With stocks, why bigger looks better
Owning stocks of U.S. multinational companies these days feels like sleeping with the enemy.
You know the allegations. Many of these giants have been outsourcing American jobs for decades. Now, as their earnings have rocketed with the economy’s rebound, they’ve been hoarding cash at a time when business investment is desperately needed.
And even as the federal budget deficit balloons, some multinationals are pushing the Obama administration for a tax holiday before they’ll bring home foreign profit they’ve left parked overseas.
In the grand scheme of things, it’s easy to make a case that these companies have become more powerful and more financially secure since the 2008 economic meltdown — quite the opposite of what has happened to most consumers, small businesses and state and local governments.
From Wall Street’s flinty-eyed view, all of this is exactly why there’s so much to like, if not love, about shares of many U.S. blue-chip firms.
For want of a better way to put it: If you can’t beat ‘em, it’s probably better to join ‘em. Because if the world doesn’t end, stocks of the biggest companies may have more potential to pleasantly surprise you than disappoint in the next few years.
Already this year, the blue-chip Standard & Poor’s 500 index is up 6.8% amid the broad market advance.
But big companies still can be a tough sell with investors after the last decade, which turned out to be a lost decade for the S&P 500 index. Even including dividends, an investment in the S&P lost a net 9.1% in the 10 years through 2009.
That was mostly because of the collapse of technology shares when the dot-com bubble burst in 2000. Chip titan Intel Corp.’s stock price, at $22.14 on Friday, still is down 70% from its record high of $74.87 reached in August 2000.
Investors simply way overpaid for tech stocks relative to the companies’ underlying earnings, if there even were any earnings.
Yet tech didn’t have a monopoly on price-to-earnings ratios in nosebleed territory back then. The future looked so stunningly bright, people also were willing to pay inflated prices for shares of many non-tech big-name firms: drug maker Pfizer Inc., for example, as well as Wal-Mart Stores Inc. and Coca-Cola Co.
In March 2000, the average S&P 500 stock’s price-to-earnings ratio was an extraordinarily high 27 based on the companies’ estimated operating earnings for that year.
Now, two bear markets later, the average S&P 500 P/E has been cut in half, to about 14 based on Standard & Poor’s own estimate of 2011 operating earnings for the companies in the index. That’s below the historical average of about 16 going back to 1935.
A lower P/E doesn’t guarantee success with a stock. It’s just one yardstick to use in measuring value. And below-average P/Es tend to denote slow-growing companies.
Still, classic value investors such as Jeremy Grantham, co-founder of money manager Grantham Mayo Van Otterloo Co. in Boston, see relative appeal in the blue chips at these prices.
Grantham, who called the market turn in the second quarter of 2009, said at the time that “quality stocks — the great franchise companies — were the cheapest stocks.” In an investor letter he wrote last month, Grantham said he still considered the highest-quality blue chips to be “very cheap,” although he also believes that the market overall is likely to head down again later this year.
Meanwhile, in Silicon Valley things are getting nutty again, if you believe the multibillion-dollar market values being ascribed to Facebook, Twitter and Groupon, which still are privately held. But for investors who have no desire to risk money in another potential tech bubble, blue-chip stock valuations offer a lot more comfort.
Consider: In 2000, shares of glass-technology company Corning Inc. rode that bull market to a peak of $113 on expectations for booming sales of its fiber-optic products.
Eleven years later Corning remains a big, and profitable, player in the businesses of glass panels, including for Apple Inc.’s iPad, and in telecom components. But the stock now sells for about $23, giving it a P/E of 11.5 based on analysts’ consensus earnings estimate of $2.01 a share for 2011.
Brian Barish, who manages the $1.4-billion Cambiar Opportunity stock mutual fund in Denver, owns Corning in the portfolio. Given the company’s growth prospects, “I don’t see why this stock can’t get up to a market [P/E] multiple,” meaning closer to 14 times earnings, said Barish, whose fund was up 19% last year, beating 94% of its peers. He also owns energy stocks such as Chevron Corp. and Hess Corp., which he regards as “still cheap” given his outlook for oil prices.
The caveat about 2011 P/Es, of course, is that they are estimates. The powerful earnings rebound of the last 18 months has fed Wall Street’s expectations for more. If analysts are overly optimistic about earnings gains this year, big stocks won’t look so cheap in retrospect.
Severe cost-cutting fueled the first part of the earnings turnaround. Now, companies need rising revenue to generate earnings. That is happening: Revenue for the S&P 500 companies overall rose 8% in the fourth quarter from a year earlier, according to Thomson Reuters data.
With their global reach, “Big companies are able to get revenue where they can,” said Joe Battipaglia, market strategist at Stifel Nicolaus & Co. in Florham Park, N.J.
So if U.S. economic growth slows, blue chips could gain a bigger advantage over smaller firms, whose shares have outperformed the giants since the rally began in 2009. That outperformance means you’re paying up for those shares now: The average estimated 2011 P/E for small-company stocks is 19, according to S&P.
As for bonds, if you think interest rates are more likely to rise than fall, that’s trouble for most types of fixed-rate securities. If rates rise enough, it also will depress the prices people are willing to pay for stocks. But income-hungry investors should remember that blue chip stocks pay dividends that can rise as earnings grow.
Steven Romick, a value-oriented investor who manages the $5.2-billion FPA Crescent mutual fund in West L.A., can invest in a broad spectrum of assets, including stocks, bonds and cash securities. Currently he has 60% of the fund in stocks, dominated by big names such as Wal-Mart, Occidental Petroleum Corp., Amgen Inc. and PetSmart Inc. Romick is holding 23% of the fund in cash, and the smallest portion in bonds.
“Large-cap companies are a much greater value, certainly than bonds,” said Romick, whose fund has gained 6.8% a year over the last five years, beating 97% of its peer funds.
Ultimately, the best reason to stick with blue chips is that many have emerged from the deep recession in fighting form — thanks in no small part to their ruthless cost-cutting.
If they’re going to cash in on a continuing economic recovery, you might as well go along for the ride.
