Today’s Exponential Investor is all about why you should own small caps, not large caps.
Which is right in the remit of Exponential Investing. But I suspect the argument for why will be new to you.
We’re not going to get into the recent underperformance of the FTSE 100’s behemoths. Nor the profit potential of small caps. Nor their room to grow. Nor the exponential gains on offer.
Instead, we’ll focus on a factor that I expect to dominate Britain’s smaller companies. Something rarely mentioned in association with those stocks.
Let’s take an “evidence first, explanations later” approach.
Take a look at yesterday’s stockmarket action. At the time of writing, the FTSE 100, in purple, is up half a per cent. The pound (blue) is up a per cent. And the FTSE 250 (red) is up one and a half.
The same chart since Thursday is a little more confusing, but shows the same story. The pound, in blue, trades 24 hours a day. The stockmarket trades during the day only. That’s why the purple and red line are interrupted.
But as you can see, the FTSE 250 is up 6% alongside the pound, but the FTSE 100 is flat.
If you own FTSE 100 stocks, instead of small caps, you’ve missed out on the gains. If you own mid-cap FTSE 250 stocks, you’re doing rather well. 6% in a week is impressive, and most of that came on a single day.
But what do these charts really show you? That the FTSE 250 is closely correlated to the pound. The FTSE 100 isn’t.
But the last week has been fairly unusual. Usually, the FTSE 100 trades inversely to the pound. After the Brexit referendum, the FTSE 100 rose to record highs as the pound tumbled.
So what’s going on? And what does this have to do with small caps?
Well, the FTSE 100 is full of huge companies that earn their money in foreign currencies. About ¾ of revenue comes from overseas. Which means the exchange rate is more important to their share price than domestic UK issues.
The FTSE 250 contains many smaller companies that have much stronger ties to Britain. They care more about what’s going on in the UK economy than exchange rate markets.
And the pound cares about what’s going on in the UK economy too. That’s why the pound and the FTSE 250 trade together. They’re both impacted by optimism and pessimism for the UK economy.
Good news for Britain makes true British stocks (not multinationals listed in Britain) go up, and the pound go up too.
Bad news for Britain makes the pound go down, and thereby the FTSE 100 go up.
Why do small cap investors care about all this?
Well, if Britain’s economy does well in coming years, the FTSE 100 won’t see the benefits. The pound will rob investors of their gains as the rising exchange rate drags down the value of international earnings.
Meanwhile, the smaller companies in the FTSE 250 will do well alongside Britain and the pound.
But most British investors own FTSE 100 stocks, not the smaller FTSE 250 stocks. Getting exposure to global companies is sold as a benefit to everyday investors. But that only holds true if the pound is falling. Which it won’t if Britain does well.
Over the last week, we’ve had news about a deal with the EU. The pound spiked, making UK stocks spike. But not the stocks you see reported on the news each night. The FTSE 100 behemoths and their international revenue streams missed out on the gains.
My point is, British investors, if they’re optimistic about Britain, need to be in FTSE 250 type shares, not FTSE 100 type shares. Or the pound will rob them, as it did this week.
But you can go one better. The FTSE 250 is still mid-cap. It’s full of medium-sized companies that focus on Britain. Why not buy small cap stocks that are even more exposed to Britain only?
If you’re optimistic about Britain, that is.
I am. And I’ve put together a report which explains why. And it also lists which stocks to buy and sell if you agree with me.
You can find out what they are here. But before you go, don’t forget my giveaway: if you believe in Britain after Brexit, owning the FTSE 100 shares does not make sense. You’ll be robbed by the pound.
Which means most passive investors who think they will profit from a prosperous Britain will end up disappointed.
Will you be one of them?
Until next time,
Editor, Southbank Investment Research