Sagging Large-Cap Stocks Could Snap Back

The stocks of big companies have stumbled for the last five years, but mutual fund manager John Snider thinks they could be ready to run in 2006.

Snider, co-manager of Los Angeles-based TCW Galileo Focused Equities fund, says two major factors -- valuations and economic conditions -- favor a reversal of fortune for big-name stocks, which paced the roaring 1990s bull market but have mostly lagged behind their smaller counterparts since Wall Street’s plunge in 2000.

“You don’t often get the sun and the moon and the stars aligned like they are for large-caps right now,” he said.

The trend may be starting to change already, Snider and other portfolio managers say.

In the fourth quarter, mutual funds that specialize in the stocks of big “growth” companies averaged gains of 3.3%, compared with a gain of 1.7% for small-company growth funds, according to investment research firm Morningstar Inc. Snider’s fund rose 5.3% in the fourth quarter, giving it a full-year gain of 3.7%.

So-called large-capitalization stocks -- large-caps for short -- are the companies with the highest market values (a company’s market capitalization is calculated by multiplying its share price by the number of shares outstanding). They are the blue chips such as Microsoft Corp., Caterpillar Inc. and Exxon Mobil Corp. that populate the Dow Jones industrial average and the Standard & Poor’s 500 index -- gauges that say “stock market” to many individual investors.

Investors whose retirement portfolios are riding on blue-chip stocks have been eagerly awaiting such a shift. But market pros are divided on whether the fourth-quarter surge by large-cap stocks was an anomaly or a harbinger of better things to come.

Skeptics caution that large-cap stocks can struggle for extended periods, such as the 1966-1982 span that began and ended with the Dow around the 1,000 level. Even if blue-chips snap back this year, they note, long-term investors should keep in mind that smaller stocks have bested bigger ones over the long haul.

Snider and other large-cap bulls argue, however, that stocks such as Exxon Mobil, Bank of America Corp., drug maker Pfizer Inc. and telecom giant Verizon Communications Inc. are still cheap relative to their expected per-share earnings this year.

Exxon Mobil, for instance, closed Monday at $59.40 and is expected to earn $5.47 a share in 2006, giving it a forward price-to-earnings ratio of 11, compared with 16 for the S&P; 500 overall. In general, low P/Es indicate potential bargains.

“Large-cap looks very attractive relative to small-cap right now,” said David E. Nelson, manager of Legg Mason American Leading Companies fund in Baltimore. “Back in 2000, it was the opposite situation, and look what happened.”

Economic conditions also favor large-cap names, some say.

The U.S. economy is in its fifth year of expansion since the recession that ended in November 2001. When expansions mature, corporate profit growth tends to slow, making the steady dividend payments and stability of larger companies attractive to investors, Snider said.

Since the 1970s, whenever profit growth has slowed, bigger stocks generally have outperformed smaller ones, he said. This year Wall Street analysts expect S&P; 500 operating profits to increase only 7%, compared with 11% in 2005.

Last year was the first in which the earnings growth rate fell after three straight increases, Snider noted, calling it no coincidence that big-cap indexes closed the performance gap of recent years, matching the mid-single-digit gains of small-cap indexes. In the fourth quarter, most large-cap stock indexes and mutual fund categories beat their smaller-cap rivals.

Bob Turner, chief investment officer at Turner Investment Partners in Berwyn, Pa., which runs the growth-oriented Turner Funds, said institutional investors such as pension funds probably would lead a large-cap revival as they became less enamored of so-called alternative investments such as hedge funds.

Loosely regulated that charge high fees and cater to wealthy individuals and institutions, hedge fundshave attracted billions of dollars in recent years, but their returns have been mixed.

The fascination with real estate investing also could wane if housing prices finally slip, Turner said.

For institutional investors, the easiest place to put new money to work quickly is in an exchange-traded fund or index mutual fund that tracks a large-cap index such as the S&P; 500.

Nelson believes that large-cap growth stocks, in particular, could be due for a sharp snap-back because they have been so hard hit since 2000. That fund category has posted an annualized loss of 3.4% over the last five years, according to Morningstar, badly lagging categories such as small-cap “value” (up 13.5%) and emerging markets (up 18.7%).

Even so, some investment pros warn against going hog-wild for large-cap stocks, at least for longer-term investors.

For one thing, history favors smaller, nimbler companies. In the last 80 years, according to research firm Ibbotson Associates, large-company stocks have returned an average of 10.4% a year including dividends, while small stocks have returned 12.6% per year.

In addition, after a particular market sector has enjoyed an extended run -- as large-cap stocks did during the 1990s bull market -- it can take a long time for that sector to return to favor with investors, said James P. O’Shaughnessy, senior managing director at Bear Stearns Asset Management in New York.

O’Shaughnessy studied trends dating to 1834 for his forthcoming book “Predicting the Markets of Tomorrow” and found that when large stocks dominate for 20-year periods, they typically languish over the succeeding 20 years.

That doesn’t bode well for the S&P; 500, which in March 2000 ended its best 20-year run ever -- returning an annualized 13.9% after inflation.

“Yes, we’re five or six years into this new cycle [of small-cap stocks outperforming large-caps], but we could have another 10 or 15 years to go,” O’Shaughnessy said.

What’s more, small companies have an inherent advantage when it comes to posting outsize percentage gains.

“When you have a $400-million market cap, it’s a lot easier to double in size than when you have a $40-billion market cap and everybody is gunning for you,” O’Shaughnessy said. “The smaller companies tend to be faster guys in simpler businesses.”

While large stocks make up about 75% of the stock market, many investors have tied higher percentages of their retirement accounts to them, he said.

They could look smart this year if big-caps surge, but O’Shaughnessy recommends that most investors match the market makeup by putting 75% of their stock portfolio in large-caps and the rest in small- and mid-cap stocks or mutual funds. More aggressive investors, he says, should consider putting as much as 40% of their money into small-cap stocks.

David Klaskin, who could be considered a neutral observer because he runs both the Pioneer Oak Ridge Large Cap Growth and Pioneer Oak Ridge Small Cap Growth funds in Boston, says he has a modest tilt toward smaller stocks.

“There are really good opportunities with smaller companies if you’re selective,” he said, “but it’s harder to add value if you’re buying the largest companies whose businesses are already mature.”

In the end, some market pros think mid-caps, loosely defined as companies with market values between $2 billion and $10 billion, offer the perfect compromise: solid growth opportunities with less risk and volatility than smaller names.

Turner of Turner Funds says he likes stocks with market values in the $5-billion to $15-billion range -- straddling the boundary between mid-cap and large-cap companies. Examples include Starwood Hotels & Resorts Worldwide Inc., leather goods maker Coach Inc., apparel retailer Chico’s FAS Inc. and Ultra Petroleum Corp.

“Small-cap is an area filled with minefields,” Turner said. “On a long-term basis, we’ve always felt that mid-cap is the sweet spot.”