A resurrection is expected-but do the old rules apply?
The refrain that large-cap stocks will lead the
market this year is starting to sound very familiar. Chances are you
heard that same line in early 2005, when many people believed large
caps would end their long schneid and become the pacesetter while
finally ending the dominance of small caps. They were half right,
because small caps did indeed cede leadership to another group-the
mid-caps. Once again, large caps brought up the rear, according to
Standard and Poor's indexes.
So why could this year be different? History and valuations offer compelling reasons, say fund managers and financial strategists.
The Russell 1000 index of large-cap stocks is valued at 17.7 times trailing earnings versus 26.4 times for the small-cap Russell 2000 index, as of January 31. Meanwhile, the S&P 500 index is valued at 14.8 times forward earnings estimates for the same period, while the S&P Small-Cap 600 sports a multiple of 17.0 times and the S&P Mid-Cap 400 is at 17.4.
Backwards or forwards, it's clear that large-cap stocks offer cheaper valuations. "Historically, when you see that kind of discount for large-cap stocks it has been a good time to own these names," says Jerry Senser, co-manager of the large-cap ICAP Equity, Select Equity, and International funds.
The bargain argument is mirrored by Milton Ezrati, senior economic strategist at the mutual fund company Lord Abbett. "The valuations and other factors are lined up to where we believe it's really time for large caps," he says. "I don't think you can make the case that large caps will show better earnings than small caps. But you can make the case that large-cap earnings are more thoroughly discounted, so it's more of a value play."
But investors cannot live by value alone. If there was ever a hall of fame for companies as stock investments, such giants as Microsoft, Pfizer and Cisco Systems are sure-fire first-ballot nominees. But based on their price performance in recent years, it seems many investors think these and other large-cap stalwarts should be relegated to the old-timers game. In other words, where's the growth?
Perhaps a better question is: What is growth? And add to that another question: What is value? To paraphrase the Kinks' classic hit song, "Lola," it's a mixed up, muddled up, shook up world in large caps, as certain former growth stocks in areas like technology are now touted for their valuations while more traditional value-oriented sectors such as energy scorched the charts last year.
The role reversal can be a bit confusing for both retail and institutional investors alike as they try to solve the growth versus value conundrum. "That's a debate a lot of shops are having right now, including ours," says Joe Milano, portfolio manager of the large-cap growth T. Rowe Price New America Growth fund. Microsoft, for example, is found both in growth- and value-oriented T. Rowe Price funds.
Adds Senser, "I think a lot of old definitions of growth and value are less applicable today than five years ago because of changes in how some of these industries operate." He cites the once-hot pharmaceutical sector, where the dearth of major new products and the growing number of generics have crimped earnings and dimmed investor enthusiasm.
For many, the issue of growth versus value boils down to such basic metrics as price-to-earnings or price-to-book. Alec Young, equity market strategist at Standard & Poor's, believes p/e ratios remain the best yardstick. Given the market multiple of 15.1 times forward earnings on the S&P 500, he says anything trading below that is value and anything trading above that is growth. Using that criterion, energy remains a value sector with its 10.4 multiple, as do financials at 12.2 times. Information technology remains the most expensive at 21.
Even so, Young says it's still tough to separate growth from value even when using the black-and-white standard of price-to-earnings. "A lot of these big stocks are in limbo," he says. "Some are too expensive and their yields are too low for the value guys, but they don't have enough growth for the growth guys."
S&P analysts focus more on the performance of different market-cap sizes than they do on the growth versus value angle. As such, Young cites the slowing economy as a plus working in large caps' favor. Many economists call for GDP to grow in the low- to mid-3% range in 2006; solid growth, for sure, but a deceleration from recent 4% gains. Moreover, the economy grew only 1.1% in fourth quarter 2005, down significantly from the third quarter's 4.1% clip and the smallest gain in three years. Although overall GDP increased 3.5% in 2005, that's down from a 4.2% gain in 2004.
It's evident to many observers that the post-2002 economic recovery has crested the hill. Conventional wisdom holds that small caps do better in the early stages of economic expansion as they leverage their earnings growth and investors have a greater appetite for risk, while large caps do better during the back end of a growth cycle when investors look to old standbys for decent growth at lower prices.
Not everybody buys into that argument, though. Brian McMahon, president and chief investment officer at Thornburg Investment Management, says larger corporations aren't as U.S.-centric as their smaller brethren and aren't as beholden to the American economy. "Bigger companies like General Electric are better able to tap into the global economy."
Scouring the investment landscape for the Thornburg equity mutual funds, McMahon sees a lot of big companies with solid businesses, piles of cash, fat dividend yields and compressed trading multiples. "Some had trouble moving the top line or managing expenses, so the bottom line didn't grow as much," he says. "But they remain great businesses."
And they can be had on the cheap. McMahon points to Pfizer with its AAA credit rating, nearly 4% yield, favorable market demographics and a forward p/e of 12 times. He believes the company can make $2.25 a share in the next couple of years, a more optimistic take than the consensus analyst forecast. If he's correct, that's a growth rate roughly one-third more than its current multiple.
A survey of investment managers by the Russell Investment Group (publishers of the Russell indexes) found an overwhelmingly bullish take on large-cap growth stocks. The survey was sent to a few hundred U.S. and overseas fund and money managers, with a response rate of about 30%. Russell reports the respondents' average assets under management are $40 billion, meaning these are opinions that move money.
Survey results showed 80% were bullish on large-cap growth versus 9% bearish, while large-cap value rated 36% bullish versus 28% bearish. Much of the gung-ho sentiment toward large-cap growth is a function of favorable economic conditions for large caps as a whole, potential earnings vis-à-vis current valuations, and the anticipated reversal in the sector's performance of recent years.
Joe Milano, the T. Rowe Price growth fund manager, notes that the past five years were ugly for growth across large-, mid- and small-cap sectors. He reeled off the litany of major, market-altering occurrences-9/11, the recession, the Iraq war, rising interest rates and zooming energy prices-that put the clamps on a lot of people's risk appetite. And add the notion that some people are still licking their wounds from the massive bear market earlier this decade. "You need to take incremental risk to be in the growth area," he says.
Clearly, investors weren't in the growth mode as the Russell 1000 Growth index lost 35.48% in total cumulative returns over the past five years while the Russell 1000 Value index gained 41.67%. (The small-cap Russell 2000 Growth index dropped 12.13% during this time; the Russell 2000 Value index leaped 136.19%.)
The Russell survey's stunning consensus for large-cap growth stocks can be either reassuring or scary, depending on your perspective. "Instinctively I find it scary, particularly when I agree with the consensus," says Randy Lert, Russell's chief portfolio strategist. "I don't find it reassuring because I wonder if we're all missing something."
For sure, potential landmines include more natural disasters in the U.S. (imagine a Katrina-like disaster striking Manhattan), higher energy costs, geopolitical events in Iran or Israel, or a recession. But the outlook for large-cap growth evidently looks inviting to participants of the Russell survey. Lert said that I/B/E/S forecasts a 14.57% earnings growth rate this year for the Russell 1000 Growth index. That compares with the 9.32% rate for the Russell 1000 Value index, where the top five holdings are Exxon Mobil, Citigroup, Bank of America, Pfizer and JP Morgan Chase.
In the end, haggling over the performance of large caps and other caps, as well as growth and value, is more than just academic debate. There's a good chance many stock and mutual fund portfolios are overweight in yesterday's winners, meaning they'd miss the boat if large caps finally shine in 2006.