Large-cap stocks are back in vogue, or so it seems. After producing inferior profit growth for three straight quarters, large-caps outperformed their smaller cousins in the first three months of the year, with year-over-year earnings growth of 13.1% compared with 11.4% for small-cap firms, according to Thomson First Call. Those numbers include actual results for firms that have reported and estimates for the rest. Large-cap stocks also have risen at a slightly faster pace this year compared with small-cap stocks, with the S&P 500 up 5.8% on the year compared with just 4.5% for the S&P 600. Although the difference might seem slight, it is noteworthy considering that the S&P 500 has consistently underperformed its small-cap counterpart over the last three years. "Valuations on some of the big- and mega-cap companies have come down much more than the overall market," said John Waterman, managing director of investments at Rittenhouse Financial, a large-cap growth fund. This multiple compression, along with a big slide in the dollar, has helped large-caps put in a better performance this year, analysts said. A weaker dollar helps large firms, because they tend to do more business overseas and benefit from more favorable currency exchange rates. "Earnings in areas that have held up -- like pharmaceuticals -- are still pretty good, and earnings in areas that fell off a cliff -- like technology -- appear to have bottomed and are starting to improve," Waterman said. The strength of large-cap stocks in 2003 has enabled large-cap mutual funds to produce returns of 4.5% so far, while small-cap funds have recorded a gain of just 3.4%, according to Lipper. In both cases, growth beat value. "As of Jan. 1 this year, there was a rotation from small-cap value into large-cap value," noted Bob Rowe, managing partner at Rowpyn Investment Partners. "We're entering a period of large-cap dominance over the next 12 to 24 months."
Rowe, who has developed a methodology to track where funds are flowing, said that after three years of market devastation, investors are now looking for safe, recognizable companies with stable earnings growth and respectable dividend yields. "My sense is that early in an economic recovery, investors tend to gravitate to what they feel safe with, and that tends to be the large-cap stocks," agreed Don Cassidy, a senior research analyst at Lipper. Some analysts also prefer larger-caps because they argue that these companies are better able to absorb rising costs associated with the passage of the Sarbanes-Oxley Act. Since the legislation was enacted last July, 70 public firms have reported that they intend to go private, a 46% increase over the same period a year ago, according to USBX Advisory Services. The average size of these companies, meanwhile, dropped by 50%, and this suggests that smaller companies are hurting from rising costs. "Our conclusion is that
Sarbanes-Oxley is just one component of a long-term irreversible trend in which only large, liquid companies find publicly traded shares to be an asset," the firm said in a recent report. Still, others say there are reasons to be optimistic about small-cap firms. Steven DeSanctis, an analyst at Prudential Securities, believes that the earnings picture is actually brighter than it appears for many smaller firms. According to his data, which encompass many stocks from the Russell 2000, small-cap earnings were up 17% in the first quarter, easily beating results from large-cap firms. Meanwhile, revenue growth from small firms has been superior recently. In addition, the profit outlook for smaller firms looks strong. Small-cap earnings are expected to rise 7.8% in the second quarter, compared with 6.1% for the S&P 500, according to Thomson First Call, and the trend is similar for the third and fourth quarters.
Analysts do tend to slash their earnings estimates on smaller companies more than they would for larger firms, but DeSanctis is optimistic nevertheless. He said that small-caps, which tend to be more volatile than large-caps, "gained traction" in April as investors began taking on more risk, and he believes they should continue to outperform now that the war in Iraq is over. "Looking at the previous eight conflicts, once the fighting begins, small-caps beat the large caps by an average of 1.2% over the ensuing 12 months," he said. DeSanctis also believes that, as a percentage of assets, more money is flowing into small-cap funds right now, which should give money managers "some ammunition to purchase new small-cap ideas" going forward. Ryan Beck & Co. market strategist Kevin Caron agrees that smaller companies are poised to do well this year, noting that a recessionlike environment is "ideal" for these firms. Since 1946, small-cap stocks posted average one-year returns of 37.8% following a recession compared with average one-year returns of 23% for larger firms, he said. Caron also noted that small-cap stocks are trading at a 23% discount to large-cap stocks, while mid-caps trade at a 16% discount. "We feel that investors should continue to look to these categories for leadership and position portfolios accordingly," he said.