Could These Be the Most Overrated Stocks?

Large-capitalization companies that pay dividends -- those are the stocks that have been catching my eye lately. Solid, dependable businesses like ExxonMobil (NYSE: XOM  ) and Merck (NYSE: MRK  ) are trading at very reasonable multiples and paying at least a decent dividend.

Of course, there's another name for these kinds of stocks that most investors are familiar with: "blue chips."

My enthusiasm for this slice of the market meant that an article in The New York Times over the weekend -- "Stage is Set (Again) for a Blue-Chip Revival" -- caught my eye. As the title suggests, the author is a bit skeptical that the hoped-for outperformance from blue chips will materialize any time soon.

Will it happen this time?
The author begins by highlighting just how long some investors seem to have been waiting for big-cap blue chips to make their move. He writes:

Ever since big blue-chip domestic stocks fell out of favor in early 2000, many market strategists have regularly been predicting their imminent return to glory.

He goes on to review the sad state of affairs that blue-chips have faced ever since then. After the tech bubble he suggests that they never got their second wind and in the wake of, the financial bust they were outperformed by small caps as well. He makes it sound a lot like a Disney movie where you just keep believing in the smooth-faced, likable hero, hoping that he'll come out on top, but he just can't seem to top the forces of evil aligned against him.

And the facts are certainly true -- between January of 2000 and today, the Russell 2000 and S&P SmallCap 600 have solidly outperformed the S&P 500. Over the past five years, same thing. Over the past year ... same darn thing.

But what about now? If we stick to the good old Disney formula we should be able to expect that the hero will overcome all of the tough lumps he's taken, rise to the occasion, and win in the end. So is it finally time for blue chips to shine?

Yes.
Rightly, the article points out a few factors that are in large-caps' favor. Cash on the books is one of them. Though Exxon has more debt than cash, the $13 billion on its balance sheet still represents money that can be sunk into growth, share buybacks, or dividends. And that's in addition to the free cash flow that the company produces in its operations.

Other companies are even better situated in terms of cash. Microsoft (Nasdaq: MSFT  ) had nearly $37 billion in cash on its balance sheet at the end of the last quarter and very little debt. It is now taking advantage of the low-interest rate environment to raise debt in order to return more capital to shareholders.

Another advantage is global exposure. While there are concerns about how fast the U.S. economy will be able to grow in the years ahead, high-growth economies like China, Brazil, and India are seen continuing to climb. It's the large-cap blue chips like Procter & Gamble (NYSE: PG  ) and Yum! Brands (NYSE: YUM  ) that can -- and are -- tapping these growth markets.

Kiss of death
The worrisome issue that the article raises, however, is the sense that everyone seems to be on the large-cap bandwagon. When it comes to investments, crowded ideas tend to be terrible ideas, so if this is true, then blue chips could end up disappointing investors yet again.

Fortunately, the data doesn't at all back up the idea that everyone is really flocking to large-caps. When it comes to the movements of the stock market, to say that actions speak louder than words vastly understates the case. While words can influence actions, if nobody's taking action, then there's a measurable lack of conviction.

In the case of blue chips, the simple fact that the group continues to underperform its smaller counterpart suggests that either there are a lot of folks saying one thing ("Buy large caps!") and doing another (buying small caps), or there is a small, but loud, minority that has been consistently evangelizing for blue chips.

Of course there's also good reason why large caps have underperformed for years. Back at the height of the bubble, well-known, large-cap stocks were trading at inane valuations. At the end of 2000, Cisco's (Nasdaq: CSCO  ) stock fetched 97 times operating earnings and Hewlett-Packard (NYSE: HPQ  ) had a multiple of 28 on the same measure. Even P&G had a multiple of 25.

Those out-of-whack multiples took time to come back down to earth. Some of the readjustment took place through earnings growth, while some of it came through a falling stock price. I can't speak to what exactly the "market strategists" cited in the Times article were looking at, but for years these stocks continued to carry hefty valuations, and until they found their way into cheaper territory there was no reason to expect that large caps would outperform.

Today, the situation is much different. Cisco's operating income multiple is down to less than 11, P&G's is at 12.6, and HP's multiple has fallen all the way to 7.8.

Past performance and all that jazz
Those on the sales side in the equity markets like to say that "past performance isn't a guarantee of future results." That's mostly because they don't want to be caught with their legal pants down if their recommendations go the wrong way -- and since nobody's batting 1,000 in this business, that's inevitable.

But in the case of blue chips, the cliched line is particularly true. It's been a decade of poor returns, but that doesn't mean that there's another decade of poor results ahead. Valuations have fallen significantly over the past ten years and that's left us with a lot of attractive opportunities among very stable, very well-known companies.

Want the very best large caps? You need to start picking stocks -- that is, if you don't believe that stock picking is dead.

Microsoft is a Motley Fool Inside Value recommendation. Procter & Gamble is a Motley Fool Income Investor pick. The Fool has written calls (Bull Call Spread) on Cisco Systems. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Microsoft. Motley Fool Options has recommended a bull call spread position on Yum! Brands. The Fool owns shares of ExxonMobil, Microsoft, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


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