INTRODUCTION

Small-cap stocks have performed very well over the past decade, significantly outperforming their large cap peers.  The length of this outperformance is unusual as typically small- or large-cap stocks alternate the performance lead every few years.  Considering the challenging global market conditions, attractive valuations and the current economic recovery phase, FundQuest believes the stage is set for large-caps to outperform in 2011. 

 

TODAY’S MARKET ENVIRONMENT

The current economic environment is showing some signs of improvement, yet it remains shaky and uncertain.  The data indicates that the environment over the next few quarters will most likely be marked by volatility and restrained economic activity.  Large-cap stocks have long been thought of as a safer investment in times of turbulence and slower growth due to their business maturity, stronger balance sheets and better access to capital markets.  Furthermore, concerns over inflation, political turmoil in the Middle East, and the European debt crisis could place long-term pressure on stocks.  Larger companies, because of their exposure to global growth and pricing power, may be better positioned than their smaller cap brethren to navigate the challenges of the global economy.

 

Moreover, the market rally over the last few years has mostly favored risky assets.  The result is that larger, high quality stocks have lagged and are now trading at compelling valuations.  The largest U.S. companies, as measured by the Russell Top 200 Index, have returned 30 percent since the market low in March 2009, compared with a 45 percent return for small U.S. stocks in the Russell 2000 Index.  The large companies that comprise the Russell Top 200 Index are trading at 13.9 times trailing earnings for the last 12 months.  By comparison, the Russell 2000 small-cap stock market index is trading at 20.5 times trailing earnings.  The historical average trailing price-to-earnings ratio for large-cap stocks since 1979, as represented by the Russell Top 200 Index, is 14.3.  This same average ratio for the Russell 2000 small-cap index is 15.9¹.  Price-earnings ratios represent the price investors pay for each dollar in annual earnings-per-share. A low ratio may indicate a stock is undervalued.          

 

Large-cap stocks tend to outperform small- and mid-cap stocks in the more mature stages of a recovery.  Historically, small- and mid-cap returns peak in the year following a market bottom and then slow.  Since 1926, small-caps have averaged gains of 41.4% in the first year of a bull market, followed by gains of 12.4% in year two and 8.7% in year three.  Likewise, mid-cap gains slow from 37.3% to 9.5% to 6.3%².  Small companies generally lead the early market rebound because they are more nimble operationally and invest in their growth as the recovery gains momentum.  A low interest rate environment also bodes well for smaller cap stocks because they tend to rely heavily on borrowing, whereas larger companies are able to use cash on hand.  With rock bottom interest rates set to rise coupled with a moderating recovery, small-caps face significant headwinds compared to well-established larger cap companies.   

 

CONCLUSION                           

Thus far in 2011, large-cap stocks continue to lag their smaller cap peers by approximately 60 bps as of Q2 quarter-end³.  However, the case for large-cap outperformance remains compelling.  Many investment professionals feel that it is only a matter of time before performance begins to revert to the mean.  Shares of giant, mature companies that pay out attractive dividends and benefit from multinational revenue streams are overdue for gains and represent the most attractive part of the market today.  Going forward, it may be advantageous for investors to have some exposure to larger, more stable quality companies within a diversified portfolio.

 

 

REFERENCES              

¹ Fidelity Viewpoints, 5/2011

² Bank of America Merrill Lynch Research

³ Morningstar Direct, 2011

 

 

(c) FundQuest

www.fundquest.com