You might think that the FTSE 100 is now barren ground for picking winning shares. After all, the index has made a tremendous recovery since the 2008/9 bear market and posted strong gains since June's Brexit vote.
However, while the unprecedented stimulus measures post-2008/9 have sent share prices soaring, many heavyweight blue chips have been struggling to grow their revenues and earnings. Let me show you what I mean.
Reasons to feel blue about blue chips
Last year, almost half of the companies in the FTSE 100 posted a fall in their revenues. Meanwhile, many companies have posted rising profits purely due to cost-cutting rather than business growth, something that isn't sustainable in the long run. In other cases we've seen earnings growth produced by companies leaving out lots of 'nasties', so that 'adjusted' earnings look good, while real earnings may be negative. Finally, FTSE 100 companies have been buying back billions of their own shares, which has the effect of flattering their earnings.
So, share prices and dividends have raced higher, even though, in many cases, companies haven't really been growing. According to the FTSE Actuaries, the top index is now trading at a sky-high earnings multiple (P/E) of over 36. Furthermore, dividend cover is just 0.75, which means that a quarter of shareholders' payouts are being funded from the companies' balance sheets -- in most cases by increased borrowings.
Given the high valuation of the FTSE 100, and the number of companies struggling to grow their top lines, increasing their profits cosmetically and borrowing cash to fund their dividends, is the index now the worst place to look for winning stocks. Should we be turning our backs on the heavyweight blue chips and looking instead to younger, nimbler companies that are set to grow their revenues and profits rapidly from relatively low bases?
Smaller company appeal
I'm certainly coming across many smaller companies that are forecast to grow at rates that show a clean pair of heels to the average FTSE 100 company. In the last 10 days alone I've written about a tasty retailer that's just posted a 229% rise in profit, a holiday specialist bucking the tough travel market, and a niche e-tailer and a leisure firm that are forecast to grow earnings by 43% and 55% respectively.
Now, while companies such as these have tremendous growth prospects and are certainly worth considering, there's no such thing as a free lunch. Many of them trade on really high earnings multiples, and being young, rapidly expanding businesses there is a higher risk in executing on their growth strategies. Smaller companies rarely progress without the odd hiccup or setback and, of course, some end up not prospering at all.
So, while I think there is a place for small cap growth stocks in the portfolios of most investors, I wouldn't turn my back on the FTSE 100 for some core holdings.
Back to blue chips
Not only is the sheer size and relative stability of blue chips appealing, but also a number of these heavyweights are now set to put their struggles with revenue and earnings growth behind them. Shell, GlaxoSmithKline, Vodafone and Tesco are just four popular names that are on track for a resurgence in growth this year and in the years ahead.
So, the FTSE 100 appears to be far from the worst place to look for stocks that can deliver winning returns for investors.
Five of the best
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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.