The best investment potential lies in the smaller firms of the FTSE 100 rather than in 30 or so largest, I believe. Around 50% of the index is made of companies with a high cyclical element to their operations and many of those are among the 30 largest — banks, oil companies, commodity producers, insurance firms and the like.
A big red warning flag
I’m wary of firms that are ultra-sensitive to macroeconomic conditions, particularly now when we sit mid-cycle with arguably benign economic conditions. I think big banks such as Barclays (LSE: BARC) make dangerous investments today. The firm’s profits are high, with City analysts predicting pre-tax earnings around £5,924m for 2017, which means profits will have recovered from their 2011 level. Meanwhile, at a share price of 157p, the forward price-to-earnings ratio sits at just over seven, which is low.
If you believe one-time star-performing Fidelity fund manager Peter Lynch, a low apparent valuation can be like a big red warning flag with the cyclicals. After a long period of improving and high profits, as we see now with Barclays, the market tends to try to smooth out the effects of cyclicality by compressing valuations to discount higher earnings in the knowledge that lower earnings are on the way. It rarely works, and share prices tend to plummet anyway when earnings collapse as the cycle turns down.
As I look at Barclays from here, the way up looks winding, slow and torturous. The way down looks straight, fast and easy. An investment now could work out okay, but I feel it comes with an awful lot of risk. The time to invest in a cyclical like Barclays is when earnings and the share price are on the floor in the hope of catching the next cyclical up-leg. I don’t think that time is now.
Investing in enterprise
Rather than risk an investment in Barclays, I think small and medium-sized private company investor 3i Group (LSE: III) could be a better bet. The firm’s history stretches back to 1945 when it was set up to tackle a funding gap in Britain’s smaller enterprise landscape. Today, 3i’s reach is global and it calls on a network of professionals to apply expertise and experience aimed at developing its investment companies.
Unlike the highly financially geared operations typical of large banking organisations, 3i is in the strong position of having what it describes as a robust balance sheet with net cash of £165m and nil gearing as of 31 March 2016. Such financial muscle is another factor that helps to ensure a positive outcome for the company’s investments.
It’s interesting to compare how investors have fared in 3i and Barclays:
|
Company |
Share price 1/1/12 |
Share price 14/6/16 |
gain/loss |
Dividends |
Total return pence |
Total return percent |
|
3i |
181p |
501p |
320p |
59.5p |
379.5p |
210% |
|
Barclays |
176p |
157p |
(19p) |
29p |
10p |
6% |
It’s true that past performance of an investment is no reliable guide to its performance in the future because investments can go down as well as up. But a good track record like 3i’s speaks volumes about a company’s form, I believe.
At today’s 501p share price 3i trades on a forward P/E rating of just over seven for the year to March 2018 and pays a dividend yielding around 4.3%. That’s a comfortable valuation for a firm that has proved its growth credentials, but I can’t help thinking the valuation might allow for a certain amount of cyclicality in the business.
An economic slowdown will likely weaken 3i’s shares at some point, but the firm’s business model strikes me as more focused and ‘cleaner’ than that of Barclays, which could lead to a swifter recovery.