Why we are looking so closely at commodity and banking-related businesses

There was much excitement among investors and media alike this week as the FTSE 100, the benchmark index of the UK’s biggest companies, briefly hit its all-time high. Yet those few words hide a multitude of sins because what they really mean is the price return for the FTSE 100 is now back where it was in April 2015 – and actually not so very far from where it was in November 2007 and January 2000.

Still, before you get too depressed by that news there are of course dividends to consider and, sure enough, that brightens the picture a little. The total return on the FTSE 100 between 1 January 2000 and 30 September 2016 is 78% – certainly better than a poke in the eye or indeed keeping your money in the average current account during that time but, annualised over 16 years, it is not that impressive.

Are there any other crumbs of comfort we can offer? Well, the FTSE 100 is not the whole UK market, of course. It is a huge proportion of it – about four-fifths in fact – but there are other bits. So what about the next largest part, the FTSE 250 index of mid-sized stocks? Over that same 16-year period, this made 177% on a price return basis (versus the Footsie’s zero) and 340% (versus 77%) in terms of total return.

So the FTSE 250 has done substantially better than the FTSE 100, which begs the question – how? What has driven this huge outperformance? The reasons seem unlikely to be structural – after all, if this was simply a smaller-companies phenomenon, then the FTSE Small-Cap index ought to have done even better than the FTSE 250 and it certainly has not.

Let’s try another tack. The total return from an equity investment over any given period is made up of three elements – any dividend paid by the business in that time, any uplift that comes from earnings per share growth and any change in valuation. And when you look at that last element – as measured by the spot price/earnings (P/E) ratio – for the two indices over the 16 years, an intriguing point starts to emerge.

For while the FTSE 100 has become more expensive – going from a spot P/E ratio of 30x in 2000 to 36x now – the FTSE 250 is actually cheaper. Having been on a spot P/E ratio of 22x in 2000, it is now at 20x, which feels intuitively wrong. We know the FTSE 100 is full of businesses that have been struggling in recent years – banks, oil companies, retailers – so how come the index is now more expensive?

The answer – the real kicker – lies in how the two indices’ earnings per share numbers have done. For while, as a group, the FTSE 250 companies have seen their earnings per share more than triple since 2000, the FTSE 100’s is actually below where it was back then. Yes, in 16 years, the UK’s largest and, one presumes to have reached that size, most successful businesses have achieved absolutely nothing in terms of earnings growth.

That is staggering really but, again, what has driven it? The following chart shows the growth (or not) in earnings per share for the FTSE 100 and FTSE 250 going back even further than 2000 and what you will immediately notice is that the two lines are effectively in lockstep from the turn of the century all the way until 2011/12.

Source: SocGen 

In other words, all the FTSE 100’s underperformance in earnings has come in the last five years and, what is more, it has all been driven by commodities. Oil, gas and basic materials have fallen apart in this time and, as you might imagine, this has not affected the FTSE 250 nearly so much. So, while there appears to be no structural element to the FTSE 100’s travails, there is a significant compositional one that cannot be ignored.          

While we are in this analytical frame of mind, shall we – to retain the commodities theme – dig a little deeper? Take a look at the next chart, which this time illustrates the drag not only resources businesses but also financial stocks have had on the UK market over the last five years. Of these two huge elements of the FTSE 100, one was brought low by the commodities bear run and the other by the financial crisis.

Source: SocGen

That pair aside then, you can see the FTSE 100’s earnings have held up pretty well over the period, suggesting this entire phenomenon of negative earnings growth since 2000 can be attributed to the impact of some highly cyclical businesses. This is confirmed by one of our preferred metrics, the 10-year cyclically-adjusted P/E ratio, which we will look at in a little more detail in the near future.

For now, suffice it to say that, here on The Value Perspective we believe we are currently being offered lower multiples of much lower profits on a mean-reverting basis. Firm believers in the long-term power of mean reversion that we are, therefore, we are looking very closely at commodity-related and banking-related businesses and you should not be too surprised to find significant weightings to both sectors in our portfolios.

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