In the summer of 1990, the U.S. economy was quickly losing
altitude. By the fourth quarter, the nation's GDP had fallen by
nearly 4%. Unemployment began to rise, and the economic weakness
would eventually cost George H.W. Bush a chance for a second
By Oct. 1 of that year, the Russell 2000 small-cap index had
fallen to just 119. Yet just 16 months later, it surged past the
200 mark, reaching 250 by September 1993. Investors shouldn't
have been surprised. Small-cap stocks always do well when the
economy is in a funk, but investors sense that better days lie
Well, it's happening again.
Although the U.S. economy has posted a halting and
unimpressive recovery, investors have again embraced seemingly
risky small caps. The 200% gain in the Russell 2000 since the
markets bottomed out in March 2009 surpasses the S&P 500's
gain by a whopping 50 percentage points.
Yet for a host of factors, it's time to trim your exposure to
small caps and go big. Mega-cap stocks, which are the 100 largest
companies in the S&P 500, haven't held this much appeal --
relative to small-cap stocks -- in quite some time.
Analysts at BMO Capital Markets took a look this issue in a
historical context and concluded that "Although mega-cap stocks
have traditionally underperformed during the first few years of
bull markets, the degree of underperformance in the current cycle
is quite exceptional." They add that "this is typically the part
of the (economic) cycle where mega-cap outperformance
Before we delve into the reasons why mega-cap stocks should
soon rotate into favor, it's helpful to know why they
traditionally underperform in the early stages of economic
recoveries. The simplest explanation: Small-cap companies tend to
feel the painful effects of an economic recession more deeply (as
was the case in the early part of 1990), and as a result, have
the potential for the most robust earnings rebound as the economy
Mega-cap stocks, on the other hand, don't typically suffer
from severe profit droughts when the economy slows, and are
instead like ocean liners steaming ahead at a constant pace in
In fact, that relative dullness can work against mega-cap
stocks when markets are moving higher at a rapid clip. "These
stocks have a reputation of being the most predictable and thus
least interesting area of the market (e.g., the perception that
better performance opportunities exist elsewhere)," noted BMO's
Perhaps the greatest appeal of mega-caps right now is the
relative valuations. The recent phase of underperformance has
left many of them with price-to-earnings (P/E) ratios below the
S&P 500 average of 16.
And these relatively low P/E ratios have two implications.
First, these stocks are likely to be spared from indiscriminate
selling if investors look to shed pricey stocks in a falling
market. And they have more room for multiple expansions if the
market moves higher.
The Foreign Factor
Mega-cap stocks have also underperformed because they have
relatively greater exposure to global markets. Though it's hard
to pinpoint the specific numbers for mega-caps, the typical
company in the S&P 500 derives roughly 46% of sales from
abroad, which is roughly twice the level of small caps. And much
of the foreign sales are derived from European
Yet at some point, perhaps as soon as the next few quarters,
the European drag will abate, and soon thereafter become a
tailwind as European spending (especially in terms of capital
equipment) starts to make up for lost time.
The United States: Safety And Upside
Of course, these mega-caps still derive the bulk of their sales
in the U.S., the world's largest economy. Though economic growth
has been underwhelming thus far in 2013 (expanding 1.1% in the
first quarter and 1.7% in the second quarter), most economists
anticipate a steady strengthening led by consumer spending. If
they're right, a firmer economy will enable these mega-caps to
generate decent (albeit unspectacular) growth in sales and
profits in coming years.
But what if the economists are wrong and the U.S. economy
starts to sputter? (Bespoke Investment Research notes that two
straight quarters of sub-2% GDP growth yields a 70% chance of a
recession in the next 12 months as the economy hits "stall
speed"). Well, mega-caps are the place to be in such a scenario.
BMO's analysts found that the return on equity of mega-caps
"never dipped below 15% throughout the entire financial crisis."
That's a claim the small caps can't make.
Bulletproof Balance Sheets
One of the hallmarks of the recent era is the stunning rise in
cash balances at almost every major U.S. corporation. By one
estimate, mega-caps' cash balances now account for 16% of their
total asset base. That figure is below 10% for the bottom 400
companies in the S&P 500. Equally important, the global
rivals to these mega-caps have not had the luxury of building up
such robust cash balances. And greater financial strength should
allow domestic mega-caps to go on the offensive and pursue global
market share as the global economy mends.
I'm partial to a few mega-caps in particular, starting with
, which I profiled a few weeks ago.
The insurer just announced its first dividend since the global
crisis took root, and by math, the payout should rise smartly in
I also remain a huge fan of both
, which I also discussed recently.
Over in the technology sector, I still see further upside for
Cisco Systems (Nasdaq: CSCO)
even as shares have risen roughly 30% thus far in 2013.
If you prefer to go the exchange-traded fund (ETF) route, then
iShares S&P 100 Index (
is a solid choice. Vanguard gives investors two ways to invest in
the theme: the
Vanguard Mega Cap Growth Index ETF (
Vanguard Mega Cap Value Index ETF (MGV)
. The latter fund may hold greater appeal, not just because it
has lagged the major indices over the past five years, but also
because "large-cap value stocks (low price/book) have outpaced
their growth counterparts by roughly 2% annualized, from 1927
through 2012," according to Morningstar.
Risks to Consider:
Mega-caps may remain out of favor if investors continue to
favor higher-beta assets that are perceived as bull market
Action to Take -->
The seemingly never-ending surge for this bull market has a whiff
of mania about it -- yet at some point, the current momentum
investing trend will peter out. When that happens, investors are
likely to take note of the relative value and safety that
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