Is It Time for Large Caps to Shine?

It's not really a surprise that small-cap and mid-cap companies have generally outperformed large caps over the past decade, but that outperformance is rapidly increasing.

Over the past five years, the SPDR S&P 500 Trust, an ETF that tracks perhaps the broadest measure of large-cap performance, rose a mere 12%, while ETFs tracking the S&P Mid Cap 400 and Russell 2000 returned 31% and 18%, respectively. More interestingly, this divergence didn't become readily apparent until after the stock market lows of March 2009. Following one of the largest lessons of our time on regulating risk after the near-collapse of the U.S. banking system, are we to believe that investors once again have an insatiable appetite for risk? I'm not inclined to believe so and feel that we could be on the verge of a major shift away from small and mid caps and back toward large-cap outperformance.

Consider this: According to The Wall Street Journal, the S&P 500's P/E is currently just above 16, while the Russell 2000's trailing P/E stands at a whopping 52. And even though the Russell's multiple drops to 22.5 based on future earnings, the S&P's falls as well -- to around 13.5.

Large cap, big value
Just running a simple stock screen of large-cap companies ($10 billion-plus) trading at single-digit P/Es will yield a bunch of names -- and this isn't just confined to one sector, but spread across the entire market:

Company

Industry Market Cap Forward P/E
Cisco Systems (Nasdaq: CSCO  ) Networking $88 billion 9.3
Microsoft Software $202 billion 8.7
Chevron (NYSE: CVX  ) Oil and gas $203 billion 7.8
Hewlett-Packard Networking $78 billion 6.8
Bank of America (NYSE: BAC  ) Banking $114 billion 6.6
Best Buy Specialty retail $12 billion 8.3
Intel (Nasdaq: INTC  ) Semiconductor $116 billion 9.2
Pfizer (NYSE: PFE  ) Pharmaceutical $165 billion 9.2
General Motors (NYSE: GM  ) Automotive $43 billion 5.9
International Paper (NYSE: IP  ) Materials $13 billion 8.9

I think we can say without any semblance of a doubt that large caps are incredibly inexpensive. Now let's have a look at why this group just might be set to outperform.

It's all about the dividends
I can thank fellow Fool Morgan Housel for doing a lot of the legwork here, but S&P 500 companies are paying out an incredibly low ratio of their profits in the form of dividends. Many may see this as even more reason to forgo dividend-paying companies in favor of investments that offer a higher risk-vs.-reward ratio, but I see things a little differently.

Today's S&P 500 dividend payout ratio of 29% isn't an indication that companies aren't sharing the wealth with shareholders so much as it is an indication of prudent fiscal management. Large-cap balance sheets are more financially secure than they've been in decades and are considerably less likely to face dividend interruptions or "economic hiccups" than they were as little as a decade ago.

A lower payout ratio also leaves plenty of room for improvement. High payout ratios could signify a dividend payment which is unsustainable, much like what we saw in the 1940s. It seems only logical that as small- and mid-cap stock prices become lofty, investors will trade them in for more fiscally responsible large-cap dividend payers.

Beta matters
With the stock market having bounced so vigorously off its March 2009 lows, many traders are setting themselves up more for downside protection than share appreciation. One factor to consider when fortifying your portfolio against a downturn is a stock's beta, or its volatility relative to the S&P 500.

By nature, large caps often have much smaller price swings than their small- and mid-cap counterparts, making them a significantly more attractive choice in downtrending and sideways markets. And unless you've been hiding under a rock for the past year, you're probably aware that the U.S. debt ceiling is about to be hit, and Europe is still in the midst of a large sovereign debt crisis. Are large caps looking more appealing yet?

The money has to go somewhere
In the end, institutional money has to wind up somewhere, and large-cap companies make the perfect buy. Institutional money started flowing out of the emerging markets back in February because of political instability in the Middle East. Likewise, in the U.S., bond rates continue to fall, with the 10-year Treasury yield having dropped below 3% for the first time since December. These are all recipes for cash to be flowing into the safety net of large-cap stocks.

What do you think? Is now the time to move into large-cap stocks or are you staying put in small- and mid-cap companies? Share your thoughts with us below and consider taking the test to find out whether you're investing Foolishly.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. The Motley Fool owns shares of Bank of America, Intel, Best Buy, and Microsoft; has created a bull call spread on Cisco Systems; has bought Intel calls; and has shorted Bank of America. Motley Fool newsletter services have recommended buying shares of Cisco Systems, Microsoft, Chevron, Intel, General Motors, Best Buy, and Pfizer, and creating diagonal call positions o n Microsoft and Intel. 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. The Motley Fool has a disclosure policy that speaks softly, but carries a big stick.


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