As the FTSE 100 finally closes at a new all-time high, we will no doubt hear more commentary celebrating this historic moment. As an unconstrained investor, this sort of event is largely meaningless to me. After all, an equity index is simply a collection of shares of different companies, any one of which may or may not be represent an attractive investment opportunity. That said, the FTSE 100 index itself is so widely followed making this moment an opportune time to take a closer look at the path it has taken from its past peak of 6930 in December 1999 through to today.
Despite its wide acclaim, the FTSE 100 index has actually been a pretty poor performer over this 15 year time period. Most other major stock market indices such as the S&P 500 in the U.S. have outperformed the FTSE 100. The FTSE 250 index which consists of smaller market capitalisation companies has trounced the FTSE 100, rising nearly 170% over this period. Part of the underperformance of the FTSE 100 can be explained by its higher dividend yield, but even adjusting for this there is no getting away from the conclusion that the index has been a laggard.
To understand the poor performance, we need to look closer at the composition of the index itself and how this has changed over time. In my view, the FTSE 100 has shown an unhealthy tendency to concentrate itself into certain companies or sectors. This has often been driven by a particular investment fad of the day. These sectors have then gone onto to perform poorly driving down the overall performance of the index, particularly when compared to its more balanced peers.
I’ll illustrate this phenomenon by graphing the percentage weight of three different sectors in the FTSE 100.
The peak of the FTSE 100 in December 1999 marked the top of one of the most bizarre periods of stock market history – the telecoms and technology boom1. This was the “new economy” era. Computers, the internet, media and mobile phones were revolutionising the economy and society by improving productivity and lowering the cost of consumer products. The stock market of the day had concluded that these trends justified eye-watering valuations for the leading technology and telecoms companies. New valuation ratios were invented (“eye-balls”) to justify these valuations.
On the back of rising valuations and a lot of new issuance of shares, the FTSE 100 became heavily concentrated into the technology and telecoms sectors. Subsequent history has shown these valuations to be hopelessly optimistic. Most – although not all – of the “new economy” era companies suffered from brutal competition that brought their profits and stock market valuations right back down to reality. As the chart above shows, the telecoms sector has fallen from 18% to a mere 5% of the FTSE 100 today.
Next up, we have the basic materials sector. Here again, a genuine fundamental change – in this case the emergence of the Chinese economic powerhouse – created a boom that subsequently turned into an investment fad reliant upon unrealistic long-term commodity demand and price forecasts. For a while in the 2000s, supply of iron ore and copper was unable to keep pace with seemingly insatiable Chinese demand, resulting in very significant commodity price increases. But, as often happens with commodity businesses, high prices lead to supernormal profits which in turn encourage new supply.
And this is exactly what happened. All the major minors embarked on vast capital expenditure plans which were based on very optimistic long-term forecasts of Chinese demand. In addition there were IPOs of companies keen to list their shares during the boom era – Glencore1 being the most prominent example. Since then, Chinese demand has disappointed, commodity prices have collapsed and basic materials sector has significantly underperformed. This has weighed on the FTSE 100’s performance, which at the peak of the commodity boom was 17% weighted to the basic materials sector, much higher than any other major equity index.
Today, the sector that seems to be driving the FTSE 100 higher is consumer goods, which consists of well-known household names1 such as Unilever, Reckitt Benckiser and Diageo. From a low of 5% back in 1999, it has risen to 18% today. In my view, a significant part of this is entirely justifiable as these companies have generally performed well operationally, created shareholder value and were undervalued in relative terms for much of this period.
However I am concerned that another investment fad may be developing within this sector. Five years of quantitative easing combined with generally weak and deflationary economies have created an exceptionally low bond yield environment. Many of the companies in this sector are seen as safe investments, with dividends that will always grow. Investors increasingly see them as alternatives to bonds. There is even a new financial term for them: “bond proxies”. Yet absolute valuations are already at levels that look stretched. For example Unilever is valued on 22x p/e, versus a long-run average of closer to 16x2. Simply falling to its long-run average would constitute a 30-40% fall in the share price.
I don’t mean to particularly pick on Unliever because the same situation can be seen in many other companies. Equally I am not predicting a sudden fall in these companies’ share prices. But I do worry that the factors driving these shares upwards are not fully justified by their underlying fundamentals.
1. This is no recommendation to buy or sell any particular security
2. Source: Bloomberg