The FTSE 100 features the 100 largest UK listed companies and are referred to as large cap or blue chip stocks. The next 250 largest listed companies form the FTSE 250 and are referred to as mid-cap stocks. Investors tend to focus on the FTSE 100 but the FTSE 250 has handsomely outperformed its larger rival.
In December 1999 the FTSE 100 hit a peak of 6,930 and currently stands 7% below this level at around 6,400. Over the same 15 year-year period the FTSE 250 has increased by 165% from 6,400 to around 17,000.
Both performances exclude dividends and the FTSE 100 has delivered a higher dividend yield than the FTSE 250. Nevertheless, the total return of the mid-cap index still trumps that of the FTSE 100.
FTSE 250 since 2000: worth looking toward mid-caps?
It is easy to buy into the FTSE 250 through low cost Exchange Traded Funds (ETFs) that are listed on the LSE. Vanguard’s FTSE 250 ETF (LSE: VMID), for example, has an ongoing charge of only 0.1%.
The key issue for investors is whether the FTSE 250 is set to continue to outperform the FTSE 100. To help answer this question we need to evaluate the drivers of the both indices and see if they are set to remain in place.
Drivers of FTSE 100 underperformance
The weakness of the FTSE 100 is typically attributed to its sector exposure with banks and resources two overweight areas. The five largest FTSE 100 stocks include two oil companies, a bank and a mature pharmaceutical company.
FTSE 100 makeup at September 2015
Source: Deutsche Bank FTSE 100 ETF factsheet
We have seen the banking sector face major headwinds since 2007 with Royal Bank of Scotland and Lloyds having to be bailed out. The resource sector is also currently seeing weakness on the back of lower commodity prices.
The FTSE 100’s exposure to cyclical sectors has meant that it suffers during downturns and takes a long-time to recover. This was evident in both the post-2000 downturn and also the post-2007.
FTSE 100 since 2000
The FTSE 100 is also exposed to the fortunes of its largest companies with the top ten stocks dominating the index. As such issues at individual companies, such as BP, can have a meaningful impact.
It is also worth noting that FTSE 100 companies generate around 70% of their revenue from outside the UK. This can be beneficial but does reduce the exposure to the domestic UK economy.
Larger companies can also perform poorly on account of their size and may have less scope for growth. A lack of focus and more bureaucracy can mean weaker decisions such as HSBC’s takeover of Household before the credit crunch.
FTSE 100 firms are also often the product of takeovers and mergers where the long-term benefits are questionable. GlaxoSmithKline is the result of a merger in 2000 but the performance of the group has recently been poor.
Bigger isn’t necessarily better when it comes to the long-term performance of listed companies. It can mean less management oversight with the shareholder base widely distributed between financial institutions.
Drivers of FTSE 250 outperformance
Turning to the FTSE 250 and it is not dominated by its largest constituents with the top company only 1.36% of the index. The largest FTSE 250 stock is worth £5bn while the 30th largest is not far behind at £2.8bn.
In the FTSE 100, by contrast, the largest company is worth £114bn while the 30th largest is worth only £15.8bn. The largest company in the FTSE 100, Shell, is worth around 6% of the index.
FTSE 250 makeup at September 2015
Source: Deutsche Bank FTSE 250 ETF factsheet
The FTSE 250 also features stocks that have a greater focus than their FTSE 100 peers. The largest FTSE 250 real estate group, for example, is Derwent London, which focuses on London commercial property.
The largest FTSE 100 real estate group is Land Securities which is a more diversified business. It is unlikely to be a coincidence that Derwent London has significantly outperformed Land Securities since 2000.
FTSE 250 stocks also have more scope to grow than their peers in the FTSE 100 index. This may explain the tendency for them to retain a greater proportion of their profits to reinvest in expansion.
FTSE 250 stocks are also more exposed to the UK than is the case for FTSE 100 stocks. This can have advantages and disadvantages but it appears to have worked out well since 2000.
In terms of the sector exposure and the FTSE 250 has a heavy weighting in the financial sector. However, the main focus is consumer credit companies, asset managers and investment trusts rather than banks.
The largest company in the FTSE 250 is the consumer credit business Provident Financial. The business has performed well for investors since 2000 despite the impact of two major downturns and the credit crunch.
In terms of resources and at September 2015 the FTSE 100 had nearly a fifth of its value in basic resources and the oil and gas sector. For the FTSE 250 the figure was less than 7% and as such it is less exposed to the Chinese slowdown.
Will the FTSE 250 continue to outperform?
The factors that saw the FTSE 250 perform well since 2000 appear to remain in place. The index is well diversified and features focused companies that are investing to grow their businesses.
The FTSE 100, by contrast, still has a meaningful exposure to the banking and resources sectors. These are cyclical industries that see significant weakness during downturns.
If the global economy sees an upturn then the FTSE 100 might outperform the mid-cap index. However, over the long-term the FTSE 250 appears to be well placed to outshine its larger rival.
At September 2015 the P/E for the FTSE 100 was 16.92X and the dividend yield came in at 4% (Deutsche Bank ETF factsheet). The FTSE 250 had a P/E at 16.77X and a dividend yield at 2.54%.
In the UK the FTSE 100 dominates as the benchmark that fund managers struggle to outperform. It may be the case that the best way to beat the FTSE 100 is to avoid it and opt for the FTSE 250.
Given this backdrop the FTSE 250 is a strong area to hunt for individual stock ideas. FTSE 250 positions in the Fat Prophets UK portfolio include Cineworld, Moneysupermarket, Dart Group, Bovis Homes and Daejan Holdings.
This report was produced by Fat Prophets Senior Analyst Andrew Latto
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