An Investor’s Secret Weapon: The FTSE 100

Passive investing: the investor’s dream. Why bother researching and managing individual share holdings when you can buy a tracker fund that follows the FTSE 100? Buy, hold, relax, enjoy, sell two or three decades later, and live it up on your gains — simple!

The trouble is it probably won’t work

That’s a tempting proposition, but it is unlikely to work out like that. The FTSE 100 doesn’t make an attractive long-term investment, in my book, but it does arm us with a secret weapon to boost our returns if we use it differently. Let me explain…

By weighting, cyclical companies make up around 50% of the FTSE 100 index.  The majority of that cyclical element falls into the sectors of banks with firms such as HSBC Holdings and Lloyds Banking Group, commodities with companies like BP and Rio Tinto, and financials and insurers with names such as Prudential and Aviva.

Stock markets look ahead, trying to anticipate forward earnings and prospects for listed firms, and share prices usually adjust ahead of fundamental macro-economic and company-specific information-flow.  That effect is most pronounced with the cyclicals, those firms whose profits tend to rise and fall with alarming magnitude in tune with economic cycles — don’t forget cyclicals form 50% of the FTSE 100 index.      

Cyclicality can really drag on the upwards performance of the FTSE 100. As macro-economic cycles mature and unfold into a period of growth, such as recently, cyclical sectors tend to discount rising profits by reducing valuation multiples. As profits improve year-on-year with the cyclical firms, we tend to see dividend yields rising and P/E multiples falling — a valuation compression effect. That’s why I don’t think the FTSE 100 is the right vehicle to send us to a rich and easy life in retirement if we simply buy and hold a passive investment tracker.

Why does it happen?

The stock market — a collective of all investors participating in it — is smarter than we generally think. As a group, we investors got the measure of cyclicality long ago and the market looks ahead for the next occurrence of peak-earnings. Every increase in yearly earnings with the cyclical firms tends to move us one-step closer to that top and, from bitter experience, the stock market knows what’s coming next.

What we then usually see is the next cyclical decline into the next economic contraction. It can be a dramatic event for cyclical firms, characterised by collapsing profits, dividend-abandonment and, despite the market’s attempts to adjust with valuation-compression, share-price destruction. That’s a double-whammy for long-term holders of a FTSE 100 index tracker. Not only is there upwards resistance in the good times thanks to valuation-compression, there’s also a deep hole to fall into as share prices fall every time the market senses a down-leg in the economic cycle — the share prices of cyclical firms react violently to changes in the economic outlook and hence the FTSE 100 does, too.

Use the FTSE 100 to boost your returns

Because of the exaggerated effect we see in FTSE 100 movements, due to its high cyclical content, we get some definite peaks and troughs in the medium-term chart. It’s certain that if the macro-economic environment gets colder the FTSE 100 heads down, perhaps further down than the share prices of some of the steadier, more defensive constituents within the less cyclical 50% of its ranks.

That potential definition of movement makes the FTSE 100 a good vehicle for buying at cyclical bottoms. Because cyclical share prices are so responsive to changing conditions, troughs can be very deep and narrow — we often see a ‘v’-shaped recovery in the index. If we can get on that upward movement, the ride can be fast and furious.

What next?

The FTSE 100 makes a good secret weapon for boosting returns if we use it wisely. To me, that means waiting for a collapse in the index and then buying it on the first sign of an uptrend developing.

However, like all weapons it’s dangerous if not used carefully. On that note, I reckon it’s best to avoid buying when the index remains in downtrend, wait for the uptrend to develop first, and then to sell when the uptrend seems over. Whatever we do, we shouldn’t buy and hold, and hold, and hold — that’s a rollercoaster that tends to drop us off where we started!

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.