Ready for a Big-Cap Comeback?
By Gene Marcial
Several savvy professional market watchers see the pendulum swinging back -- toward the big-cap stocks and away from the rampaging small- and mid-cap issues. The small fry have been outscoring the large-cap stocks that dominate most of the major stock indexes -- the Dow Jones industrial average, Standard & Poor's 500 index, and the Nasdaq composite index.
That's because the once dominant blue chips -- among them IBM (IBM ), Intel (INTC ), Cisco Systems (CSCO ), and AOL Time Warner (AOL ) -- have crashed. Last year, for example, the S&P's small-cap index, which is composed of companies with market capitalization of about $800 million, outperformed by some 30 percentage points the S&P 500, whose components boast an average market cap of $20 billion.
In sum, the small-caps rose 15% and the big-caps dropped 15%. The big-caps, in part, suffered from the impact of Enron: Earnings of the blue-chip companies, including General Electric (GE ), IBM, and Tyco Intl. (TYC ), have come to be perceived by investors as highly inflated, largely as a result of the general wariness on Wall Street in the wake of Enron's fraudulent earnings.
In addition, the big-caps also were burdened by an overall negative bias toward stocks, due in part to fears about terrorism and the recession. That has brought about heavy selling and profit-taking, which mostly affected the big-cap stocks, where most investment managers have made their huge capital gains during the bull market in the early '90s.
Now, some market technicians believe the small stocks will take a breather as they digest the huge gains that were driven by strong prospects for earnings growth. The small fries also benefited from their relatively lower valuations in terms of price-earnings (p-e) ratios and price-expected growth (p-eg) ratios, which represent forward estimated p-e ratios divided by their forward earnings growth estimates. Since growth prospects for small companies were higher compared with those of big companies, institutional investors focused on the small-caps.
That situation, however, has been reversing itself. The average p-e of the S&P 500, which in early 1999 was nearly 50% higher than that of the small caps, is now about 15% lower than the p-e of the small companies, notes Stephen Leeb, editor of the Personal Finance newsletter, which is published out of McLean, Va. Investors will surely take note of this growing disparity in valuation and will, predictably, plow back a lot of their funds to the big-cap stocks. Also, notes Leeb, investors are starting to shake off their concern over the "Enron effect." "As fear of fraud is replaced by an urge for safety in what still promise to be stormy times," Leeb sees big investors turning to the big-cap companies for "safe refuge."
BLOATED AND EXPENSIVE.
No doubt there are still many highly overpriced blue chips. But Leeb sees some large "bargain behemoths" that deserve investor attention. Among them: AOL, currently trading at around $19 a share; Citigroup (C ), $45; Home Depot (HD ), 41; Intel (INTC ), 28; Pfizer (PFE ), 35; Tyco, 19; and Wells Fargo (WFC ), 52. Leeb notes that their p-eg ratios remain low, ranging from 0.6 in the case of Tyco) to 1.2 for Intel and Home Depot. Their estimated long-term earnings growth range from 14% (Tyco and Wells Fargo) to 18% (Pfizer and Intel). On the other hand, the S&P 500's average p-eg ratio is 1.6, and its long-term average earnings growth is 9%.
In Leeb's list of 12 "bargain behemoths," which he argues have the "greatest near-term growth potential," each has a p-eg of at least 10% less than that of the S&P 500. Leeb says he would avoid blue chips that are still "bloated," with lofty p-eg ratios, such as AT&T (T ) with a p-eg ratio of 8.54; Coca-Cola (KO ), 2.80; Procter & Gamble (PG ), 2.21; and Anheuser Busch (BUD ), 2. "Many of these are great companies and would be buys if they were cheaper," says Leeb, who adds: "At their current prices, they are far too richly valued."
Among the companies with low p-egs, Leeb is high on AOL Time Warner. It has been out of favor because of recent management changes, complex accounting, and, says Leeb, its "apparent lack of a broadband strategy." He acknowledges that AOL probably won't achieve the 20% earnings growth the Street expects, saying: "It's just too big to sustain that kind of growth." But then he adds: "AOL remains the world's premier media company with potential growth higher than that of any of its competitors."
In spite of the much criticized management changes, the "bottom line is that the company is currently run by a seamless combination of top players from both the original AOL and Time Warner," argues Leeb. In his eyes, the critical question remains "whether the company's unmatched media assets will be able to blend with AOL's unrivaled Internet brand name." He believes AOL will be able to do just that -- migrate from the dominant dial-up services to a broadband delivery system. He notes that the company owns the second-largest cable system in the U.S, noting: "This company remains on an inexorable path that will meld together the best content with its vast distribution assets."
If, indeed, the big-caps are on their way back, it could provide the missing "leadership" ingredient that this market needs to produce a broader and more lasting advance.
Marcial is BusinessWeek's Inside Wall Street columnist