High Valuations, Strong Dollar Weigh Down Large-Cap Funds

If many investors felt left out of the second-quarter stock market rally, there may be a good reason: The lion’s share of stock mutual fund assets are still in funds that favor big-name stocks--and those funds continue to struggle relative to other market sectors, especially smaller stocks.

The average large-cap growth stock fund rose 6.5% in the quarter, according to fund tracker Morningstar Inc. That was a sharp improvement from the 19.7% average plunge in the first quarter. Yet the typical fund still was down 15.7% from year-end as of June 30.

By contrast, the average small-cap growth fund soared 17% in the second quarter, slashing its year-to-date loss to 3.3%. The average small-cap value fund rallied 13.1%, widening its 2001 gain to 13.4%.

After leading the market rally of the late 1990s, large-cap, blue-chip stocks have lagged their smaller counterparts for more than a year. Besides the crash in technology shares, the big-cap-to-small-cap market leadership shift has been Wall Street’s biggest story of the last year.

And some analysts aren’t ready to predict that the shift has run its course.

“It’s a matter of both momentum and valuations,” said Don Cassidy, senior research analyst at fund researcher Lipper Inc. in Denver.

“New money from investors has been going into what’s been winning--micro-cap, small-cap and mid-cap--and as those fund managers buy more stocks, that may be helping to boost their prices,” he said.

In effect, that creates a “virtuous cycle” for smaller stocks, as strong performance attracts money, begetting another round of strong performance.

Cassidy noted that large-cap growth stocks benefited from a similar cycle in the late ‘90s. “Investors are always attuned to what’s working,” he said.

But there may be other reasons, besides sheer momentum, that many investors are more interested in smaller stocks than bigger names these days.

The strong dollar, particularly against the euro, is depressing many multinational giants’ foreign earnings. And the dollar shows no sign of weakening, despite the slow-growing U.S. economy.

At the same time, price-to-earnings valuations remain relatively high for many large-cap stocks, Cassidy and other analysts say. P/Es are high despite shaky fundamentals and a near lack of earnings-growth visibility at many big companies.

“People are naturally more sensitive to valuation ratios now after getting burned in the market,” said Marc Gerstein, director of investment research at Multex.com, which tracks market trends.

The blue-chip valuation problem, Gerstein said, isn’t limited to so-called “new-economy” stocks.

He noted that Procter & Gamble and Coca-Cola, for instance, both trade at price-to-earnings ratios roughly twice as high as analysts’ estimated annual profit growth rates for the companies in the next three to five years.

That means that the PEG, or price-to-earnings-growth, ratios of the stocks are about 2.0.

By contrast, the average small-cap stock now trades at a PEG ratio of roughly 0.8, Gerstein said.

A low PEG ratio doesn’t necessarily mean a stock is a screaming bargain, but in a nervous market--where valuations matter once again--it can be comforting for investors looking for values and wary of overpaying, experts note.

With big-cap stocks’ near-term returns remaining stunted and smaller stocks advancing, the longer-term returns for the two sectors are converging.

Large-cap growth funds, for example, posted an average annualized gain of 11.8% in the five years ended June 30, according to Morningstar.

But small-cap value stock funds now have pulled ahead of large-cap growth for the five years, with an average annualized gain of 12.9%.

By contrast, at the end of 1999 the five-year average annual return of large-cap growth stock funds was 28.5%--far above returns of all fund sectors other than technology.

Measured over the last 10 years, annualized returns for the nine major categories of domestic stock funds tracked by Morningstar are clustered even more tightly than the five-year returns--between 13.2% and 14.6%.

The lesson, analysts say, is an old one: Diversification matters.

“This proves the argument that markets do cycle,” said Phil Edwards, head of fund research at Standard & Poor’s. “More than anything, the last few years have taught us that diversification counts and you need to have a little bit everywhere. You just can’t abandon a style.”

Added Cassidy: “It got really comfortable to just throw money at large-cap growth. But in investing sometimes you have to do what’s uncomfortable.”

The portfolios of many investors remain tilted toward large-cap stocks. Lipper’s data show large-cap funds have three times the assets of small- and mid-cap funds combined.

Of course, big stocks, by definition, are going to dominate in terms of overall market capitalization. But as the last year has shown, their capitalizations can stall, or decline, while smaller stocks rise in value.

Still, investment pros also remind that big stocks got that way for a reason: The companies tend to be leaders in their industries. And despite the stocks’ weakness of the last year, many experts aren’t counting them out in the longer term.

“A big secret to long-term success in the market is simply keeping your money in play in blue-chip, industry-leading stocks,” editor Charles Carlson writes in recommending Johnson & Johnson’s stock in the July edition of DRIP Investor, a newsletter that covers dividend reinvestment plans.