| BUSINESSWEEK ONLINE : MARCH 1, 1999 ISSUE | ||||||||
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| FINANCE
Big Caps, Big Edge Virtually every foreseeable trend favors large companies For four years in a row, Wall Street pundits have resolutely made the same New Year's prediction: Small-cap stocks will outperform blue chips over the coming 12 months. Each time, they have been wrong, but that hasn't stopped them from making the same forecast again this year. Their argument is simple: Small caps have lagged behind the large caps for so long that they have become historically cheap in comparison. And, they say, such disparities in valuations usually don't last very long. But the small-cap bulls may be sorely disappointed. Investors have latched on to big stocks since early 1994, and it is not a fad. The powerful economic forces such as disinflation, globalization, and profits growth that made large caps big winners are still firmly in place. ''Sure, the valuation dichotomies are massive, but the world has changed [and] the power of scale has grown increasingly important,'' says Beth F. Terrana, portfolio manager of the $11 billion Fidelity Fund, who has 86% of the fund's assets in large-cap stocks. POOR START. For investors in small caps, the last five years have been frustrating. They made money, but nowhere near what they could have made by investing in large-cap stocks (chart). In 1994, the Russell 2000, a widely followed index of small-cap stocks, trailed the large-cap-dominated Standard & Poor's 500-stock index by about three percentage points, a lag that kicked off the recent era of underachievement. Last year, that performance gap was a yawning 31 percentage points--and the results so far this year are not encouraging. For the first seven weeks of 1999, the Russell was down 7.7% while the S&P was flat. Are the small caps just going through a prolonged down cycle? After all, they trounced big stocks in the early 1990s. For some seven decades, small-cap stocks earned an 12.4% average annual return, vs. 11.2% for large caps, according to Ibbotson Associates in Chicago. And the law of numbers suggests that small caps could offer investors far more growth potential than companies that have already grown quite large. That's theory. The facts, at least those of the last few years, show that big is beautiful. In 1998, for instance, the largest 25 stocks in the S&P 500 accounted for 63% of the index's 28.6% gain and the 100 largest accounted for 99%. It hasn't hurt that in each of the last three years, economists have forecast slower growth for the economy. So investors continued to buy the stock of the bigger, more established companies and to shun the scrappier and ever-cheaper small caps. The trend favoring the giants is not likely to change soon, and the reason is profits. The superior performance of large caps has been driven by their ability to generate high, sustained profit growth, says Wharton School finance Professor Jeremy J. Siegel. He calculates that in the last five years, the average earnings growth of the nation's 30 largest companies has been 19.5%, vs. just 11.6% for all the companies in the S&P index. Comparable growth for the Russell 2000 is less than 10%. ''As long as the top earnings growth is concentrated in the big-cap companies, their momentum will continue,'' says Siegel. The profits being generated by the nation's top companies are extraordinary by historical standards, helping to explain why investors are paying record prices for many of those stocks. During the large-cap bull market of the late 1960s and early 1970s, the growth rates of the earnings of then-market leaders General Motors (GM), AT&T (T), and Exxon (XON)scored only three percentage points higher than the rest of the market, according to Siegel. The ability of some large companies to generate high profit growth is no fluke. Many of the market's biggest winners are in two fast-growing industries: technology and pharmaceuticals. They've skillfully adapted to rapid change and have used their enormous financial clout and richly valued stock to buy smaller companies with promising new products and undercut competitors on price. That's not all. Most of these companies--like Microsoft (MSFT), Intel (INTC), and Pfizer (PFE)--are stars on a global stage, not just the U.S. So foreign investors want to own them as well. That drives their prices even higher. Are these stocks now overpriced? Not necessarily, says Siegel: ''These companies are in nonsaturated markets with unlimited potential for growth.'' The big boys are also the biggest beneficiaries of low inflation. In an economy where companies have little or no pricing power, these world-class players have greater ability to control costs than small companies. For example, larger companies can more easily strong-arm suppliers into lowering prices, while smaller customers may have too little clout with the suppliers to lean on them hard. That's not all. ''Small companies,'' says Thomas M. McManus, a portfolio strategist at NationsBanc Montgomery Securities LLC, ''often lack the pricing power they need to boost revenues.'' A lack of pricing power would obviously hurt small caps if the economy were to slow down. And if the economy were to go into recession, small caps would take an even nastier hit than the big stocks. However, coming out of recession, the small stocks tend to outperform the bigger companies, says Roger G. Ibbotson, chairman of the investment research firm that bears his name. Indeed, in 1991, the Russell 2000 surged 46%, leaving the S&P 500, which gained only 30.5%, in the dust. The large-cap stocks are also being propelled by momentum in the stock market. Watching the success of the S&P 500, investors are flocking to S&P index funds, pushing billions of dollars into the same large-cap winners. The cash flowing into mutual funds that hold stakes in small companies, by contrast, fell 74% last year from the level of 1997, according to Financial Research Corp. Some large investment firms have also pulled back from small caps. Fidelity Investments, for example, has just seven of its 153 domestic-equity fund managers and analysts following small caps on a full-time basis. Another reason that institutional investors are shying away from small caps has to do with problems executing trades on the NASDAQ market, where most of the small companies trade. Lee Kopp, president of small-cap specialist Kopp Investment Advisors Inc. in Edina, Minn., says that NASDAQ market reforms in recent years have resulted in fewer firms making markets in small-cap stocks. This void has reduced the liquidity of small stocks, making it more difficult to execute institutional-size trades without adversely affecting the stock price. ''Trying to buy just 50,000 shares of a company can easily push the price up 50 cents,'' Kopp says. He also complains that the frenzied trading in Internet stocks during the past year has made the entire small-cap sector more volatile, with the headlines tending to scare off many would-be investors. Still, while smaller stocks are cheap relative to large stocks, they are not cheap when viewed from the perspective of their historical performance, according to Andrew Engel, senior research analyst at Leuthold Group. Engel estimates that small caps are trading at an average price-earnings ratio of 17.1, well above their long-term average of 13.9. Eventually, small-cap stocks may get their due. Right now, however, economic and market conditions clearly favor the large companies. Investors who have piled into large-cap stocks or mutual funds that own them will continue do a lot better than those who pin their hopes on the small fry. By Geoffrey Smith in Boston To read a letter to the editor about this story, click here. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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