Shares: When size really is important

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A CURIOUS aspect of the way the FT-SE 100 index is compiled, with different shares regularly being dropped or promoted according to changes in their market capitalisation, is that the index resembles a managed portfolio. I was reminded of this when I put my view to various equity market strategists that the constituent companies of the FT-SE 100 index had weathered the recession with remarkable aplomb, as measured by the high proportion which had kept earnings and dividends growing. Of course they did, was the answer, because companies which cut or pass their dividends tend to drop out, to be replaced by more successful ones.

This also explains why the FT-SE 250 index, measuring the performance of the 250 companies next in size below the FT-SE 100, outperformed so strongly in the first quarter of 1993 (rising by 8.5 per cent, against a mere 1.1 per cent by the FT-SE 100). The reason is that many companies in the building materials and construction sectors have dropped from the FT-SE 100 index to the FT-SE 250, while the narrower index has become dominated by the big defensive stocks, such as brewers, stores, food retailers, and health and household companies, which account for almost a quarter of its total capitalisation. When investors switched interest from growth stocks to recovery plays, the FT-SE 250 took off and the FT-SE 100 ground to a halt.

This move has been so dramatic that observers such as Trevor Laugherne, an analyst with Kleinwort Benson, think it is now time for the big stocks, and particularly the four groups just mentioned, to have their turn again. Many of these stocks have traded options, so if he is right, investors with a gambling instinct could have fun buying out of the money calls in such shares as Glaxo, Bass, Kingfisher, Marks & Spencer and Sainsbury.

Shares may now rest for a while (or they may not). But Mr Laugherne points to two factors which could drive the market higher later in the year. First is the dramatic way in which business sentiment is improving. At the beginning of the year the consensus expectation was for 1 per per cent economic growth this year. Four months later the consensus has moved up to 1.5 per cent, with up to 3 per cent pencilled in for next year. If that rate of improvement in expectations continues for much longer, people are soon going to be forecasting a boom.

The second point is the widespread expectation that 1993 and 1994 are going to be good years for corporate profits. A number of observers, such as Mr Laugherne and Nick Knight at Nomura, are looking for corporate profits to grow by as much as 50 per cent over the next two years. Not only does that imply quite modest price- earnings ratios two years from now, it also means that the 1993 interim reporting season could be good for shares. Around half of UK companies report on a calendar year basis, which means many will be reporting first-half figures in August and September. If the picture is as positive as some expect, that could give a lift to shares, so make sure any call options you buy don't expire until after September.

Another positive factor suggested by the performance of big-company shares in recession is that there is an each-way bet element in well-chosen larger companies' shares. A substantial number of the present constituents of the FT-SE 100 index have kept their dividends climbing through the recession, even if growth has slowed since the later 1980s. Allowing for the self-selection bias referred to above, this suggests well-managed big companies can prosper in both boom and slump because of a remarkable ability to cut costs. For example, M&S recently reported six- month figures showing turnover down from pounds 2.644bn to pounds 2.637bn, yet pre-tax profits raced from pounds 215m to pounds 257m. Companies have also been ready to reduce their dividend cover levels to keep dividends moving ahead.

Pessimists suggest this good performance in recession means there will be little more to gain in recovery. I don't agree. More likely, the greater efficiency that has generated growth even in recession will lead to a profits spectacular in the boom which may be coming.

Investors should make sure to have in their portfolios a cross-section of FT-SE 100 shares. Pick companies which have kept their dividends climbing without a break through the downturn and where the last chairman's statement was encouraging on prospects. You may be surprised at the width of the choice.

We will provide some pointers next week.