Personal Finance: Market leaders may not be tops

EVEN BY the demanding standards of the past, this has been an exciting and volatile year in the stock market. The dramas of the summer may be over for now, but there is no question that this has been a year full of strange and unsustainable phenomena, the Russian and hedge fund crises being just the most dramatic examples.

It has certainly been a year when many tried and tested methods of picking stocks have failed to deliver their customary results. The divergence in performance between large cap and small cap stocks has, if anything, accelerated in the past year.

So much so that Anthony Bolton of Fidelity Investments, for example, unquestionably one of Britain's most consistently successful fund managers, told me last week that he can rarely recall a time when the disparities in relative values have been so great. In his view the continued domination of the market performance charts by just a handful of blue chip companies has created some wonderful bargains in the lower reaches of the market.

Bolton's view is that the onward march of indexation, which encourages the buying of the largest stocks in the main market indices, coupled with increasingly herd-like behaviour by institutional investors, is in danger of creating a valuation bubble at the very top of the market.

Jim Slater is another professional investor who has come to exactly the same conclusion. He has admitted that the smaller growth stocks his own selection method is designed to throw up have struggled to make progress in current market conditions.

In Slater's view, it is very difficult to find any value at all among the market leaders. Buying Glaxo, for example, on a p/e ratio of more than 30, is hardly an attractive-looking prospect, whatever your method of share valuation.

Yet the increasingly lopsided performance of the Footsie index itself may now, he thinks, be throwing up some interesting investment opportunities. For safety-conscious investors, who find midcap and smaller stocks too risky, or for those with income requirements, he reckons there is a lot to be said for taking a fresh look at some of the relatively unfancied members of the Footsie index.

Using a screening method inspired by the research of a well-known American contrarian investor, David Dreman, Slater has picked out eight Footsie stocks which he believes could make a sensible portfolio of blue chips for cautious investors.

The results of this exercise are set out in the table. All these companies are, by definition, large, well capitalised and securely financed businesses.

The average yield of this group, at 6 per cent, is almost twice the average of the FTSE 100 index as a whole, and looks attractive in an environment of 2-3 per cent inflation and falling interest rates. The p/e ratio of around 12 is barely more than half the Footsie average (currently 22). Since the exercise was first carried out last month, three of the shares (Bass, P&O and Royal Bank of Scotland) have made positive advances, but the others have still to make much, if any, progress.

This seems to me an interesting approach and one whose results I shall monitor over the coming months. What is not in doubt, it seems to me, is that the current surge in large cap stock valuations is unsustainable.

The one thing which every serious research study shows is that a sure- fire way to lose money on the stock market over time is to buy the most popular shares of the moment (ie those with the highest p/e ratios and the lowest dividend yields). The risk in chasing the market leaders higher is therefore substantial, and prudent private investors will look elsewhere for value in the Footsie in current conditions.

Jonathan Davis can be contacted by e-mail at: davisbiz@aol.com