Big hopes for big fish
Don Hodges made a lot of money the last few years buying stocks of small and mid-size companies.
But these days Hodges is betting that bigger is better.
The Dallas-based manager of the top-ranked Hodges has about two-thirds of his portfolio in large-capitalization stocks, such as Coca-Cola Co. and Walt Disney Co. That’s a reversal from three years ago, when large-cap stocks accounted for only a third of his holdings.
Hodges runs a multi-cap, or “go anywhere,” fund, which can buy stocks of any size. And like many other multi-cap managers, Hodges thinks large-cap stocks are poised to outdistance shares of smaller companies for the first time in seven years.
“I think large-cap has been undervalued,” Hodges said. “It’s time for that part of the market to start outperforming.”
Mutual fund investors may want to look to what Hodges and other investment pros are doing as they manage their own portfolios and retirement funds.
Indeed, many of the forces that have propelled shares of big companies in the past are once again falling into place.
Overseas economies are strong and the dollar is weak, benefiting companies that do business abroad. Also, large-cap stocks are moderately priced relative to their earnings. And the stock market had a shaky summer, making the relative stability of large companies more appealing.
To be sure, money managers have repeatedly predicted a resurgence of large-cap dominance in recent years only to be proved wrong, or at least premature.
But large-cap indexes outpaced smaller-stock measures in each of the last two quarters and are on pace to come out on top for the year for the first time since 1999. That’s because large-caps held up better during the stock market’s deep sell-off this summer and have jumped more in the recovery that began last month.
In the third quarter of this year, in fact, the Russell 2,000 small-cap index lost ground, falling 3.1%. Meanwhile, the Standard & Poor’s 500 index and the Dow Jones industrial average -- both made up of large-cap stocks -- ended the quarter in positive territory, recording total returns of 4.2% and 2%, respectively. Total return figures assume dividends are reinvested.
Large-cap versus mid-cap
That disparity translated into the performance of mutual funds that individual investors might hold. Large-cap growth funds had an average total return in the third quarter of 5.4%, compared with 3.7% for mid-cap growth funds and only 0.9% for small-cap growth.
Over the first nine months of 2007, large-cap growth funds returned 14.1%, mid-cap growth funds gained 16.6% and small-cap growth funds climbed 11.5%.
Fund tracker Lipper Inc. defines large-cap stocks as those with a market capitalization -- share price times the number of shares outstanding -- topping $11.9 billion. The dividing line between small-cap and mid-cap stocks is $3.5 billion, according to Lipper.
The large-cap revival is good news for many individual investors who stuck with funds that invest in big companies.
Eric Cohen, an immigrant-rights attorney from San Francisco who keeps his retirement and children’s college money in large-cap funds offered by American Century, noticed his portfolio lagging in recent years.
“I was seeing the stock market go out the roof but not seeing my portfolio go out of the roof,” Cohen said. “I’m very excited now that [large-caps] are turning the corner.”
Dan Boerger, who owns a marketing company in Malvern, Pa., was tempted by small stocks but kept mostly to large-cap funds at Vanguard Group because he was drawn to their relative safety.
Now, “I’m enjoying excellent returns and I didn’t have to sacrifice my risk tolerance,” he said.
“Small-caps and mid-caps are likely to generally underperform large-caps in the months ahead,” Lori Calvasina, a stock strategist at Citigroup, wrote in a recent report.
Large-caps led the way through much of the late-1990s bull market as investors became enamored of technology giants such as Intel and Cisco Systems. But overvalued large-caps fell hard in the bear market that struck in March 2000, clearing the way for small-caps.
From the start of the new bull market in October 2002, the S&P; 500 has risen 101%. The Russell 2,000 is up 158%.
Mutual funds are taking notice of the large-cap move.
Vanguard Group, for example, is planning to launch three funds that will invest in so-called mega-cap stocks -- the largest of the large-caps, such as General Electric Co. and Microsoft Corp.
Multi-cap managers in the last two years have shifted about $25 billion out of small-cap and mid-cap stocks and into large-caps, according to Lipper.
The large-cap reawakening is being paced by tech and other growth stocks that have strong earnings prospects despite a slowing U.S. economy.
That doesn’t mean small-cap and mid-cap shares will falter, fund managers say.
Even if the large-caps shine, the performance gap is unlikely to be as wide as was when small stocks outperformed, some experts say. And if the Federal Reserve helps the economy skirt a recession, smaller companies, especially those with an overseas presence, should continue to do well, they say.
That thinking found support last week. On Monday, when stocks rallied on signs that the credit crunch was dissipating, the Dow climbed 1.4% to a new high, but the Russell 2,000 surged 2.4%. On Friday, the market rallied again on a rebound in U.S. job growth. The S&P; 500 rose 1% to a record, while the Russell 2,000 jumped 1.9%.
“The potential strength of large-cap is not at the expense of mid- and small-,” said Zachary Karabell, manager of the Alger China-U.S. Growth fund, which invests in Chinese and U.S. companies of all sizes.
Still, there is growing sentiment among fund managers that big stocks are finally due their day in the sun.
The strength of European and Asian economies helps companies with sizable foreign operations. And the weak dollar gives a boost to companies such as McDonald’s and Caterpillar when their sales in strong overseas currencies are translated back into dollars.
“The scenario for large-cap outperformance is going to remain in place as long as international economies are doing well and the dollar is weak,” said Rob Lloyd, manager of AIM Summit, a multi-cap fund.
Bulls say large companies have boosted earnings and become increasingly efficient in recent years. But their moderate stock-price gains mean valuations are reasonable.
Based on analysts’ estimates for earnings this year, the price-to-earnings ratio of the S&P; 500 is 16.4, compared with 27.2 for the Russell 2,000, according to Bloomberg.
As always, a lot depends on the economy.
All stocks would suffer if the economy turned down. But given their big rise, small stocks could be most at risk.
After large rallies in the past, the Russell 2,000 has sometimes fallen sharply and quickly in ensuing sell-offs, according to data from Russell Investment Group.
Russell 2,000’s fall
After rising 48% from mid-1997 to mid-1998, the Russell 2,000 sank 37% in the next 5 1/2 months. The large-cap Russell 1,000 fared better during that decline, losing only 16%.
But if the economy maintains its footing, small-caps should do well, managers say.
Growth stocks of all sizes are rallying, small-cap managers say. And many small companies are doing booming business overseas and should benefit from the same trends stoking large-caps, said Doug Pyle, manager of the Excelsior Small Cap fund.
“They can both do well,” Pyle said. “One doesn’t have to do well at expense of the other. They can both do better at the same time.”
