Foolish Special
[ Wednesday, December 15, 1999]
The Trouble with Trackers
By Rob Davies (TMFEssex)
TMF Eagle remarked the other day, while preparing the Evening Fool, that the market seems to be barmy. The most expensive stocks, like Colt (LSE: CTM) are getting more expensive while the cheaper stocks, like Somerfield (LSE: SOF) are getting even cheaper.
What is going on?
The culprits, I think, are the tracker funds.
We all love them because they are low cost, and an easy way to invest in the stock market, but they do have an intrinsic problem. They are indiscriminate and take no account of value. New money coming into the market is directed at the biggest companies. As it gets bigger it attracts more money. This is precisely the opposite of conventional economics, which says that people buy less of a product as its price rises. Tracker funds do the reverse. Now that they make up 20% of the UK equity market, their effect is becoming more noticeable.
Purely mechanical trackers will automatically trigger an order when cash levels rise to a certain level and, in order to minimise the tracking error, it is important for the fund to deal as soon as possible. To some extent that increases the volatility of the stock price because the order is executed regardless of price. By contrast, old-fashioned value investors are left sitting on the sidelines agonising over their buy orders while the stock continues its inexorable rise. They want to buy the stock, but are reluctant to pay too much. So they wait. But while they wait other tracker funds come in and buy the shares, pushing them even higher.
Eventually, of course, the managed funds have to buy as well. If they don't, and as a result become drastically underweight in a stock or a sector, the trustees of the fund will point out to the manager that he is increasing his risk profile. That is fine if it gives him better returns, but woe betide any manager who takes a flier and then produces a dismal performance. At the end of day no one wants to underperform the market, and the best way of ensuring that is to have a portfolio that mimics the main market.
So not only do we have tracker funds, but we have closet tracker funds too. That means a big chunk of the market, probably well in excess of 50%, is simply buying what goes up and selling what goes down. Which rather begs the question: what do all those analysts, salesmen, traders and fund managers contribute to the process?
Whatever these guys do, the end result is that big companies get more expensive and small companies get cheaper. A research paper by noted value-driven fund manager Phillips & Drew estimates that big companies in the US stand at a 67% premium to "average" companies. In another example of this phenomenon, the paper asserts that the top 50 companies in the US stand at a 35% premium to the next 450, and these are rated 13% more highly rated than the next 500. And this paper was written in February 1999. Something similar is undoubtedly present in the UK.
An increasing focus on the larger companies has left the small companies totally friendless and trading on depressed valuations. Many small companies in the UK have become so disenchanted with their valuations that they have simply left the market through management buyouts (MBOs) or takeovers. By the end of the third quarter, 39 companies had taken themselves private through this mechanism this year; of those, 8 had valuations of over £100m, representing a substantial capital reallocation. The change in capital structure is obviously favoured by the low level of interest rates, in nominal terms at least. So there seems to be a mechanism that provides an end point at the low end of the market, but what happens at the top end? Is there a limit to how big a company can get?
Not judging by the experience in the US. The biggest company in the US is Microsoft (NASDAQ: MSFT). It is capitalised at $463b, and has a prospective price to earnings (P/E) ratio of 55. By any measure this is an optimistic valuation. And the company doesn't even pay a dividend. Sure, it's growing, but the recent judgement by the Department of Justice must raise some questions about the business model. In the UK the biggest company is BP Amoco (LSE: BPA) with a capitalisation of £121b and a prospective P/E of 32. And that is for a supposedly boring mundane commodity business. At least Microsoft has the virtue of being in a high-technology growth market.
While many of us are value investors it is hard to ignore the performance of these hi-tech shares, so greed and envy push us towards tracker funds as well.
But the valuation issue is a very real problem and can best be illustrated by the following few tables. The first is a conventional list of the top ten FTSE All-Share companies, ranked in descending order by market capitalisation.
All the numbers are in £ millions.
Company Market Cap
BP Amoco 121,124
Vodafone AirTouch 96,543
British Telecommunications 91,539
HSBC Holdings 69,595
Glaxo Wellcome 68,375
AstraZeneca 49,812
Shell 47,572
Smithkline Beecham 47,668
Lloyds TSB 45,820
Barclays 27,409
Now let's take a look at the top ten companies ranked by net profit, again in descending order.
Company Net Profit
British Telecommunications 2,983
HSBC Holdings 2,604
Lloyds TSB 2,120
Unilever 1,973
BP Amoco 1,967
Glaxo Wellcome 1,836
National Westminster 1,617
Barclays 1,335
Halifax 1,171
Abbey National 1,058
General Electric Company 1,054
The next table lists them by shareholders' equity. This is the figure that accountants say the company is worth, and is arrived at by adding retained profits and deducting losses and dividends from the capital subscribed by the initial shareholders.
Company Shareholders'
Equity
BP Amoco 25,826
HSBC Holdings 18,444
British Telecommunications 15,156
Shell 13,895
CGU 9,551
National Westminster Bank 8,648
Barclays 8,237
Cable & Wireless 7,997
Royal & Sun Alliance 7,560
Lloyds TSB 7,517
And then, ranked by revenue:
Company Sales
BP Amoco 63,304
Unilever 27,094
British Telecommunications 16,953
Prudential 19,070
Tesco 17,158
Allied Zurich 16,811
Sainsbury 16,433
British Airways 10,000
Diageo 9,930
Marks & Spencer 8,224
Glaxo Wellcome 7,983
Cable & Wireless 7,944
British American Tobacco 7,120
HSBC 7,076
Several things about these lists are quite striking and I have selected some of the more obvious in no particular order.
Vodafone AirTouch (LSE: VOD) only appears in the market capitalisation list, where it comes second. In terms of sales, profits and equity it is simply nowhere to be seen. No wonder Chris Gent is so keen to make an acquisition using his paper while he can. The valuation of this company relies entirely on projections of future growth in the mobile phone market.
BP Amoco (LSE: BPA) can justify its place at the top of the pack on criteria other than pure market value. It is the largest in terms of shareholders' funds and equity. However, there is considerable scope on what weighting you would give the stock, depending on which list you used.
The variation in the range of net profits is much smaller than the ranges using the other criteria. I am sure that is significant but I can't quite think why. I suspect part of the reason is the variety of ways companies account for sales. Of all the measures I suspect that reported sales are the least reliable, although in theory they should be the most useful.
There are many interesting features in these tables, and they are worthy of much more detailed discussion than I can give time to now. But the real point of these lists is to assess the viability of basing a tracker fund on them. Now, I fully appreciate that this data is raw and unfiltered. I have no idea how much it needs to be adjusted for exceptional events or for acquisitions and disposals, but it is a reasonable base to work from.
Nevertheless, basing a portfolio on one, or perhaps all three, of these criteria would remove the problem of tracker funds being over-invested in the most expensive shares. For example, in the market cap weighted index BP Amoco makes up 18% of the top ten. But in the ranking by net profit it only accounts for 10%. Weighting the portfolios this way would give a much more even distribution to a fund. Moreover, it would not force the fund to put most of its fresh money into the most expensive share. Instead, new money would go into the company making the most money.
An intriguing aspect of this exercise is to assess likely performances over different economic scenarios. In a period of rapid economic growth it seems reasonable to assume that the fund based on revenue would have the better growth rate. This reason for is something called operational leverage, and I hope a quick digression to explain this will be allowed.
Let's take 2 companies, both with revenues of £100m. One has operating margins of 20% and the other 10%, in other words operating profits of £20m and £10m. Now assume in the next year that revenues of both firms increase by 10% to £110m, and, more controversially, that the cost base is unchanged. As a result operating profits for both firms rise by £10m. This takes the operating profit for one firm from £20m to £30m, and the other from £10m to £20m. Both are healthy increases, but in percentage terms one has risen by 50%, which is good. However, the second firm has experienced a 100% gain in its operating profit, which is even better. This is a much more dramatic increase in profit, even though revenue growth at both firms was the same. That is what we mean by operational gearing; a small change in the firm with lower profitability has a bigger effect on profits.
Now to return to our other ways of sorting a tracking fund.
In a bear market, the fund based on shareholder's equity should hold up the best because it will have a bigger weighting of so-called value stocks. At least that is the theory.
Critics of this system, i.e. using anything other than market capitalisation, will point that it will always be underweight in growth shares. While that is true, it would be perfectly possible to construct a tracker that was based on incremental sales growth. The biggest holding would be the company with the fastest sales growth, and so on.
In essence, then, the proposal is that tracker funds could be based on any number of different criteria, and not just market capitalisation. Doing that would remove a massive distortion that is building up in the equity market. And the person, or fund, that did it first would have a huge advantage.
Whether it would work in practice is another issue. But we would love to know what you think, so tell us on the Investment Strategy board.
