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.

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.