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[LARGE CAPS] R.I.P blue chip stocks

Steve Coffey is an investment analyst with UBS

The past 12 months or so has been a difficult period for truly large cap Australian fund managers to outperform their benchmark. This is due to the dramatic underperformance of large cap stocks against the broader market. 

The graph below shows the long term relative price performance of the 20 Leaders against the ASX 200. The 20 leaders currently makes up more than 60% of the ASX200, but over the past 12 months has underperformed the broader benchmark by around 8%. This implies that the 180 stocks excluding the 20 Leaders have outperformed 20 Leaders by around 15%. 

 

20 Leaders relative to ASX200

 

Source: FactSet & UBS Asset Management

In this environment, a fund manager benchmarked against the ASX200 could outperform by 20% simply by not holding the largest 20 stocks. 

The last few weeks have seen particularly severe underperformance of the 20 Leaders. In volatile markets and when there are concerns about the economy, large cap stocks typically outperform, as people gravitate to more diversified corporates with stronger balance sheets. This has not been the case recently and instead, the underperformance has actually accelerated. We are putting this down to a cyclical phenomenon, rather than something structural. 

It certainly doesn't feel like the bull market of 2001-2005, when large caps underperformed as investors chased leverage. It also appears at odds with what's happening overseas. In the US for instance, the S&P100 has outperformed the S&P500 over the past year. So what is causing the current period of large cap underperformance in Australia? 

Some of it has been the weakness of the banks, their recent capital raisings, and concerns over household gearing. We find it hard to envisage a scenario where only the banks are hurt by a bursting housing bubble, and the rest of the market sails through unscathed.

Some is the weakness in materials stocks caused by weaker commodity prices. 

The underperformance of previous market darling yield stock Telstra.

And some of it is likely to be investors selling their big, liquid Australian positions to fund either redemptions or a reallocation to other markets, or selling in anticipation of this happening. 

These periods are painful in the short term, as it makes it difficult to outperform given our large cap focus. But to misquote Mark Twain, "reports of the death of blue-chip stocks have been greatly exaggerated".

On the upside, share prices that deviate from fundamentals create opportunities for long-term investors & thanks to the recent sell-off, we have built positions in some big underperformers. In Suncorp, we now see less earnings risk following the company's profit downgrade, and early signs that the general insurance cycle has bottomed. We also added to AMP in the lead up to the result, having taken profits at much higher levels last year. And more recently, added to our position in Wesfarmers, one of the best managed corporates in Australia.

Although we recognise these short-term thematic and technical drivers of performance, we are stock pickers, who build portfolios from the bottom up. We don't change the way we manage money to chase short term performance. While others try to pre-empt the mood of other equity market investors, our investment process dictates that we remain focused on the sustainable cash flow our companies can generate at mid-cycle - a process we have applied successfully in Australian equities for more than 20 years.

Published on: Friday, February 26, 2016

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