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.