Is It Finally Time for Large Caps to Outperform?

I've been patiently waiting for large-cap stocks to make a comeback. It turns out that it's good that I'm a very patient investor because my calls last year weren't particularly timely.

That's not to say there's been reason for disappointment; the rising tide has lifted pretty much all boats -- large caps, small caps, U.S. stocks, foreign stocks, you name it. And yet over the past year, the small-cap Russell 2000 index has still noticeably outperformed the large-cap S&P 500 index. But the tide may be turning.

Bespoke Investment Group recently broke down the year-to-date performance of the Russell 3000 index and found that the performance was positively correlated with size. In other words, the larger the stock, the better it's performed.

The turnaround has also been apparent in the comparative year-to-date performance of the Russell 2000 and the S&P 500.

Source: Yahoo! Finance.

Is the day of the large cap upon us?

A long time coming
The past decade has been a great one for small-cap investors as small-cap stocks have absolutely trounced their large-cap counterparts.

Source: Yahoo! Finance.

Between 2000 and today, the S&P 500 has lost 11%. The Russell 2000, meanwhile, has gained 60%. That's some pretty impressive outperformance.

Is this because small-cap stocks are simply companies with better growth prospects that will always outperform larger, slower-growing companies? I won't dismiss the fact that small caps often have more growth opportunity than large caps, but there is a simpler explanation -- and that is that valuation multiples have increased for small caps while they've drastically decreased for large caps.

Consider this: At the beginning of 2000, the largest 1,000 stocks had an average price-to-earnings ratio of 35.8, while the next-largest 1,000 stocks had a P/E of 23.2. Today, the largest 1,000 stocks have an average P/E of 27, while the next-largest 1,000 have a P/E of 28.6.

And it's actually even more extreme if we look at the very largest stocks. The 100 largest stocks in 2000 had an average P/E of 50.8, while the 100 biggest stocks today have a P/E of 22.1.

In other words, the past decade has seen a shift of investor preference away from large caps and toward small caps as they searched for more attractively valued stocks. And now that all may change if investors start to realize that the better values are among the larger stocks.

Getting more growth for your money
As I noted above, small caps often have a growth advantage on large caps, and we don't want to ignore that. However, if we compare the stocks of the Russell 2000 to those of the S&P 500, we can see that even when we take growth into account, large caps look like the better bargain today.

The average trailing P/E for the Russell 2000 today is 31.9, and the average PEG ratio -- which I calculate as trailing P/E divided by the estimated long-term growth rate -- is 2.5. The stocks of the S&P 500, meanwhile, have an average current trailing P/E of 24.2 and a PEG ratio of 2.3. And, once again, if we look at only the 100 largest stocks of the S&P, it's even more marked -- they have a trailing P/E of 20 and a PEG of 1.9.

Investors still have to be choosy even if they're working with the more-attractively priced large caps. Generally, a PEG ratio of 1 or below is considered a good value, while anything more than 2 is seen as relatively pricey. On that basis, stocks like Pfizer (NYSE: PFE  ) and Amazon.com (Nasdaq: AMZN  ) don't look particularly compelling. Pfizer's low expected growth rate of 3% means that makes it look expensive on a PEG basis, while even Amazon's heady expected growth rate can't keep up with its even more heady P/E.

But there are plenty of large caps that we could consider compelling values based on the same measure.

Company

Price-to-Earnings Ratio

Expected Long-Term Growth Rate

PEG Ratio

Apple (Nasdaq: AAPL  ) 18.2 21.3% 0.85
Intel (Nasdaq: INTC  ) 10.2 11.0% 0.93
Ford (NYSE: F  ) 9.5 12.6% 0.76
Boeing (NYSE: BA  ) 15.4 17.8% 0.87
Visa (NYSE: V  ) 16.9 19.4% 0.87

Source: Capital IQ, a Standard & Poor's company.

As potential investments, this is only a starting point, and the usefulness of the PEG ratio is highly dependent on the accuracy of the growth projections. However, based on the stocks above, it seems that the large-cap bargains are hiding right in plain sight -- it's not as if these are stocks that investors' have never heard of.

The right place, but the right time?
As always, it's tough to figure out the "when" for anything in the stock market. So far this year the large caps have had the edge, but that doesn't mean it can't reverse and further widen the valuation gap between small and large caps.

But even if the timing may not be perfect, I still think the lower relative valuations will make large caps the place to be for some years to come.

Here is a simple strategy for beating the market, and, interestingly, the four stocks highlighted are all large caps.

Intel and Pfizer are Motley Fool Inside Value selections. Apple, Amazon.com, and Ford Motor are Motley Fool Stock Advisor picks. The Fool has written puts on Apple. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Intel, but does not own shares of any of the other 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 prefers dividends over a sharp stick in the eye.


Read/Post Comments (10) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 27, 2011, at 4:35 PM, Fundament wrote:

    Well, I have two opinions to buy small and mid caps. At first, I believe that small and mid caps perform significant better as large caps after recessions and in times of an economic recovery; But such stocks will lose more within recessions and could end into total losses. Second, small and mid caps have normally a better growth perspective due to its size. Sometimes, they have good perspectives to be acquired from a large cap. If you a risk averse, you should invest in large caps, cheap large caps with strong expected growth. That’s why I think your conclusion is really good. I found a sheet with additional cheap American large capitalized stocks with highest expected growth:

    http://t.co/JBFH6x0

    The average current P/E ratio amounts to 14.62. Price to sales ratio is 1.07. The expected earnings growth for next year amounts to 34.56 percent.

  • Report this Comment On January 27, 2011, at 4:37 PM, Fundament wrote:

    Well, I have two opinions to buy small and mid caps. At first, I believe that small and mid caps perform significant better as large caps after recessions and in times of an economic recovery; But such stocks will lose more within recessions and could end into total losses. Second, small and mid caps have normally a better growth perspective due to its size. Sometimes, they have good perspectives to be acquired from a large cap. If you a risk averse, you should invest in large caps, cheap large caps with strong expected growth. That’s why I think your conclusion is really good. I found a sheet with additional cheap American large capitalized stocks with highest expected growth:

    http://t.co/JBFH6x0

    The average current P/E ratio amounts to 14.62. Price to sales ratio is 1.07. The expected earnings growth for next year amounts to 34.56 percent.

  • Report this Comment On January 27, 2011, at 4:44 PM, Merton123 wrote:

    The Nasdaq dropped over 50% during the Tech bubble in the early 2000s. Right after the Tech Bubble burst the best place for buying was the debri of the Nasdaq. Interestingly the Nasdaq hasn't recovered from its early 2000 highs but the S&P 500 index has. A person investing from a contrarian perspective will wait as the money starts flowing to the large caps stocks. As the valuations for the small cap stocks return to normal buy and wait for the herd to come back to small caps within a year or two from now.

  • Report this Comment On January 27, 2011, at 5:33 PM, Borbality wrote:

    I adjusted my index funds to put more emphasis on large caps, but wouldn't be surprised if small caps outperform yet again. I guess it's good to be in all of them.

    I did buy a mega-cap to be my largest overall holding though.

  • Report this Comment On January 27, 2011, at 5:56 PM, TheDumbMoney wrote:

    Matt, I certainly hope your're right, since that's where my bets largely are -- as my hugely underperforming real life CAPS portfolio demonstrates. I am getting killed..., by stocks like INTC, JNJ, MSFT and ABT.... I just can't bring myself even to get into the cyclicals like CAT, heaven help me. Good thing the vast majority of my dough is just in a bunch of index funds and ETFs in my 401k account. I'll give it a couple more years, and if I continue to underperform I'll probably pack it in and just do index funds/ETFs for everything. In that sense CAPS has been a real eye-opener for me, and I'm grateful for it.

    Fundament, I'm not sure I think small caps inherently drop more (unless they are inherently more cyclical and/or low-quality) in a recession. For example, if my memory is correct, the S&P500 and the Russel2000 dropped by virtually identical amounts in 2008/2009, both around 52 or 53%. Cyclicality and debt levels being equal, it probably has a lot to do with the starting point for the valuation.

  • Report this Comment On January 27, 2011, at 6:28 PM, Merton123 wrote:

    I find ironic that the entire financial industry marketing is about outperforming the indexes. The science of statistics depends upon being able to pull a sample which represents the average of a population. The financial industry marketing is all about being able to pull samples (i.e., stocks) which provide a higher average then the respective population average. Then year in and year out everbody throws up their hands in amazement when the majority of investors pulls samples which do reflect the population averages less their expenses. With all that said - I have invested this years Roth IRA money in Motely Fools Indepedence Fund (FOOLX) with the belief that with there familiarity and enthusiam for the market that they can pull a nonrepresentative sample and outperform the global averages. The majority of my investment is in Vanguard S&P 500 index which has remained flat for the last decade. I will leave my money their hoping that after a bad spell that a good spell will come along.

  • Report this Comment On January 27, 2011, at 6:42 PM, TheDumbMoney wrote:

    Merton, I'm largely with you on indexes. I have always kept a small portion of my money in stocks I pick, but since I starting rigorously tracking myself a year ago, I have not outperformed, hence my ongoing semi-epiphany that maybe in fact the idiot at the table really is me, unless this is just a bad year. We shall see.

    I would say it's probably a mistake to go with one index. Vanguard, for example, has SKADS of indexing ETFs for example, with super low cost ratios, just like their mutual funds. You can go small-cap index, S&P, emerging markets (VWO), REIT, etc. Set and forget a ratio of each, and yearly rebalance, though if this article is correct, it's possible (and I certainly think so) that after a decade of underperformance the S&P is finally set to outperform, from a valuation standpoint.

  • Report this Comment On January 27, 2011, at 7:28 PM, Merton123 wrote:

    Thanks Dumberthanfool - you have given good advice.

  • Report this Comment On January 27, 2011, at 9:40 PM, bigkansasfool wrote:

    Ask, Buffett what he would pick and he'd tell you that if BRK wasn't as big as it is now he'd pick small caps over large caps all day long. Why? Less analysts covering the small caps so easier to find good companies selling well below intrinsic value. Also, the growth potential of small caps is on average higher because large caps are hindered by the law of diminishing marginal returns.

  • Report this Comment On January 28, 2011, at 9:30 AM, 57andrew wrote:

    Small caps may have growth prospects but look at how they are going to fund themselves if buying individual stocks. Most companies absorb working capital as they grow (and probably have capex needs) and throw off cash (theoretically) when they shrink. As banks have to build more and better quality capital bases or shrink their balance sheets the availability of credit may get scarcer. Running out of access to credit may be a real threat in the next squeeze. If you are young and can stand the losses thats grand but fast approaching retirement I'm happier buying boring solid big caps. That said one of my best performing funds is a FTSE 250.

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