FTSE 100: 7859.17 ▲ 80.38 (1.03%)
The 25% rally in the UK stock market since the EU referendum last June has got investors worrying whether share valuations are too high given the mixed outlook for the economy.
AXA Framlington fund manager Chris St John believes he has some arguments to reassure investors in his part of the market, the FTSE 250, which lists the medium-sized or ‘mid cap’ companies in the UK.
Mid cap stocks were hit harder by the Brexit vote than larger companies in the FTSE 100 because they were seen as having greater exposure to a potentially weakening UK economy.
Since the end of last year, however, the FTSE 250 index has caught up with the FTSE 100, with both indices now showing a total return of just over 25% since 24 June last year, as some of the gloomier economic forecasts have been ignored.
He flagged the change in the price/earnings (PE) ratio which measures share prices against their 12-month earnings, or profits, forecasts.
St John said that currently the PE ratio on the FTSE 250 was ‘at a premium to the long run average as the market is pricing in an acceleration in underlying earnings’ and ‘certainly if recent history is anything to go buy we are seeing that’.
However, he said if you go back to year ending December 2001, the FTSE 250 produced £5.5 billion of profit and in the year to October 2015 produced £18.6 billion, over a three-fold increase.
‘In terms of 12-months forward PE [at the year ending December 2001]… it was 18.9 and you would be forgiven for saying I’m not going to buy the FTSE 250 because it’s too expensive, which is an ongoing issue I have when I talk to people about the FTSE 250 space,’ said St John.
‘If you roll the clock forward to the year ending October 2015 earnings more than trebled and index valued at 16.1 and so between the two points it has de-rated but bought at start and held to the end you would have made significant returns, over 300%.’
Earnings growth is also a ‘critical influence’ on equity returns and St John said a company ‘compounding earnings can compound dividends’.
‘To get those returns as an equity holder, which is crucial is the balance sheet is appropriately strong and the companies need to be appropriately financed,’ he said.
Since 1999 the FTSE 250 earnings have been twice that of the FTSE 100 and ‘most of the returns have been driven by the compounding effect of earnings’, said St John. Total return from the FTSE 250 since 1999, including reinvestment of dividends, is 413%.
‘Start in September 1999, not a million miles from the peak of the market and think about what happened since then: the internet bubble, a pretty horrible recession and the global financial crisis…but the capital return of the FTSE 250 over this time being 215%, what is fascinating is the significant uplift you get through those reinvested dividends, nearly 200% more,’ he said.
‘How has that happened? You have a group of companies that are compounding their earnings growth and…have been able to pay compounding dividends. What has not happened is a wholesale collapse in dividend cover to drive those dividend returns up and I would argue they are sustainable and growth in dividends are sustainable as long as earnings grow.’
This growth means that investors should look to the FTSE 250 for income, said St John, although he noted that yields were not as good as in the large caps.
‘It yields less than the FTSE 100 at about 3% but the constituents are far more broad,’ he said. ‘The dividend cover of those constituents is far higher on average, it is much more sustainable and I would prefer a dividend that had a lower starting point but if it is growing sustainably and compounding, I would rather have that than a static income offered by a group of assets that are not growing their earnings.’
To deliver this growth St John is relying on ‘secular’ themes that are ‘not dependent on government policy or whether or not Brexit exists or not’.
He singled out drug distributor Clinigen (CLIN), which is the market leader in distributing drugs across borders, which St John said ‘is not without its challenges’.
The company is growing on the back of the boom in counterfeit drugs being sold and a need for a safe supply chain.
St John said the growth of self-diagnosis and consequently the purchase of drugs online means one million people a year die due to counterfeit drugs getting into the supply chain.
‘Clinigen removes that risk by taking full control of the supply chain,’ he said.