There is scant value left in rallying mid-caps but the top end of the FTSE 100 is now very cheap and attractive, according to FE Alpha Manager Alex Savvides, who has never held less of his JOHCM UK Dynamic fund in the FTSE 250 but is, for the first time, overweight mega-caps such as banks, energy and mining. 
It has been a very odd year for the UK equity market as while the FTSE 100 has been hurt by various macroeconomic headwinds ranging from China’s slowdown, falling commodity prices and uncertainty over interest rates, the domestically orientated FTSE 250 has rallied strongly on the back of an improving economy.
According to FE Analytics, the mid-cap index is up 15.82 per cent over 12 months compared to a meagre 1 per cent gain (with some huge drawdowns) from the FTSE 100.
Performance of indices over 1yr
Source: FE Analytics
The reason for mega-caps’ hefty underperformance is the large falls in some of the FTSE 100’s largest constituents (oil & gas, mining and banks) which many managers are avoiding due to the perceived headwinds facing those sectors.
However, Savvides says there will soon be a huge change in the dynamics of the UK equity market.
“Very simplistically, the FTSE 100 is cheap. But it’s not the FTSE 100: it’s probably the FTSE 20 that is cheap. The top of the market is materially cheap,” Savvides (pictured) said.
“The P/E ratios, dividend yields and other metrics are pretty extreme versus the FTSE 250. Money has been squeezed into the FTSE 250 so valuations are very high. There is a squeezed middle in the stock market and it has been going on for some time.”
“When you see the FTSE 100 versus the FTSE 250 over one year and a 16 percentage point differential in performance, it is pretty extraordinary. I’ve been in the stock market for nearly 20 years and these things do not happen that often.”
Savvides has a decent track record of outperformance since he launched his five crown-rated JOHCM UK Dynamic fund in June 2008, as the portfolio sits in the top decile of the highly competitive IA UK All Companies sector over that time with returns of 115.5 per cent.
His FTSE All Share benchmark, on the other hand, is up 52.48 per cent over the period in question.
Performance of fund versus sector and index since launch
Source: FE Analytics
However, he is the first to admit that most of that outperformance has come from his historically high weighting to mid-caps (the FTSE 250 has more than doubled the FTSE All Share since June 2008).
Given the stark outperformance of mid-caps and the valuations they now offer, the manager has made the bold decision to vastly reduce his weighting to the FTSE 250 and is now buying very out of favour mega-caps.
“We have never been more underweight the FTSE 250 since we launched this product. We have also never had more capital in small-cap and AIM stocks and we are starting to put more capital into FTSE 100 companies.”
“It is very rare we see such value in mega-caps. But it’s not just value, it is the strategic change going on within these companies.”
An area he has been buying, for example, is UK banks which, despite a strong rally in 2012 and 2013, have once again fallen out of favour due to further fines from the regulators. The FTSE 350 Banks index has lost some 5 per cent so far this year, but Savvides says now is the time to buy.
“I think it is very interesting what is going on in banks. You need to cut the noise back and focus on the reality and the reality is – these are cheap. They are cheap relative to their history and they are cheap relative to their fundamentals.”
“But they are also not just cheap; they are doing the right thing for you as investors. Why? Well, through pressure, through prior mismanagement, through prior misconduct. They have had existential threats in their business models that have forced a change in thinking and that, as a potential shareholder, should be music to your ears.”
He says these changes relate to their capital efficiency, capital management, improved balance sheets and the fact that many of them are now paying dividends.
As banks are trading below their book value and many offer yields of more than 5 per cent, it means Savvides now holds 15 per cent in Barclays, Lloyds and HSBC. He is therefore overweight the sector for the first ever time.
He is also overweight both mining and oil & gas for the first time in his fund’s history, again showing a huge change in tack from the manager.
According to FE Analytics, the FTSE 350 Oil & Gas index and the FTSE 350 Mining indices are down 9.66 per cent and 38.66 per cent over three years compared with the wider FTSE 350 index has made 24.73 per cent.
Performance of indices over 3yrs
Source: FE Analytics
While fears of the impact of a low oil price continue to dog the sector, Savvides expects the likes of Shell to rebound given the strength of the underlying business.
Mining, on the other hand, has been out of favour for a very long time now due to huge falls in the price of iron ore and other basic materials, waning demand from emerging markets and poor decision on the part of management teams.
However, given the value now on offer and changes to business models, Savvides says investors are wrong to continue to avoid miners.
“There is limited value in being underweight those sectors anymore. That supercycle has gone and now there are some value characteristics that I think are quite interesting. There are huge changes going on in the way they run these businesses that are much more attractive than the simplistic view that it is all bad out there and therefore I’m not interested.”
“They are trading below book value – materially in some cases. They are trying to maximise cash, maximise return on capital, protect their shareholders and that is good behaviour.”
He added: “I think we are doing something quite rational here. It has been a drag over the short term, there is no doubt about it, but I don’t expect it to be a drag going forward.”
Of course, Savvides’ asset allocation is very different to many of his peers in the sector and has hurt his fund’s performance over the last three and six months.
A consensual overweight position in mid-caps (while at the same time avoiding mega-caps like energy and mining) has been the major driver behind the outperformance of UK active funds relative to the FTSE All Share in 2015.
Performance of active funds versus index in 2015
Source: FE Analytics
Even more telling, however, is that five of the top 10 performing funds in the IA UK All Companies sector are benchmarked against the FTSE 250, while the remaining five all currently hold at least a third of their assets in the mid-cap index.
That has led to many of them to have a high active share, which has seen to be a positive with investors over the past year or so.
However, like Henderson’s John Bennett and other top-performing active managers, Savvides says looking more like the index will be the best way to outperform as some of the FTSE All Share’s largest constituents are now very cheap and very sensitive to even the smallest of improvements in sentiment.
“It just so happens some of my most interesting ideas at the moment are in the FTSE 100 and they are right at the top end. Actually, as you are transitioning into those stocks, you get accused of index hugging which is quite funny really because your tracking error comes down as you have to shift a lot of capital into these names.”
He added: “However, you will get small-cap returns from mega-cap stocks over the next three years and if you are not in them, you will miss out.”
JOHCM UK Dynamic has a clean ongoing charges figure of 0.74 per cent, but like all JO Hambro funds, has a performance fee of 15 per cent.
