Over the past thirty years, there has been a clear trend for equity mandates to ‘go global’. This has been driven by consultants on the basis that the world’s economies are increasingly connected and most mid and large cap companies sell products globally. The implication is that a company’s domicile does not matter greatly. On top of that the media is full of the outperformance of the U.S. market, driven of course by the Magnificent Seven Big Tech companies.
U.K. mid-caps have outperformed the S&P over 25 years
So it comes as a bit of a shock to discover from Schroders that the FTSE250 ex Investment Trusts index (i.e., companies 101-350 after taking out investment companies) has delivered an almost identical total return to the U.S. S&P since 2000. It is true that over the last five years the S&P has outperformed by 60%, but that means that the FTSE250 ex IT index must have outperformed it substantially before then.
The total return to shareholders from investment in any company is made up of the dividends paid out, the rate of earnings growth and the valuation put by the market on those earnings. The first and third are ultimately dependent to a greater or lesser extent on the second.
Schroders analysed the two indices over the same 24-year period from that perspective: the FTSE 250 ex-IT had a slightly lower earnings growth (6.4% annualised vs 7.2%) but a higher dividend yield (3.1% vs 2.0%). The U.K. index suffered from greater multiple contraction over the full period (28.4% vs 16.7%).
They also looked at whether this multiple contraction was due to a worsening in the quality of the U.K. companies. The five-year annualised level of real investment growth was in fact higher in the U.K., despite the larger dividend payouts, and the return on investment was almost identical. The implication is that there has not been an impairment of quality.
A sectoral analysis shows some sectors dominating each index: tech, healthcare, and financials in the U.S. and industrials, consumer discretionary, and financials in the U.K. But the returns in both cases come from a reasonably diversified range of sectors.
One major difference is that the U.S. is large-cap, while the FTSE 250 is mid-cap at best. Under a global definition most companies in it would be considered small-cap. There is a legitimate argument that returns from the FTSE250 should therefore be higher than the S&P. Currencies might be a second factor, but it in fact makes little difference – the analysis holds true whether done in local or common currencies.
History says mean reversion is likely
The question today is whether there will be mean reversion after 60% underperformance. In essence the question is whether the Big Tech continues to munch other firm’s lunches by disintermediating old economy activities. Services seem to be in the firing line now as AI gears up; lawyers, asset managers, and car hire are three examples clearly in the firing line. Behind them may be corporate finance due diligence, travel agents, insurance and many others.
Among industries, the big old car firms are already under pressure from Chinese electric cars, but the real pressure could be from driverless ones. And there is an intriguing question whether much traditional military hardware (aircraft, ships, tanks, even weaponry) can get replaced by drones, lasers, and other more tech-focused equipment.
The alternative thesis is that the cracks between the behemoths become more and more appetising for smaller companies. Sheer size makes it increasingly difficult to hit annual growth numbers, and so they will have to rely on either buying up the smart new technologies or to find new and unexplored markets (Africa, India, Asia?). In the first case the returns will be lower as they will be investing at a later stage and will have to pay more for the new technologies; in the second they will be reliant on sufficient economic wealth creation elsewhere so that consumers have the money to buy their products.
In our view the latter is the more likely outcome. History tells us that empires don’t grow forever, and the biggest tech companies are already challenging even the U.S. government for power. Note the recent EU1.8bn fine slapped on Apple by the European Union Commission for abusing its dominant position. In the United States some of the rhetoric from Trump’s supporters is already quite extreme. In the shorter-term I expect consolidation as some of the giants come head-to-head, but again the larger they become, the harder it will be for them to maintain annual growth rates.
Investing on a global benchmark is not optimal for UK investors
Returning to my original question, does the argument to invest in equities on a global basis hold water? The U.K. Government is pushing investors to invest in U.K. companies, both listed and private. Pension fund liabilities are in sterling, so holding U.K. domiciled assets in theory removes some currency risk. The higher yield is also helpful to maturing pension schemes as a source of regular income.
Perhaps the largest argument against investing on the basis of the global equity index is the specific risk it introduces. The United States (and the dollar weighting) accounted for over 70% as at 31st March 2024; the top ten U.S. stocks for 21.5%; the biggest single stock, Microsoft, for 4.6%. To be clear, this is not necessarily an argument against investing globally, but it is one for thinking a bit more deeply about regional weightings. What about 10% U.K., 20% Europe ex U.K., 30% Asia and 40% the Americas, as an example?
Coming back to the FTSE 250 ex IT, the ‘small-cap’ bias and greater specific risk means investors should expect to receive a higher return than the more diversified large-cap S&P500. Allowing for this, it is reasonable to say that on a head-to-head basis that the U.K. index has “underperformed” the S&P by 1% annualised (an arbitrary figure). On this argument, the Big Tech enthusiasts may justifiably say that U.K. mid-caps will continue to underperform by 1%. However, even in this case there is, in my view, a strong case for expecting some mean reversion in valuations and a catch-up of some, even if not all, of the recent underperformance.
In summary, returns from U.K. mid-caps are comparable to those from the vaunted U.S., and there are arguments to say that specific and currency risk for U.K. investors is lower. After eight years of underperformance, a degree of mean reversion seems likely. The argument for UK. Pension funds to put a substantially higher weighting in U.K. mid-caps than the 0.5% they constitute of the global equity index seems to me to be strong. For once, I find myself on the same side as the Government here, that investors should invest more in U.K. companies.
In this article I have used Schroders’ analysis. However, the interpretation, including any errors I may have made, is entirely my own. Investors should do their own research and due diligence before making any investment on the basis of this article. Neither Schroders nor Linchpin IFM will be liable for any loss or damage resulting from the use of this article.
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