"Big is better" is the mind-set of a growing number of market participants and prognosticators. In the wake of evidence of a slowing economy, Fed tightening, geopolitical concerns and corporate profit warnings, the conventional wisdom on Wall Street is that it's time to move money out of smaller, flashier stocks and into safer, more liquid names, i.e., big-caps. Such a migration seems logical, but it bucks longstanding market trends and has plenty of skeptics. Thomas McManus, an equity portfolio strategist at Banc of America Securities, was among the many strategists to recommend "higher-quality" companies at the start of 2004. "So far, this trade has been a disappointment, as smaller companies ... have outperformed significantly," McManus conceded this week. Indeed, the S&P 600 Small-Cap index has outperformed the S&P 400 Mid-Cap index, which, in turn, has outperformed the S&P 500 so far in 2004, but also over the past one-, two-, three- and (especially) five-year periods. "Will the larger companies ever catch up?" McManus wondered, offering little sense of optimism in answering his own question. "We have not been recommending an aggressive posture on large-caps vs. small-caps, because we do not see the risk/reward in our favor." Longtime small-cap advocate John Bollinger, president of Bollinger Capital, reached a similar conclusion. "It's possible large-caps will have their day, but until there's some evidence of a genuine shift in leadership, I'm loath to call it at an end" of small-cap outperformance, he said. "The S&P 600 just made a new all-time high
on June 30 . How many other indices can you accuse of a similar crime?" Joking aside, the veteran technician argued that valuations make small-cap stocks more compelling, because "at these levels of valuation, you've got to have growth, and small-caps are so much more capable of providing that type of growth."
Many argue that big-caps aren't terribly overvalued, especially relative to Treasuries; after recent declines, the S&P 500 is now trading around 17 times expected 2004 earnings and 16 times 2005 estimates. Bollinger countered that "you still have to have a lot of growth to justify" such P/Es, which are above historic norms. "I'm not so much as saying 'no' to large as I'm saying 'yes' to small-caps," he said.
| Performance Check |
Small-caps lead the way
|Period*||S&P Small-Cap 400||S&P Mid-Cap 600||S&P 500|
|Year to date||6%||3%||1%|
|* Through July 7. |
Ironically, McManus believes small-caps are historically rich vs. big-caps on the basis of earnings yield (the inverse of price-to-earnings). But their current outperformance may be "a function of a much better earnings recovery -- and perhaps also a longer one -- for smaller companies, many of which seem to gain from a broadening trend of pricing power," he wrote. This fits with his macro view that the economy isn't as strong as bulls contend. "The small-caps may continue to outperform in a market like the status quo, where the Fed cannot afford to upset a weaker-than-normal recovery and thus must tolerate sustained period of broadening pricing power," he wrote.
mid-2000 , acknowledged rising anxiety among investors to move back to big-caps. "So maybe there will be a period where large-caps enjoy relative performance," he said. "But there's no sign of it yet, and investing based on anything without present evidence is nonsense." Nonsensical or not, the lure of big-caps has become tantalizing to many, given recent market upheaval and signs of relative strength in mega-caps such as Microsoft ( MSFT), General Electric ( GE) and ExxonMobil ( XOM). Microsoft is one of the favorites of Vadim Zlotnikov, chief investment strategist at Sanford C. Bernstein, who has an overweight recommendation on tech and a preference for "the most stable -- and often larger-cap -- areas of the sector." Other software favorites of his include SAP ( SAP), Synopsis ( SNPS), Adobe ( ADBE), Mercury Interactive ( MERQ) and Oracle ( ORCL); notably, they all sidestepped the warnings barrage coming from the sector. Zlotnikov also recommends big-cap IT services firms such as SunGard Data Systems ( SDS) and Accenture ( ACN), as well as semiconductor-equipment plays such as KLA-Tencor ( KLAC). Again, his is a recommendation of big over small only within tech, but it raises a final point: While small has persistently outperformed large in the past five years, the small-cap value vs. growth trade has been "much more volatile" during the same period, Bollinger noted, expressing optimism about growth. Then again, Bollinger is upbeat about the economy. "Chat about economy slowing is a prayer," he said, providing another reason why he thinks small-caps will continue to shine.