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Big Stocks Lure Perkins, Grantham With Discount to Small-caps

Shoppers leave a Wal-Mart supercenter store in Sao Paulo, on March 8, 2010. Photographer: Paulo Fridman/Bloomberg
Shoppers leave a Wal-Mart supercenter store in Sao Paulo, on March 8, 2010. Photographer: Paulo Fridman/Bloomberg

April 27 (Bloomberg) -- Thomas Perkins beat 94 percent of his mutual-fund rivals in the past decade by investing in midsize companies. He now prefers giants such as Cisco Systems Inc. and Wal-Mart Stores Inc., and his $12.4 billion Perkins Mid Cap Value Fund is almost at its limit for big-company shares.

“These stocks have gotten so cheap that they should outperform for the next several years,” Perkins, the 65-year-old fund manager at Perkins Investment Management LLC, said in an interview in Boston. His Mid Cap Value fund returned 12 percent annually over the past 10 years, compared with the 7.6 percent average of peers, data from Morningstar Inc. show.

With big stocks trading at the steepest discount to small companies since at least 1982, the list of investors who share Perkins’s view includes Jeremy Grantham of Grantham Mayo Van Otterloo Co. and Donald Yacktman of Yacktman Asset Management Co. They are among the best-performing bargain hunters of the stock world, value managers who scoop up companies they think others have overlooked.

Large-capitalization stocks, as tracked by the Standard & Poor’s 500 Index, lost an annual average of 0.7 percent in the 10 years ended March 31, according to data compiled by Bloomberg. The S&P 100 Index, made up of the biggest of the bunch, fell 2.2 percent annually.

Those returns trailed annual gains during the same period of 6 percent by the S&P Midcap 400 Index, a proxy for midsize stocks, and 3.7 percent by the Russell 2000 Index, a benchmark for small companies.

It’s “nearly certain” that the highest-quality large stocks, known as blue chips, will outperform the market in the next seven years as more investors come to consider them underpriced, Grantham wrote in his January newsletter. He repeated his outlook last week in the April edition.

‘Sky-High’ Valuations

Large stocks had “sky-high” valuations in the 1990s, David Herro, manager of the $5.3 billion Oakmark International Fund in Chicago, said in an e-mail. It’s taken a full decade for many of them to return to attractive levels, said Herro, 49, whose fund has outperformed 92 percent of its peers in the past year, according to Bloomberg data.

The premium investors are paying today to own small-capitalization stocks versus their large counterparts is the biggest in at least 27 years, said James Floyd, senior analyst at Leuthold Group LLC, a research firm based in Minneapolis. Leuthold defines large stocks as those with a market value of more than $9 billion and small stocks as those from $300 million to $1.4 billion.

Painful Wait

At the end of the first quarter, small stocks sold for an average price-to-earnings multiple of 18.6 compared with 15.7 for large stocks. The 18 percent gap between the two is the widest since Leuthold began gathering the data in December 1982, Floyd said. In 2000, small stocks sold at about a 40 percent discount to large stocks, he said.

As Grantham and the others wait for the turn, large caps continue to underperform. The Russell 2000 more than doubled from the market bottom on March 9, 2009, through April 23, while the S&P 500 returned 84 percent, including dividends.

“It has been a painful trade,” said Michael Mullaney, who began shifting more money into the 100 biggest U.S. stocks in the middle of 2009 and helps oversee $9 billion as a portfolio manager at Fiduciary Trust Co. in Boston.

Since stocks hit their 12-year low, the $15.2 billion GMO Quality Fund has returned 52 percent, and Perkins Mid Cap Value is up 82 percent, both trailing the S&P 500. The $2.2 billion Yacktman Fund has more than doubled.

Cold Shoulder

Mutual-fund investors remain cool to large-cap stocks, data from Chicago-based Morningstar show. In the first three months of 2010, investors pulled $8.9 billion from U.S. large-cap equity funds. They added $3.3 billion to mid-cap funds and $3.8 billion to small-cap funds.

John Schonberg, manager of the $1.2 billion RiverSource Mid Cap Growth Fund, said it’s premature to bet on the biggest stocks.

“They will come back, but we have a ways to go before that happens,” he said in a telephone interview.

Schonberg said the U.S. is in the early stages of an economic expansion and that small- and mid-cap stocks usually do well in such an environment. Those same stocks will benefit as large companies use their cash to make acquisitions, he said.

In an April letter to the shareholders in his mutual funds, Yacktman pointed out that some of his top holdings, including Atlanta-based Coca-Cola Co. and Pfizer Inc. in New York, sell for lower prices than they did at the end of 1999.

Quality Merchandise

His Yacktman Fund returned 14 percent annually in the past 10 years, better than all but 13 of more than 3,000 diversified U.S. funds, according to Morningstar.

Yacktman, the 68-year-old co-chief investment manager of his Austin, Texas-based firm, looks at stocks as if they were bonds and measures the future returns a company will generate compared with its current price. That exercise leads him to “quality stocks,” market leaders with predictable performance and high returns on capital.

“We like to buy quality merchandise when it is in the discount bin,” he wrote to shareholders. In a telephone interview, Yacktman said that investors “are not being paid to take more risk” with lower-quality stocks.

Grantham, 71, wrote at the end of March that “high-quality” U.S. stocks would return 6.1 percent a year above the rate of inflation for the next seven years compared with a loss of 1.2 percent for small-cap stocks. Quality stocks have high, stable returns on capital and low debt, Grantham wrote on GMO’s Web site.

Microsoft, Johnson & Johnson

The largest holdings in the GMO Quality Fund include Redmond, Washington-based Microsoft Corp. and New Brunswick, New Jersey-based Johnson & Johnson. Both have higher returns on equity and a lower ratio of total debt to equity than the average for the S&P 500, Bloomberg data show.

Grantham, chief investment strategist at Boston-based GMO, is best known for his gloomy, and often accurate, long-term forecasts. In 2000, he predicted that U.S. stocks would lose money in the coming decade.

Grantham and his colleagues come up with their value targets by assuming a long-term average price-to-earnings ratio for stocks and applying it to a long-term average for profit margins.

“Quality stocks are pretty damn cheap right now,” said Ben Inker, director of asset allocation at GMO in a telephone interview. Because they are more stable and better able to withstand shocks, blue chips will outperform by an especially wide margin in turbulent times, said Inker.

“If Greece blows up, will that drive Coke into bankruptcy?” he asked.

EMC, Berkshire

The $3.2 billion GMO Global Balanced Asset Allocation Fund, which Inker runs and Grantham advises, had 31 percent of its money in U.S. quality stocks as of Dec. 31, according to the GMO Web site.

Perkins, whose Perkins Investment is a Chicago-based unit of Janus Capital Group Inc., cites Grantham’s notion that asset prices “revert to the mean,” or return to their historical norms, to make his case for large-cap stocks. At the moment, small stocks are expensive compared with large stocks, based on projected earnings and cash flows, Perkins said.

Like Grantham, Perkins sees large stocks as more stable, less risky and more likely to thrive should the stock market suffer a setback. If the rally continues, Perkins said, big stocks may lag behind.

Perkins’s large-cap stock holdings include EMC Corp., a technology company based in Hopkinton, Massachusetts, with a market value of $41 billion and Omaha, Nebraska-based Berkshire Hathaway Inc., with a market value of $196 billion.

Small stocks benefited from momentum as investors chased returns, Perkins said.

“That momentum has taken on a life of its own,” he said. “We might be ready for a shift.”

To contact the reporter on this story: Charles Stein in Boston at

To contact the editor responsible for this story: Christian Baumgaertel at

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