Charles Morris
Charles Morris
01/05/2020

Market Commentary – A Look Inside the FTSE 100

May 2020

Many forget that stockmarket indices, or averages as they were once known, were created by media companies rather than financiers. The likes of the Dow Jones, Nikkei, Straits Times or the Financial Times wanted to report what the market has done with one number. Half a century later, Jack Bogle came along and demonstrated that tracking the index would be an above average investment strategy, compared to many active funds. That idea morphed into Vanguard, and the rest is history.

The FTSE 100 was launched on 3 January 1984 with 100 stocks, at a price of 1,000. It is arithmetically weighted which means its constituents and weights move in line with their market value. It superseded the FT Ordinary Index (FT 30) which was geometrically weighted. That had a habit of understating market movements, and more to the point, was impossible to track. The FTSE was created for finance and the FT30 was put out to pasture. For the sake of curiosity, here are the FT 30 constituents back in 1935 courtesy of Wikipedia.

  1. 1. Associated Portland Cement                                   
  2. 2. Austin Motor
  3. 3. Bass Brewery    
  4. 4. Bolsover Colliery                           
  5. 5. Callenders Cables & Construction           
  6. 6. Coats plc            
  7. 7. Courtaulds                                     
  8. 8. Distillers Company                       
  9. 9. Dorman Long                  
  10. 10. Dunlop Rubber                             
  11. 11. EMI      
  12. 12.Fine Spinners and Doublers       
  13. 13. General Electric Company plc                   
  14. 14. Guest Keen & Nettlefolds           
  15. 15. Harrods             
  16. 16. Hawker Siddeley                                         
  17. 17. Imperial Chemical Industries     
  18. 18. British American Tobacco           
  19. 19. International Tea Co Stores        
  20. 20. London Brick     
  21. 21. Murex 935     
  22. 22. Patons & Baldwins         
  23. 23. Pinchin Johnson 1935
  24. 24. Rolls Royce
  25. 25. Tate & Lyle
  26. 26. Turner & Newall             
  27. 27. United Steel Companies
  28. 28. Vickers 1935                   
  29. 29. Watney Combe & Reid 
  30. 30. Woolworths

Some of these companies have failed, but most were absorbed into the corporate machine one way or another. Only three companies, British American Tobacco, Rolls Royce and Tate & Lyle, have retained their name and listing since 1935. But recall that Rolls Royce spend many years nationalised between then and now.

Arithmetic index weighting is one of the great financial innovations of all time. It is a long-term momentum strategy that locks onto companies by their market value. When Marks and Spencer fell out of favour, it was ejected from the FTSE 100, along with many others before it. In came Experian and Just Eat; business models that didn’t exist a generation ago. Tate and Lyle hovers at the top of the FTSE 250 Index waiting for an upgrade. The company is moving away from sugar and now makes smoothies, soups, sauces and dressings. The history of capitalism tells us that it is only the companies that adapt that survive.

Sectors

The FT 30 was inherently industrial back in the day. There was no oil (or coal), utilities, transport or telecoms because they were nationalised. Services barely existed as there were no large gym, travel,  restaurant or hotel chains. Consumer products were dominated by alcohol and tobacco, and the banks and insurers were partnerships, mutuals or private companies.

The modern FTSE 100 is poles apart. There are many more companies, and many more sectors, making it more diversified. Consumer discretionary, financials, property, utilities, energy, information technology and healthcare are much more important in today’s market compared to the industrial dominance of yesteryear. The data are not readily available to show sector weights pre-2006, when the last round of sector reclassifications was made, but we have a few reference points.

FTSE 100 by sector since 2006

Source FTSE, Atlantic House

In 1996, energy was 11.5% with companies such as Burmah Castrol, Enterprise Oil and LASMO. That grew to 12.3% by 1999 with just Shell and BP. Then by 2008, when the oil price touched $148, the weight ballooned to 24%. It has been gliding down ever since to just 9%. In real terms, Brent crude is slightly higher than at the low in 1998 following the Asia crisis. Oil is rarely this cheap.

Brent crude in real terms

Source Bloomberg: Brent Crude relative to US CPI since 1988 rebased

The financials are the other sector that have weighed down on the FTSE. After the Asia Crisis, Lloyds was the biggest bank by value with a 4.3% weight. Today it is 1.4%. Yet overall, financials, which includes life insurance, insurance and other financials, had a combined weight of 26.6%. This peaked at 32% by 2006, and now sits at 16%.

As for the winners, consumer goods were just 7.7% in the late 1990s and have been rising ever since to become the FTSE’s largest group with a 22% weight. The post-2008 low inflation, low growth world has been a boon for this sector, and the COVID crisis has provided an additional boost.

Factors

At Atlantic House, we look at sectors, but like to think of them by the factors they represent, namely quality, growth and value. Sectors can be put into factor groups which broadly explain their macroeconomic behaviour. Quality is defensive and tends to outperform when interest rates and inflation are low. Being the least sensitive to the economy, these stocks become safe havens during a crisis. Growth also enjoys low inflation but prefers the economy to be growing. Finally, value is highly sensitive to the global economy and does best when inflation is rising; something we would normally associate with the early stages of the economic cycle. The sectors have been grouped as follows:

Quality = Consumer Staples + Health Care + Utilities
Growth = Industrials + Information Technology + Real Estate + Communication Services + Consumer Discretionary
Value = Energy + Financials + Materials  

FTSE 100 by factor since 2006

Source: FTSE, Atlantic House

The FTSE was 56% value before the 2008 credit crisis. With energy and financials under pressure, this has dropped to 40%. That would be lower, but materials have performed well. The UK’s mining giants are world leaders and have been on an acquisition spree in recent years. As the economy emerges from the COVID crisis, the FTSE’s value credentials will hold it in good stead.

Quality has been the fastest growing group. It made up 27% in 2006 and has grown to 38% today. If the economy were to turn down from here, the FTSE would be more resilient than even a few months ago. Consider how many investors have increased quality and reduced value in response to the crisis; that is what the FTSE has already done courtesy of the invisible hand.

Growth reflects the domestic economy, which has contracted sharply during the lockdown. Furthermore, it has also been falling ever since the Brexit vote in 2016. As the lockdown comes to an end, and the uncertainty surrounding Brexit is finally behind us, growth has the potential to perform well.

Putting this together, the FTSE’s value exposure is low by historic standards, yet has most likely  seen its worst days. Commodities and financials trade cheaply, and the risk versus reward has swung in their favour. The increase in quality has reduced the structural nature of the FTSE’s volatility, and will provide a shock absorber. Finally, growth will enjoy a strong recovery once the lockdown ends, which will have a second wind once the Brexit negotiations are complete.  

Dividends

One fear is that investors buy the FTSE for income, and the dividends have fallen sharply. Dividend futures are referenced by the actual level of dividends paid. At the beginning of this year, the dividend future registered 315 index points, which has subsequently fallen to 150 points; a 52% fall. While alarming, companies such as the banks have been told to cut their dividends, and for many others, shoring up liquidity during the lockdown has been a prudent step.

FTSE 100 dividend future

Source Bloomberg UKDA FTSE dividend future 2020 year to date

The FTSE’s forward-looking dividend yield is calculated by dividing the dividend future by the FTSE 100 Index. The FTSE paid a 4.5% yield before the crisis, which has dropped to 2.3% on a forward-looking basis.

FTSE 100 dividend yield – implied and realised

Source Bloomberg FTSE 100 dividend yield implied (black), and FTSE 100 actual yield (red) since 1999

There are differences between the implied and realised FTSE dividend yields; the main one being that one looks back and the other forwards. However, in addition, dividend futures don’t include special or scrip dividends, and there’s a 15% haircut on RDSA’s dividend due to withholding tax. We have looked at this from both a historic and a forward-looking basis.

Dividends paid in 2019 and their current status

The total dividends paid in 2019, including specials, was £119,651m. So far this year, £26,163m have been cancelled, £3,198m have been suspended, and £7,727m have been cut, including Royal Dutch Shell. So far, we have seen a 31% drop in dividends, yet expectations are down by 52%.

Source: Bloomberg, dividenddata.co.uk

A forward look at dividends

The emergence of the dividend futures market gives us a window into future expectations. With 31% of announced dividend cuts, and the dividend future down 52%, the market sees the pain coming through over the course of the year and into 2021, before recovering thereafter.

The outlook for FTSE dividends

Source: Bloomberg, ICE. Implied FTSE 100 dividends 2020 to 2026

Taking a more granular look at the sectors within the FTSE, dividends within the value sectors have the furthest to fall. In the following table, we have looked at a bull and bear scenario for 2020. It has become clear that the consensus estimates from equity analysts remain too optimistic.

Bull and bear dividends by FTSE sector

Source: Bloomberg, ICE, AHFM. Implied, bull and bear FTSE dividends for 2020

Taking the main sector contributions one by one, there is a varied story on the outlook for the dividends of the index.

Materials – Rio and BHP have been through a gradual deleveraging exercise since 2015. Both companies are relatively well placed to survive the COVID lockdown. They have cut many of the capital-intensive operations such as iron ore mining and coal (in the case of Rio).

Energy – Shell’s decision to cut the dividend was not expected by the market, having maintained the return of capital each year since the second world war. However, we see this as a tactical move by management to hoard capital while facing an uncertain future for both upstream and downstream operations. The return of the dividend to full strength is priced in for 2022.

Financials – Whilst we believe that all of the UK banks could have afforded the dividends paid this year, the move by the PRA to force the banks to cancel dividends may cause further pain for investors who hold the shares for their income. Many management groups, such as HSBC which is going through a major restructuring, may have been reluctantly paying such high dividends and simply following precedent. In a banking sector which is increasingly complex, some banks may choose to delay returning the dividend to full strength in favour of increasing capital buffers. Their aim is to reduce financing costs further down the capital structure, and by extension, improve their return on capital ratios.

Summary

Arithmetically weighted indices are remarkable creations, and in a sense, they are alive. They move with the times to reflect the changes in the world in which we live. The FTSE is often said to be a global index that reflects the fortunes of the world. That was true then and remains true now. While this decade has seen US stockmarket dominance, the FTSE has moved in line with the best of the rest. There has been some short-term underperformance during the COVID crisis, but as the recovery takes hold, therein lies the opportunity.

FTSE and World-ex US

Source Bloomberg: FTSE 100 TR and MSCI EAFE TR in GBP since 2010

We have shown that the FTSE has never been more diversified and had so much exposure to quality companies. As the global economy gradually gets back on track, the FTSE is well placed to benefit, especially with value this cheap. Growth has been weighed down by both the lockdown and Brexit; both of which will be behind us by this time next year. The dividend cuts have been a cause for concern, but the market sees that to be temporary. Stockmarkets look forward rather than back, and the FTSE can only recover as the economy finds its feet. If we had to choose one sector for the next 10 years, our best answer would be industrials. That is where you see Britain at its best.

Charlie Morris, Tom Boyle – Atlantic House Total return Fund