My fellow Fool David Meier penned an article the other day titled "Why You Shouldn't Invest in Blue-Chip Stocks." In spite of the title, David noted that there are good opportunities among the large caps, but you have to be choosy.
The readers of David's article weren't so sure. The very first comment concluded that "I don't invest in any of the blue chip companies because they [sic] upside is very limited." Which makes sense, right? When we broadly say "blue chips" or "large caps," we're talking about massive companies like ExxonMobil (NYSE: XOM), Apple (Nasdaq: AAPL), and General Electric (NYSE: GE) -- the largest, best-known companies in the entire world.
How is it possible that investors would have overlooked an opportunity in these shares?
Follow me and let's find out.
Flow, flow, flow your funds
Fund flows refer to the amount of investor money that's either being newly invested in or pulled out of investment funds. Helpfully, the Investment Company Institute makes available data on mutual fund flows that gives us some insight into how investors are directing their money.
|
Year |
Domestic Equity Funds |
Foreign Equity Funds |
Bond Funds |
|---|---|---|---|
| 2007 | ($74.6 billion) | $138.3 billion | $109.1 billion |
| 2008 | ($151.6 billion) | ($82.7 billion) | $27.7 billion |
| 2009 | ($39.5 billion) | $30.7 billion | $376 billion |
| 2010 | ($95.9 billion) | $59.1 billion | $230.1 billion |
| 2011* | $14.7 billion | $23.2 billion | $59.6 billion |
| Total since 2007 | ($319.9 billion) | $168.6 billion | $790.2 billion |
Source: Investment Company Institute.
Notice the hefty outflows from domestic equity funds versus the modest inflows for foreign funds and the massive inflows for bond funds. Good investment opportunities start to disappear as more money starts to chase the same investments. When money is running scared from an asset class though, there's a better chance of finding overlooked opportunities. Score one for domestic stocks.
Of course as my fellow Fool Morgan Housel pointed out last year, mutual fund flows don't tell the whole story anymore and we have to consider what's going on in exchange-traded funds.
Notably, $147.4 billion of new funds flowed into domestic equity ETFs between March 2010 and March of this year. But since ICI breaks down the ETF fund flows to a more granular level, we can dig in even further here.
|
Fund Type |
Asset Growth 3/31/2010 to 3/31/2011 |
|---|---|
| Total market | 31.7% |
| Large cap | 17.7% |
| Mid cap | 31.4% |
| Small cap | 30.8% |
| Commodities | 50.6% |
| Natural resources | 70.8% |
Source: Investment Company Institute.
Despite the fact that there seems to be a lot of people talking about the opportunities in large-cap stocks, far fewer investors appear to be aggressively shoveling their money into that part of the market.
Ignoring success
To put it very simply, large caps have been performing over the past few years, and investors just don't seem to give a rat's patootie.
Just take a look at what happened between the most recent 12-month period and the corresponding 12-month period three years ago.
|
Index |
Total Net Income Change |
Starting Average Price-to-Earnings Ratio |
Ending Average Price-to-Earnings Ratio |
|---|---|---|---|
| S&P mega caps* | 19.3% | 19.4 | 17.9 |
| S&P 500 | 19.3% | 23.5 | 24.5 |
| S&P SmallCap 600 | 1.7% | 24.7 | 27.0 |
| S&P MidCap 400 | (11.6%) | 24.3 | 28.0 |
Source: Capital IQ, a Standard & Poor's company.
*S&P mega caps is an invention of the author and includes the largest 25 companies in the S&P 500.
The largest companies have larger profits and a lower price tag than they did three years ago. Yeah, that sounds awful.
Nothing new under the sun
Investors fall into and out of love with different asset classes. Sometimes they're absolutely in love with large caps (think "Nifty Fifty"), while at other times they're completely enamored with the growth opportunities available from small caps.
The chart below compares the five-year returns from the Russell 2000 small-cap index and the S&P 100 large-cap index. When the chart is above the horizontal axis, it means the small-cap index is outperforming the large cap, and when it dips below the axis the opposite is true.
As you can see, there was a period of small-cap outperformance in the early '90s, followed by a huge run by large caps that lasted through the dom-com bust and then led into the recent strong period for small caps.
What comes next? Turning data into patterns is a cognitive bias that we can fall into, but I'm going to go ahead and say that large caps look set to outrun the small fries.
Drumroll, please...
We started with this question: How is it possible that investors have overlooked a good investment opportunity in the world's largest and most successful companies?
Well, I'll tell you how. Investors have simply put their money elsewhere. They've run with the party line "large caps are too big to provide good returns," and they've plowed their money into small caps and mid caps thinking that the potential for more growth will trump all.
As a result, the three stocks noted in the beginning -- Exxon, Apple, and GE -- have respective forward price-to-earnings ratios of 9.1, 12.8, and 13.8. Yes, Apple has a forward P/E of 12.8. And they're not alone. Microsoft (Nasdaq: MSFT) trades at 9.2 times forward earnings, while Chevron (NYSE: CVX) and Pfizer (NYSE: PFE) have respective P/Es of 7.6 and 9.5.
Does this sound crazy? Maybe it does. But it's only because it sounds crazy to most people that these opportunities exist at all.
Rushing into buying anything is a bad idea, but the stocks that I've mentioned here are a good place to start your research into large cap stocks. Click on the "+" sign next to any of the tickers to add the stock to your watchlist. Don't have a watchlist yet? Click here to get started (it's free!).
