Financial Advisor

May 2010 issue

Great Expectations

Fund managers believe large-cap stocks are poised to move ahead.


If stocks were sports teams, the more mature large caps would be the equivalent of the NBA, while less experienced, less refined small caps would be like college basketball. Many fans may prefer the college game, but very few college players can make it in the NBA. And the attention small caps have received over the last 18 months is something like March Madness.

Small-cap stocks have soared 103% since the market’s low point in March 2009, while large caps have lagged—rising 73%. But portfolio managers are now becoming bullish on large company stocks and see them as the ones best equipped to benefit from the economic recovery. They boast stronger balance sheets, better access to capital and wider international market penetration, qualities that have made them the darlings of the market. And it doesn’t hurt that they’re currently trading at a discount.

“In general, if we’re going to enter a world in which credit is tougher and more expensive to get, it helps to be a larger company with a stronger, more established history and business,” says Matthew Miller, a portfolio manager with M.E. Miller Investors in Malibu, Calif.

Overseas Operations

Managers say their exposure to foreign markets is going to be key right now, because it gives them non-dollar revenues—at a time when the dollar may be weakening. Not only can they protect their earnings by generating sales in stronger currencies, but if the dollar declines, it also means their non-dollar revenues will be worth more when they convert them back into dollars at home.

But the real value in overseas exposure is the growth potential. Less-developed countries are where the real growth is expected to take place over the next decade.

“Large caps on average have more international revenue than small caps, thus providing a partial hedge against a weak dollar, and providing a relatively low-risk way to invest in emerging markets,” Miller says.

More developed countries, like the U.S. and those in Europe, are already mature and don’t expect to see their GDP grow by much more than 3% this year. Meanwhile, less-developed countries like China, India and Brazil not only have taken on less debt and avoided the subprime housing crisis but also enjoy more room to grow—which they are expected to do at about 8% this year. Companies that sell products such as computers and cell phones in those countries will be able to ride that growth curve.

“Those countries are better-positioned to come out of this downturn,” says Thomas Samuelson, chief investment officer of Advanced Equities Asset Management, based in San Diego. “As their per capita consumption grows, and they want what we have, it provides opportunities for companies providing those products.”

Emerging countries need infrastructure, roads, railways, power generation and commodities. And once those are built, they will consume more cars and fossil fuels, as well as luxury goods, managers say.

Companies likely to benefit from international exposure are Apple Inc., Johnson & Johnson and United Technologies Corp., which reap at least 50% of their revenues from outside the U.S. IBM, which gets 65% of its revenues from overseas, and Hewlett-Packard, which gets a whopping 70% of its revenues from abroad, will also be able to ride that overseas growth. And yet they’re all trading at price-earnings multiples of about 12, managers say.

“The three sectors most highly geared for foreign sales are technology, which derives more from foreign sales than U.S. sales; energy; and U.S. staples, like a Procter & Gamble,” says Christian Hviid, chief market strategist for Genworth Financial Asset Management in Encino, Calif.

Technology stocks will also benefit in the U.S. A lot of companies put the brakes on capital expenditures during the downturn, and now there’s a lot of pent up need to spend, both here and overseas. It doesn’t matter whether the buyers are seeking new PCs or upgrading their networks.

Energy and commodity stocks are close behind. The widely watched commodity index, the Thomson Reuters/Jefferies CRB Index, was down in the first quarter, but it’s already up 2.4% for this month. Nickel is already up 36% for the year to date, gasoline is up 15%, crude oil is up 10% and copper has risen 8%.

“These are commodities linked to global economic activity. Companies that produce those commodities should do fairly well,” says Samuelson.

Moreover, commodity prices generally rise when the dollar falls. That’s because most commodities are priced in dollars, and if the dollar drops, commodity producers must raise the price of the commodity in order to keep earning the same real value.

The Energy Select Sector SPDR, an exchange-traded fund that is considered to be a pure energy play and that has 30% of its assets allocated to Exxon Mobil and Chevron, is currently trading at a P/E ratio of 12. That’s low, considering that P/E estimates for the S&P 500 in 2010 are closer to 15, says Maury Fertig, chief investment officer of Relative Value Partners based in Northbrook, Ill.

Health care stocks have also appeared on fund managers’ radar, now that the Obama administration’s health care plan appears less catastrophic than some had anticipated. As investors gain a better understanding of the plan, they may feel more comfortable knowing what the future might bring. As Miller says, the markets don’t like uncertainty, but now that uncertainty about reform has diminished.

“Now that the reforms have passed, and we have more clarity about what the scope of what might happen is, I think investors are becoming more comfortable with owning health care stocks,” he says. “And the sector is very cheap. It’s been very cheap relative to other sectors for the last several years.”

There also appears to be a lot of research and development in the pipeline, which should bear fruit in the next decade. Despite that reason for optimism, the sector is currently priced at about 13 times earnings.

“You’re basically getting a free option, in terms of future R&D success,” says Hviid of Genworth. “You’re not paying a whole lot for the sector, but you have an embedded option—if you get a few approvals from the FDA and get some blockbuster drugs and peak sales potential that aren’t being priced in.”

The large pharmaceutical companies also tend to pay dividends of about 3% to 5%, compared with the S&P average of about 2%. “Valuations in large caps are generally more attractive than other parts of the equity market right now, because they’ve experienced less of a run-up in their prices over the past year,” says Fertig.

Closed-end funds with a meaningful exposure to large-cap stocks are actually trading at discounts of as much as 15% to their net asset values, Fertig says. The Legg Mason Partners Capital and Income Fund, for instance, was recently trading at $10.81, and yet its net asset value was $12.10. Liberty All-Star Equity Fund is trading at a 13% discount to its NAV.

“We find that particularly compelling,” Fertig says. “There are 650 closed-end funds, and the average fund trades at just a 1% discount to its NAV.” It doesn’t hurt that some of these funds are also paying a 5% dividend.

“We think right now is a good time for large caps,” says Serena Perin Vinton, the portfolio manager of the Franklin Growth Fund in San Mateo, Calif. “A lot have gone through cost-reduction programs, so any kind of revenue pickup will bode well for them.”

Their cash-to-assets ratios are at 25-year highs, while their capital expenditures relative to depreciation are at 25-year lows. And we’re at a point where there’s pent-up demand for equipment in various sectors of the economy, Vinton says.

“There’s really no reason for these companies, that are going to grow roughly 10%, to be trading at a discount,” says Vinton.

Limit Retail

The one large-cap sector in which managers are not too keen is retail, which some think has too much capacity right now. While discount stores may be able to differentiate themselves, others will not, and there’s simply not enough foot traffic to make their profit models work, Vinton says.

“We’d much prefer to look for businesses that don’t have excess capacity and have room to grow over the long term. We feel industrials and health care and technology are areas that have the ability to do that.”

But while managers have turned their attention to large caps, some, like Todd Lowenstein, portfolio manager for HighMark Capital Management in San Francisco, believe the sector has already been picked over and may be trading too high. The market has already priced in a pretty optimistic recovery premium on some of these stocks, and those scenarios may not come to fruition, Lowenstein says.

“We’re finding less opportunity there because we think it’s been picked off and the market has been anticipating pretty aggressive growth scenarios.”

He says he likes some cyclical stocks, like Union Pacific Railroad and Deere & Co., but he bought them six months ago, when they were cheaper. For now, he likes high-quality companies doing well even if the economy isn’t. With that in mind, he likes Microsoft Corp., Walgreens and Automatic Data Processing Inc., stocks that used to trade at 20 to 30 times earnings. Lowenstein says he wouldn’t have touched them with a barge pole at that price. Today, those multiples have contracted by about 50%, and he thinks they’re a bargain, for what you get.

“We think they’re misunderstood and underappreciated, relative to their potentials, and that the market will reward them when people understand how great they are,” he says.

But on the whole, he believes the large-cap market is suffering from the curse of high expectations, which can only lead to disappointment. Lowenstein thinks that high expectations, combined with high multiples, can hurt a company even when it’s doing well, simply because the price falls when earnings aren’t as high as everyone anticipates.

“We think the economy is increasingly on a self-sustaining path, but the question is whether what’s being baked into the industrials and materials is too aggressive,” he says.


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