Investors who buy into large cap stocks in the current market are taking a major risk, according to FE Alpha Manager George Godber, who warns that further dividend cuts are likely within the “expensive” FTSE 100 index over the coming years. 
While fears such as falling inflation figures, weak economic growth in the eurozone and geo-political tensions have persisted, the last 12 months or so have actually been a good period for UK investors as the FTSE All Share is up by close to 10 per cent.
However, due to those macroeconomic fears, it has been large caps that have driven the UK rally. FE data shows that the FTSE 100 has outperformed smaller companies over the past year and has even broken through its historic high over recent months.
Another major reason why investors have been piling into larger, more liquid UK stocks is because of the upcoming general election. A number of experts have said the FTSE 100 is the best place to be as it is largely an international index which should also benefit if the expected political uncertainty were to cause sterling to weaken.
Performance of indices over 1yr
Source: FE Analytics
However Godber, who has the ability to invest across all areas of the UK market within his CF Miton UK Value Opportunities fund, says investors are making a big mistake by naively focusing on larger companies for their perceived safety.
“There is this comfort trade at the moment where investors are focusing on the apparent safety that large caps have to offer,” Godber (pictured) said.
“Of course, there are large caps and there are large caps. The UK has some of the highest quality companies in the world which are bullet-proof in their own right due to their cash generation and any mega-cap that can continue to grow its dividend is worthy of a high rating.”
“However, we currently have 11 per cent in the FTSE 100. That has been as high as 35 per cent and we will take it back up to that level if there are opportunities. At the moment though, by buying large caps you are either taking valuation or balance sheet risk.”
By valuation risk, the manager says that the FTSE 100 looks expensive. For example, if you were to strip out the likes of banks and natural resources, the blue chip index is trading on a multiple of around 18 times.
Apart from that though, the manager says the other major concern within large caps is that many companies don’t have the financial stability to maintain their dividend at current levels.
He notes how the likes of Centrica, Morrisons, Tullow Oil, Tesco and Severn Trent have all cut their dividend so far in 2015 due to operational issues within their business models, sector specific trends or macroeconomic factors – and he expects more FTSE 100 names to join the list.
Performance of stocks versus index in 2015
Source: FE Analytics
“Five large caps have already had to cut their dividend this year – and a number are paying their dividends out of debt. I would not be at all surprised if there were further dividend cuts over the coming months,” Godber said.
As FE Trustnet has highlighted over recent months, concerns have been raised about the dividend outlook for some of the largest contributors to the UK equity income market – most notably GlaxoSmithKline, Vodafone, BP and Royal Dutch Shell.
Godber admits that it may feel uncomfortable backing smaller companies with a hotly contested general election on the immediate horizon, but says he sees a much better risk/reward trade-off further down the market-cap spectrum as investors can find attractive valuation support and more robust dividend cover.
“We have a low weighting to larger capitalisation shares currently; we are not anti-large cap at all but few shares meet our strict valuation and financial strength criteria in the FTSE 100.”
He added: “While the prognosis at the larger end is somewhat bleak, we have overall been a net new buyer of shares in the quarter. Further down the market cap spectrum, valuations are better and we are finding many rock-solid balance sheets to go with it.”
Following a number of years as manager of the FP Matterley Undervalued Assets fund, which he has recently resumed responsibilities for, Godber launched the highly rated CF Miton UK Value Opportunities fund with Georgina Hamilton in March 2013.
According to FE Analytics, the fund – which now stands at £216m – has been a top-decile performer in the IA UK All Companies sector over that time with returns of 42 per cent, meaning it has more than doubled the gains of the FTSE All Share.
Performance of fund versus sector and index since March 2013
Source: FE Analytics
Thanks to Godber and Hamilton’s strict valuation and multi-cap approach to the UK market, the fund was a top decile performer in the remaining months of 2013 and again in 2014 – but is currently lagging in the bottom quartile in 2015, largely thanks to the managers’ low weighting to larger companies.
FE data shows that they currently hold 33.3 per cent in the FTSE 250, 22.7 per cent in the FTSE AIM, 19.4 per cent in the FTSE Small Cap and 7.5 per cent in cash.
There are several industry experts who disagree with Godber’s assessment of the current market; for example, SCM’s Simeon Downes recently told FE Trustnet that large caps are likely to continue to outperform over the short to medium term.
“It will be interesting to see, should there be a UK Labour-based coalition government, if there is a dramatic fall in UK equities. The polls have been predicting a hung parliament for some time. Many of the largest UK blue-chips are dominated by overseas operations which could benefit were there to be a subsequent fall in sterling,” Downes said.
However, an increasing number of FE Alpha Managers have warned about the risks involved of buying larger companies now.
Invesco Perpetual’s Martin Walker believes that many investors are falling into a big value trap at the moment, as the market isn’t priced correctly.
Speaking at last week’s FE UK Growth Event, he said that when inflation and economic growth pick up, bond yields will inevitably start to rise, which in turn will hurt expensive defensive mega-cap equities.
“It has really been those bond-like equities which have really been driving the market over the last few years and in terms of sectors I would include FMCG [fast-moving consumer goods], regulated utilities, but also large-cap pharmaceuticals,” Walker said.
“Fund managers’ Pavlovian reaction to a market that he or she is getting twitchy about is to run to defensive shares, that’s the instinct in all of us. However, I think that is the worst thing you can now do – in fact, I think it is a trap.”
“It has been defensive shares which have been driving the market valuation up. Investors, in my view, should look to take shelter from any kind of bond market rotation by looking at value areas of the market – now more so than ever.” 
He added: “Particularly value areas that have exposure to global growth.”
FE Alpha Manager Alex Savvides, who runs the JOHCM UK Dynamic fund and attended the FE UK Growth Event, agrees with Godber and he too has been buying small caps as a result.
“This fund has been going through a renewal period,” Savvides (pictured) said.
“The stocks that drive the fund forward over the next two years will be very different to the stocks that drove it forward over the previous two years. Small caps have fallen out of the bottom end [of the market] in the last 15 months and there is some value in small cap stocks that is not typically there,” he said.
He added: “There has been a divergence and we have been responding to it. This is quite important for anyone who owns the fund.”