The Case for US Large-Cap Stocks
George Sertl, portfolio manager at the Artisan Partners US Value Team comments on opportunities in US large-cap stocks.
As value investors, we are frequently asked about our views on valuations. Our response is dependent upon market conditions at the time, as well as other factors. We manage assets across the market capitalization spectrum, so we observe the differences between small-, mid-, and large-cap stock valuations at any given point in time.
Over the past five years, stocks have seen significant gains off the large correction that occurred as a result of the financial crisis. In US trading, all three market-cap segments have advanced over 200% on a cumulative basis since the 2009 market lows.
US equities have benefited from a strong rebound in corporate earnings, first due to cost cutting, and then followed by improved global demand. The positive backdrop for riskier assets has been aided by low interest rates, in part due to ample liquidity by central banks.
Valuations, from our perspective, seem to be on the high side of fair, depending on one’s view of margins. That said, on a relative basis, the large-cap segment of the market is where we are seeing the most attractive valuations right now—and it’s been that way for a few years.
Relative to the market, the largest companies in the US are historically cheap. Exhibit 1 shows the median price-to-forward earnings for large caps relative to the rest of the market over the past 35-40 years. In the late 1990s, either small caps were extremely cheap or large caps were really expensive relative to each other. Since that peak, the valuation differential has substantially declined and bottomed over the past several years.
Exhibit 1Source: Morgan Stanley Research. As of 30-Sep-14. Mega Caps are defined as the 30 largest companies by market capitalization in the S&P 500® Index. The Rest of the Market is the remaining stocks in the top 1,500 US stocks by market capitalization.
For most of the current bull market, small-cap stocks have outgained large caps. We’ve recently seen a reversal of this relationship in 2014 as small caps have lagged year to date. As this has occurred, the valuation differential has compressed, but the largest companies still remain historically cheap relative to the rest of the market.
Relative returns by market capitalization oscillate over time. Historically, after they have underperformed for a period, large caps relative to the rest of the market tend to outperform and vice versa. After years of small-cap outperformance, the relative pattern has reversed in 2014. While our approach is focused on the fundamentals, recent performance patterns can help reinforce the idea that now might be a good entry point into the large-cap space.
Not only do US large caps look relatively cheap, they also have a quality advantage. In Exhibit 2, measures of quality and valuation are shown for large caps relative to their mid- and small-cap counterparts as represented by broad market indices.
Large caps have a more attractive return on equity, better fixed-charge coverage ratio and trade at lower multiples. So not only are large caps cheaper, but also tend to boast better balance sheets and stronger business economics.
Exhibit 2 Source: Artisan Partners/FactSet/Russell/Standard & Poor’s. As of 30 Sep 2014. The Russell Top 200® Index measures the performance of the largest cap segment of the US equity universe. The Russell Midcap® Index measures the performance of the mid-cap segment of the US equity universe. The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe.
Additionally, in the large-cap space, companies tend to be more professionally managed with more stable business models and typically are more diversified. Because of these characteristics, the inherent risks of investing in large-cap equities are markedly less than small-cap stocks.
Another way to assess the attractiveness of large-cap stocks is to look at the earnings yield relative to a company’s cost of debt. By comparing the earnings yield on the stock to say, the company’s ten-year bond yield, one can determine how well investors are being paid to take on the risk of being an equity owner versus the risk of being a long-term bondholder of the same company.
Many of the large-cap companies we own can raise long-term debt at a cost of 3%-4%, but have earnings yields of 7%-9%. High earnings yields indicate equity investors are getting paid well to take on equity risk compared with the debt of the same company. In our view, the opportunity is most notable among large-cap companies due to their lower cost of capital.
Some of these companies, such as mobile technology leader Apple and networking equipment giant Cisco Systems, also have a lot of net cash on their balance sheets, which tells us their earnings yields would be even higher on an unlevered basis, and it also illustrates the financial strength of these companies.
In conclusion, we currently find US large-cap stocks attractive due their quality and valuation advantage over smaller-cap stocks. They also look appealing in comparison to the yields on offer in the bond market. This is creating, in our view, a better opportunity in the asset class from a risk/reward perspective.