FTSE 250 companies will continue to comfortably outperform large-caps over the foreseeable future, according to Thomas Moore, who says mid-caps will benefit from an “intense” economic recovery while plummeting dividends within the FTSE 100 means the index is largely a value trap.
While the FTSE 100 did reach its highest ever level this year, it has been mid-caps that have dominated the UK market in 2015 thanks to an improving economic backdrop and the certainty of the general election result.
According to FE Analytics, the FTSE 250 index has posted double-digit gains year to date while the FTSE 100 is up just 2.58 per cent following its 7 per cent fall since April, which was driven by various macro woes such as the Greek debt negotiations, China’s stock market collapse and falling oil price.
Performance of indices in 2015
Source: FE Analytics
These relative returns have been the primary driver of active funds’ outperformance relative to trackers, with passive funds littering the bottom quartile of both the IA UK Equity Income and UK All Companies sector so far this year.
Moore, manager of the five-crown rated Standard Life Investments UK Equity Income Unconstrained fund, says that while the FTSE 250 is trading on a higher P/E ratio than the FTSE 100 (18 times compared to 15.9 times) the mid-cap index will continue to outperform. 
“The P/E ratio is higher among FTSE 250 companies at the moment [compared to the FTSE 100], but I must stress that we believe that this slightly higher price is worth paying for significantly better growth prospects in terms of earnings per share, dividend per share and, of course, the cashflows backing up those dividends,” Moore (pictured) said.
First and foremost, the manager says mid-caps (which are far more domestically exposed than the internationally-focused FTSE 100 index) will benefit from a “pretty intense” UK economic recovery over the coming few years.
“This [recovery] has been going on for some time,” Moore said.
“It wasn’t that long ago that the doomsayers were telling you there was going to be a ‘triple-dip’ in the economy. The statistics actually told us there wasn’t a ‘double dip’ and the recovery has been ongoing with household consumption bottoming in 2009 and it’s been improving ever since.”
“There are some good sound reasons for that to continue. Real wages were announced last week and they have continued to move ahead which is very supportive for household consumption. At the same time, companies are beginning to feel more confident about hiring.”
He points out that there has been a change in the employment landscape over the past six or so years since the global financial crisis, with the number of full-time employees now in net positive territory – meaning consumers will be more confident to spend.
He says this, once again, will boost growth within mid-caps.
“It’s not just about a part-time employment anymore, which was again part of the doomsday stories a few years ago. That is very good news for the UK domestic sector of the stock market.”
Of course, there will be FTSE 100 companies benefiting from this trend but the manager says there is another reason why he is avoiding large-caps within his UK Equity Unconstrained fund, namely because earnings per growth within the blue-chip index is lagging.
“The FTSE 100’s dividend cover is falling dramatically,” Moore said.
Dividend cover of indices over 20yrs
Source: Datastream
“The line is pointing very firmly downwards. This was what was worrying me 12 to 18 months ago about dividend growth and high dividend yields that looked alluring at first glance but when you delve deeper you see the vulnerability and that has been caused by the reduction in coverage of earnings.”
“I would rather buy these large-caps when dividend cover is higher and when there is great scope to grow dividends. I do not see that today, I see dividend risk so I see the current yields as a value trap.”
As the graphs shows, however, dividend cover within the FTSE 250 is moving in the opposite direction as – unlike in large-cap land – companies have been increasing their earnings per share.
With issues such as a falling oil price, the strength of sterling and a lack of underlying growth, Moore warns that many of the largest and most important dividend payers in the FTSE All Share may be forced to cut their dividend before the end of the year.
“FTSE 250 companies have been squirreling away some of the capital they generate each year so that they can invest and pay some of it back in the form of dividends. Now I know which of those two markets I want to be heavily exposed to,” Moore said.
“I suspect we are going to have some pretty bad news coming out of some of the largest companies in the UK market in the coming months and I don’t want to expose my clients to those names.”
Moore picks out the likes of BP, Shell, AstraZeneca, GlaxoSmithKline, British American Tobacco, HSBC and BHP Billiton as companies with potentially risky dividends, which is a concern for the wider market given they account for around 35 per cent of the FTSE All Share’s total dividend payments.
They also account for 25 per cent of the FTSE All Share’s index weighting and are among the most popularly held stocks within the IA UK Equity Income sector.
Moore has always been willing to go against the grain within his now £930m fund, as instead of focusing on headline yield he aims to find a growing source of income. His unconstrained approach has also meant he has tended to have a higher weighting to mid and small-caps relative to his peers.
Both these aspects have worked well for his investors from a total return and income earned point of view since he took charge in the portfolio in January 2009.
According to FE Analytics, Standard Life Investments UK Equity Income Unconstrained has been a top decile performer in the sector over that time with returns of 218.76 per cent, beating the FTSE All Share by more than 110 percentage points in the process.
Performance of fund versus sector and index under Moore
Source: FE Analytics
The fund has also been a top quartile performer, and beaten the index, in five out of the last six calendar years and is comfortably outperforming once again in 2015.
FE data shows investors have been paid more in income from the Standard Life fund over that time compared to the likes of Artemis Income, Threadneedle UK Equity Income and Invesco Perpetual High Income as if they had bought £10,000 worth of units when Moore took charge, they would have since been paid £5,217.52 in dividends.
As the chart below shows, Moore has been able to increase his pay-out in every year since he inherited the portfolio as well.
Standard Life Investments UK Equity Income Unconstrained's dividend history
Source: FE Analytics
While Moore says many active managers will be able to avoid the dangers facing some of the UK largest stocks, he warns investors about the danger of buying trackers in the current environment (as many have been doing recently).
The major reasons for that is due to the headwinds facing some of the index’s largest stocks such as the threat posed by China’s falls, the plummeting oil price and a general lack of dividend cover.
“I don’t want to be negative on other people’s exposure, but I would point to large-cap stocks as potentially risky given the direction of dividend cover and the trends we are seeing in earnings and cashflows.”
He added: “I would encourage investors to take a look at the individual names.”
Standard Life Investments UK Equity Income Unconstrained (which holds more than 50 per cent in the FTSE 250 and Small Cap indices and 38 per cent in the FTSE 100) currently yields 3.68 per cent and has a clean ongoing charges figure of 1.15 per cent.
