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Mega cap stocks are mega cheap, according to Leigh Harrison, head of UK Equities and manager of the Threadneedle UK Equity Alpha Income Fund. Indeed, for Harrison there has been a massive shift in the valuation profile of the UK market over the past few years. Seven years ago the top 15 companies in the index were trading on a forward PE of more than 20 times earnings while, outside the FTSE 100, no tier traded at more than ten times. Now, the top 15 are on 11 times and none of the tiers below the 100th stock trade on less than 15 times.
There are two main drivers of this shift in valuations: the superior earnings growth of mid and small caps and the wave of takeovers and buyouts that has swept through the lower tiers of the market.
Of these drivers, the first is still in place. The Mid 250 is generating 15% earnings growth versus around 7% for the FTSE 100. But is this growth mismatch sufficient to justify such a gulf in valuations? Harrison certainly doesn't think so. He adds that whether the second driver remains in place is more of a moot point.
"Much has been made of the wall of private equity cash waiting to be deployed. What's interesting is that the number of private equity deals has plateaued but the size of those deals has crept higher. With the level of gearing being applied to deals still some way below the peaks seen in previous cycles, there is the scope for some big names to come into play.
"Meanwhile, the market has made terrific progress in recent months and I suspect that investors may be underestimating the threat of stubborn inflation and higher interest rates. Thus, a more defensive stance may be appropriate in the short term."
With these factors in mind Harrison's fund has been reducing mid and small cap exposure and moving further overweight in mega caps in recent weeks.
Key holdings now include BT, GlaxoSmithKline, BP, Shell, Vodafone and BAT. Although the firms concerned are hardly the most likely of takeover targets, Harrison says that he wouldnt be surprised at any takeover activity in this area of the market.
06 June 2007 © Moneyextra.com
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