Large-cap stocks stink right now. There, I've said it twice. That's the conclusion I've drawn after reading and thinking about the topic over the past few weeks.
Lots of people have been saying that big companies, relative to their financial performance, are cheap. That could be true, but I really question whether they're cheap enough to tempt me to lay out some of my hard-earned capital. After all, I'm not in the market to outperform by a few percentage points. As a smaller investor with a long time horizon, I'm looking to handily outperform the market, and I don't think large caps are the best place for my money.
Built to last, not grow
I recently re-read Nature: An Economic History by Geerat Vermeij. Yeah, I don't get out as much as I used to.
According to Vermeij, "power ... is the measure of economic performance." Power is defined as energy over time, and in business, cash is the equivalent of energy. The more cash it creates over time, the more powerful the company becomes. Vermeij also says, "Powerful entities are large, metabolize rapidly, have a wide individual or collective reach, and possess a flexible, hierarchical organization characterized by semiautonomous interacting parts subject to diffuse central control."
General Electric (NYSE:GE) fits this definition perfectly. It's huge in terms of the number of operating businesses and employees, not to mention sales and profits. It's always working very hard -- 50-to-60-hour workweeks are not uncommon -- and it has employees working deals and designs all over the globe. Plus, Jeffrey Immelt has set up the organization to get the information he needs to lead the businesses as a whole rather than having to oversee their operations individually.
Without a doubt, GE is a very powerful company. But it took well more than 100 years to become a $379 billion company. Growing its market capitalization at 10% per year, how likely is it that the company will duplicate itself in only 7.3 years? That's a big reason why large-cap companies might not be so attractive as investments. Once they're powerful, they're designed to last, not grow.
Size limits
Vermeij also reminds us that, "The technological and organizational qualities that bestow economic and physical power will increase only if the benefits of greater power exceed the high costs of investment in power-enhancing innovations."
The elephant is the largest land mammal. There's a limit to its size, based on the availability of energy and the functions of its skeleton and organs. Might there also be a limit to how big a company can get before it requires more energy simply to maintain itself as opposed to using excess energy to become more powerful?
How much bigger can GE, Wal-Mart (NYSE:WMT), or ExxonMobil (NYSE:XOM) really get before their infrastructures simply can't bear their own weight? Wal-Mart manages almost 2 million workers, and that task's not going to get any easier as more stores open around the world. ExxonMobil spends tons of money looking for oil, and the low-hanging fruit has already been picked. Will those investments pay off, or are they required simply to maintain the company's power?
That's a lot of cash
Only 23 companies generated more than $20 billion of operating cash flow last year and only 12 generated more than $10 billion in free cash flow. Sorry folks, it's tough for companies to generate tons of cash.
Take Pfizer (NYSE:PFE), for instance. Last year, the company produced an extraordinary $15.5 billion in free cash flow. Sure, it can grow that number. But are the right incentives in place to get it done? Could some breakthroughs by smaller pharmaceutical companies prevent those additional cash flows from appearing? Could scientists at Pfizer find working for those smaller companies more attractive? After all, smaller drug companies have much larger payoffs for bringing new discoveries to the market. Could those make for better investments?
Things are going too well
So as you can see, despite their power, large companies face an uphill battle. To make that climb even harder, things have been going very well for large corporations recently. So, rather than being cheap, I get the feeling that most of these companies have been filling in the performance to justify some of their metrics. Paying 15-18 times earnings for many companies that are growing earnings at 10% per year doesn't seem cheap to me. That seems just about right considering that the quality of those earnings is very high. More importantly, I wouldn't want to rely on margin expansion via "popularity" to power my investment returns.
Too much competition
That brings me to that last problem when I look at and think about large caps today. Am I, the little investor, powerful enough to compete with the big boys who can only play in the large-cap universe? Think about the competition in that space for just a few extra points above the market: Jeremy Grantham, Bill Miller, Mason Hawkins, Fidelity, Warren Buffett ... insert your favorite money manager with billions of dollars of assets under management here. These guys have to buy stocks like those mentioned above, as well as those of companies like Google (NASDAQ:GOOG) and Citigroup (NYSE:C), and buy them in large quantities, in order for them to be a meaningful part of their portfolios.
Someone else can have them
I won't rule out investing in large caps entirely. Under the right circumstances, large caps can provide a way to beat the market by a few points over time. Remember the carnage in 2002? Many large caps were pretty compelling back then.
But right now, I just don't see it. Large caps already have so many inherent challenges, there's lots of smart money chasing them, and there's not enough bad news driving prices down. It's just not an easy way to make a buck or 10. Maybe one day we'll have a market meltdown that will bring large caps back into play. For now, I'll keep searching in other places.
Small companies offer greater opportunities, because the market sometimes has trouble pricing them. They aren't slam dunks by any means, but Tom Gardner and Bill Mann have found lots of good opportunities for Motley Fool Hidden Gems subscribers. To see what they've found recently and how they're outperforming the market by a large margin, come join free for 30 days.
Wal-Mart and Pfizer are both Motley Fool Inside Value recommendations.
Retail editor David Meier has a beneficial ownership in shares of GE, but does not own shares in any of the other companies mentioned. He's ranked 4,320 out of 30,414 in CAPS. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
