Yet, if you ask me, the supposedly hyperefficient capital markets have this asset class priced way too low. And that presents a big opportunity.
Consider the performance of the S&P 100. These companies have had superior returns on equity of 19.9 percent, versus 14.7 percent for the next thousand largest companies. They have stronger balance sheets, higher profit margins and are creating massive amounts of free cash flow–more than they can fruitfully spend on research and investment. They are using this surplus to retire debt, raise their dividends and purchase their own shares. Their dividend yield is roughly 2 percent, and if you add back the 3 percent of their shares that they are buying back, the return of cash to their shareholders is about 5 percent a year. That’s significantly better than mid- and small-capitalization companies.
The earnings of large-cap companies are also growing faster than the broad market indexes. Earnings-growth forecasts are inexact and fraught with peril, but the current expectation is roughly 16 percent versus 12 percent for the rest. Why is this happening? Big caps are dominant companies in superior businesses. Having been at the forefront of globalization, big multinationals have more exposure to international economies, both developed and emerging. It’s hard to be precise, but perhaps 40 percent of their sales are made outside of the United States.
With the dollar falling against many of the currencies they do business in, they are benefiting from conversion gains, so to some extent their shares are also a hedge against the weak dollar. Aside from geographic diversity, they’ve also got multiple product lines, which makes their growth more stable than companies that sell one product. GE, 3M and United Technologies are all examples of this. Others, including Microsoft, Procter & Gamble, Johnson & Johnson and IBM own some of the great brands in the world. The economies of scale they realize are an important competitive advantage. While they may not have quite the stock-market potential of smaller, single-product firms, they are also much less risky, making them unattractive targets for get-rich-quick speculators.
Throughout most of the past 50 years, big-cap stocks have traded at a 10 to 30 percent premium over the broad-market indexes, reflecting their advantages. But investor enthusiasm waxes and wanes. In the 1970s, when they were known as the “favorite 50” and the “vestal virgins,” they enjoyed a 50 to 70 percent premium. In other words, as a class, they had price-to-earnings ratios, multiples of free cash flow, price-to-sales and book value that were 50 percent higher than that of the market as a whole, despite yields that were considerably lower than those of other stocks. Then fashions shifted. There was a huge bust in the second half of the 1970s, followed by a rebound a decade later. Though briefly out of favor in 1993 and 1994, they subsequently went on a six-year tear that took them to a 27 percent premium in late 1999 and 2000. It’s been all downhill since. Today, you can buy an index of these companies at about a 10 percent discount to the rest of the market. I can’t find any evidence that they have ever been cheaper.
What’s more, there’s another reason to own them. We live in a world where every government wants to have a weak currency in order to maximize domestic employment. Competitive devaluations are the order of the day. If these policies get out of hand, people could lose confidence in all currencies as a store of value. The price of gold would soar, but gold is not a practical alternative to paper money. The substitute could be the shares of these big multinational growth companies, which represent a call on real assets around the world.
I am bullish on equity markets. I think the Goldilocks world of moderate growth, and low inflation and interest rates, will prevail. Globalization, technology and the growth of emerging markets are new and positive factors. Stock valuations are very reasonable, central banks are smarter and the world economy is less cyclical than it used to be. All the blather about “global imbalances” and “running on empty” are just that–blather. Of course, if I’m wrong, the nice thing about big caps is that they will go down a lot less than everything else. How do you buy them? Don’t try to pick individual names. Fidelity and Vanguard have big-cap index funds with minuscule fees and expenses. You can also buy the hundred biggest stocks in the S&P in an exchange trade fund called the OEF.
