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Ten Reasons for Large Caps
09/17/2004 12:00 am EST
"The era of small-cap dominance may be drawing to a close," says Joe Battipaglia , chief investment officer at Ryan, Beck & Co. Here, he offers a special report on ten reasons for investors to now be bullish on large-capitalization stocks.
"We are pulling in our horns on small caps as a group. In recent months we have seen accumulating evidence that we may be nearing the end of the period of small-cap dominance. While individual small-cap stocks may perform well on a case-by-case basis, we are cautious about the group as a whole going forward. Our concerns stem from our observations about relative valuations between size categories, cycle dynamics historically between large and small cap stocks, and in the heightened expectations for growth among small-cap analysts.
"No group dominates indefinitely. Cycles favoring large caps over small and vice versa have been with us for decades. Recent years have been very favorable to small-cap companies, which have managed to outperform their larger counterparts by significant margins in each year beginning in 1999, and that leadership continues this year as well evidenced by the -2.7% performance from the S&P 100 index and the +2.95% return from the S&P Small Cap 600 index. Cumulatively, the small-cap indices have outperformed large caps by roughly 130% since 1999. This performance is remarkably similar to that seen in the mid-1960s where small caps dominated during a period of low interest rates and relatively high multiples paid for stocks. That period of small-cap leadership lasted for five years and produced 148% cumulative excess return over large caps. Other cycles including one in the early 1940s and another during the 1970s lasted for five and seven years, respectively.
"Now, on a relative valuation basis, large-capitalization stocks appear more attractive from a strict valuation perspective. We specifically identified the S&P 500 as having entered ‘undervalued’ territory while the S&P 600 index of small-cap stocks was 'overvalued'. Given this fact and with the knowledge that the current cycle is aging rapidly, we believe the risk of underperformance has risen sharply for smaller companies as a general statement. Selectivity within the small-cap universe will become increasingly important in the 2005 timeframe and beyond.
Ten Reasons to Be Bullish on Large Caps
A more rational valuation environment than the late 1990s 'bubble' period;
The S&P 500 is "undervalued" relative to ‘fair value’;
The S&P 600 Small Cap index is ‘overvalued’ relative to ‘fair value’;
Record levels of direct investment favor large multinationals as global economy re-accelerates;
Decades of declining unit labor costs should continue if not accelerate;
Tax burdens can fall further especially at foreign subsidiary divisions of multinationals;
Flow-through of productivity enhancements from 1990s capital spending boom;
Potential for further secular declines in input prices (raw and intermediate goods);
The clock is running out on the small-cap cycle and the small-cap risk premium has risen meaningfully since 1999;
And a strong tendency for cycles to ‘mean revert’ favor large caps over small at this point.
"In September of 1998 we addressed the relative valuation disparity between large- and small-cap stocks in a piece entitled ‘Targeting Small Caps’. In that report, we stated that the era of large-cap leadership was likely to end and that small caps offered better opportunity for investors. The timing of that report was not perfect, but as the years passed the basic portfolio direction was proven correct. Today, we are taking the opposite point of view and moving our recommendation in the other direction. As it relates to small caps, we continue to believe that no group dominates forever and that better opportunities will be had elsewhere in coming years."
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