Secrets Of Success: Did you spot the mid caps' potential?

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The Independent Online

As well as updating their rigorously researched database of world financial market returns from 1900 onwards, this year's edition proffers another timely warning of the dangers in believing one-year forward forecasts of where the markets are heading.

The yearbook, produced by three academics from London Business School, chronicles the investment returns of the 17 largest stock markets in a series dating back to 1900. These 17 countries account for 91 per cent of the world's stock market capitalisation. There are data on a further seven countries where, for whatever reason, the figures do not go back that far. This brings the coverage to 98.1 per cent of the world stock market by capitalisation.

It may be worth reiterating that stock market capitalisation has only a tenuous connection to the size of economies. The United States accounts for fully 50 per cent of the world's stock market on this measure, followed by Japan, the UK, France and Germany. Despite now being the fourth-largest economy in the world, and growing at 10 per cent a year, China accounts for barely 0.25 per cent of its market capitalisation.

The data allow one to compare your own portfolio's performance against that of the rest of the world's investment community, on both short- and long-term horizons. It also puts recent market performance into some useful historical perspective, and by isolating the performance of different style factors shows what has really been driving returns in recent years.

There are some interesting points from the latest analysis. First, as I noted here a couple of weeks ago, a striking feature of 2005 was that all world markets went up in local currency terms, with just one notable exception (China).

The main explanation for the latter market's poor performance is that the Shanghai stock market is not only tiny, but unrepresentative of the companies that are driving the economy forward at its remarkable pace. Hong Kong is a better way to gain exposure to China's rapid growth, but even that did relatively poorly - Korea was the place to be.

Second, the way 2005 turned out in practice was, as the professors rightly point out, not at all what the majority of forecasters were predicting at the start of the year. In fact, the consensus at the start of the year was, not for the first time, way off beam. Anyone who followed the predictions of the serious financial press and leading investment houses would have missed a lot of the gains that later materialised by being in the wrong part of the market.

To quote the professors' words: "Relatively few commentators had been expecting most of the key developments that helped shape 2005 - an appreciably stronger dollar; oil above $70 a barrel; equity returns of 20 per cent plus except in the US; a 45 per cent return on Japanese stocks amid signs of recovery after 15 years of economic malaise; small- and mid-caps continuing to outperform; growth stocks failing to take the ascendancy; long bond yields falling rather than rising; commercial property returning close to 20 per cent in many key markets; a continuing commodity boom; and gold above $500 an ounce."

Third, if you thought that your UK equity portfolio did all right in 2005 (it will surely have gone up), don't be too pleased with yourself. The total return from the UK market, as measured by the LBS/ABN-Amro total market index, which covers the whole London stock market, down to and including AIM, was 19 per cent after inflation. Yet 20 of the 27 leading markets around the world did better; nine produced a total real return of more than 30 per cent, and five, including Japan, did better than 40 per cent.

Outside the top 27, Egypt and Colombia produced returns of 120 per cent, topping the world league tables for the second year in succession. While it is forgiveable to have missed those two - readers of Jim Rogers' last book will not have done so - even risk-averse investors should not have maintained a full 50 per cent weighting in the US stock market, one of the worst performers of all last year.

The next key theme is that style factors - differences in performance between large- and small-cap stocks, and between value and growth - were again well to the fore. For once, however, the story on size as a factor was a mixed one.

Normally, the way different sections of the market behave is closely correlated to size: if small cap is doing well, generally the further down the capitalisation scale you go, the better your shares will perform (and vice versa, when large cap is in the ascendant).

Not so, however, in 2005, which saw the continued dominance of mid-cap stocks as the driving force behind the market, not just in the UK but across many other stock markets as well.

Over the six years since the end of the bull market in spring 2000, mid-cap stocks have outperformed the rest of the market comfortably. (I would, however, bet against it continuing much longer: a bias towards the other extremes either side looks sensible from here, as the trend is anomalous historically).

Even more striking is how the performance of different sectors has diverged since the bursting of the tech stock bubble in 2000. The three sectors that led the market to its absurd peak - telecoms, media and technology - have inevitably lagged the rest of the market since, with negative returns of more than 50 per cent in the period from 2000 to 2005. That dragged down the performance of the main market indices in the process, telecoms alone making a negative contribution of 13 per cent to the market's overall return in that six-year period. The sectors that have made the biggest contribution to the overall returns of the market have been banks and oils.

The moral here is also clear. If you can recognise what is happening early enough (which to be fair, many market experts, and indeed this column, did do in 2000-01), you can greatly improve your performance just by getting on the right side of a few simple trends.

Had you plumped for value stocks and avoided the three overinflated sectors in 2000, you would have missed out on the bear market completely. In fact, you would have been rewarded very handsomely.

From here, my money is on growth (which fought value to a draw in 2005 after five years of underperformance) having its day for a while quite soon, and on technology and media stocks making a comeback as well.

jd@intelligent-investor.co.uk

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