publication, you should bear in mind that the nature of such investments and of the returns, risks and charges differ from one investment to another. Smaller companies with a short track record by their nature 12

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