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Mega-cap stocks with strong balance sheets, multinational business models, and attractive, if not growing, dividends have outperformed the broader market this year. But as some valuations become stretched, the question is how long the asset class can maintain such leadership. Providing a range of perspectives are: Bob Fetch, Lord Abbett Partner & Director of Domestic Equity Portfolio Management; Tom O'Halloran, Lord Abbett Partner & Director of Multi, Large, and Small Cap Growth; Dan Frascarelli, Lord Abbett Partner & Director of Large Cap Core and Large Cap Value; and Rick Ruvkun, Lord Abbett Partner & Director of Calibrated Equity Management.
For all the turmoil in the markets during the last year, mega-cap stocks1 have attracted quite a following. Gone are the days when such corporate leviathans were considered too big to sail past small and mid cap stocks. Now, mega caps, particularly multinationals with prodigious exports and massive profits,2 occupy a significant portion of large cap portfolios.
With financial strength that eclipses most small nations,3 these companies generally have lengthy histories of increasing earnings and sales through good times and bad, solid balance sheets, cheap shares, and impressive dividend yields.4 Many of them sell the types of products and services that people buy even when the economy struggles. And many have been making greater inroads in some of the fastest-growing emerging markets in the world at a time when the United States and other developed markets have been struggling.
To further appreciate the attraction of mega caps, consider the Russell Top 50 Index,5 where the largest company by market cap was more than $556 billion and the top 10 performers advanced between 7.26% and 50% (as of October 31, 2012), thanks to a potent combination of technology, energy, financial, consumer staples, and health care stocks. Comprising the largest 50 securities in the Russell 3000® Index,6 the Russell Top 50 has generated a long-term growth forecast of 10.02% (according to the Institutional Brokers Estimate System), and a five-year growth of earnings per share7 of 11.62%, all of which has helped year-to-date and trailing 12-month performance of this index to eclipse the broader market (see Chart 1).
Source: Russell. Data as of September 28, 2012.
Past performance is no guarantee of future results.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
One of the biggest drivers has been technology, owing to the secular growth rates of certain hardware and software companies that have out-innovated their competitors, expanded market share, and grown sales and profits at an aggressive clip. Without naming names, it is fair to say that these include some of the most valuable brands that have built a phenomenal presence around the world.8 But when it comes to how much high-flying tech companies advanced this year, Bob Fetch, Lord Abbett Partner & Director of Domestic Equity Portfolio Management, is quick to remind investors how far some of their predecessors have fallen since their heyday. Take, for example, a global electronics company whose stock has dropped more than 95% since 2000, or a major manufacturer of smart phones whose shares have plummeted almost as precipitously since 2008.
Tom O'Halloran, Lord Abbett Partner & Director of Multi, Large, and Small Cap Growth, recalls how technology companies went through an extremely difficult time period following the bursting of the Nasdaq bubble early in 2000. The stocks underperformed the market dramatically for nine years, and a number of the businesses failed or had to be sold. These hard times prompted companies in the tech sector to rationalize their capital and operating expenditures. "Now many of the mega-cap technology companies have bullet-proof balance sheets and favorable levels of profitability," he said. Although not guaranteed, "they pay dividends, and investors see that these could grow for years. This is a change from earlier decades, when they were valued solely in terms of their growth. For the first time, a number of tech companies have reached the point of being considered ongoing stable franchises."
Valuation: A Mid-cycle's Night Dream?
Of course, mega caps have been buffeted by further weakness in the eurozone; continued sluggish growth in China, Brazil, India, and Japan; and concerns that the United States would drag down the global economy if tax increases and budget cuts drag the U.S. economy over a "fiscal cliff." But, according to Fetch, mega caps remain attractive, given their resilient fundamentals that typically drive such behemoths through the middle and late stages of economic recoveries, particularly stocks whose prices were at or close to the bottom of their historical range. Cases in point are two money center financial institutions whose stocks have posted double-digit gains, both year to date and over the last 12 months. [Of course there is no guarantee that this trend will continue in the future.]
Such financials, however, bounced back from rather depressed levels. But they were another indication of mega caps' relative strength versus the broader S&P 500® Index.9 "Look at how much the multiple of the market [as represented by the S&P 500] has changed," said Dan Frascarelli, Lord Abbett Partner & Director of Large Cap Core and Large Cap Value. "The reason it went up so much was because it was at such a low multiple last year. Last summer, [the index] was selling at 11 times earnings; in normal times, it should have been trading at 15–16 times earnings. But after Standard & Poor's downgraded U.S. government debt, equity investors got scared. However, as investor sentiment gradually climbed the proverbial wall of worry, the market multiple finished 2011 at 12.2 times next-12 months earnings."
Given such momentum, some analysts have told their clients that mega-cap valuations remain attractive based on estimated 2012 earnings and when compared with two pivotal periods: December 1999 (when mega-cap valuations suffered from irrational exuberance) and June 1983 (which capped a 10-year leadership run for tech-heavy small caps).10 (See Table 1.)
Source: The Leuthold Group.
Note: P/E calculations use operating earnings, which exclude extraordinary items and discontinued operations.
* December 1999 represents the extreme small cap relative P/E discount of 48% seen at the end of the 1994–1999 small cap underperformance period.
** June 1983 represents the peak of the 1973–1983 small cap leadership run, when small caps achieved a relative P/E premium of 10%. Small caps recorded an even higher P/E premium of 14% at the end of their 1999–2006 leadership run.
As an astute observer of business cycles during his 36-year investing career, Fetch recalled the striking difference between current mega-cap valuations and those of the late 1990s. "The market was very generous back then," Fetch said. "Whereas mega-caps now are selling at approximately 12.9 times estimated 2012 earnings, multiples in the late 1990s went from the low to mid-teens to between 40 and 50 without any meaningful change in the underlying fundamentals that would justify why it was prudent to pay three to four times more for a stock, other than the fact that investors were flooding the market and chasing performance."
"The late 1990s was like a tulip bulb phase for mega-cap stocks," recalled O'Halloran. "The emerging nations of the world were starting to become meaningful in size, and there was a perception that this would provide growth for years to come for these big companies."
But as history shows, investors came to the painful realization that mega caps back then were so big that they simply couldn't grow very fast for very long. As this reality set in, mega caps experienced huge multiple compression. The financial crisis in 2008 then ushered in an environment of extremely low yields and continued fear about the stability of the financial system.
"The combination of these circumstances, namely the substantial multiple compression in mega-caps, the scarcity of yield, and the continued fear, all have combined to create an ideal environment for mega-cap stocks," O'Halloran added.
Of course, no one can predict with any certainty how long the current mix of defensive, higher-quality, and higher-beta12 mega caps will outperform other asset classes, but Frascarelli suggested investors will continue to gravitate toward stocks with the greatest liquidity, one of the key attributes of mega caps.
The Role of Dividends
Another reason for mega caps' enduring attraction is the substantial contribution that both growing and reinvested dividends have had on total return. According to a study by three professors from the London Business School (commissioned by Credit Suisse), reinvested dividends, over any significant time period, account for at least 40% of total return. "While year-to-year performance is driven by capital appreciation, long-run returns are heavily influenced by reinvested dividends," the authors said. "The longer the investment horizon, the more important is dividend income."13
Even so, Fetch noted that dividend payout ratios14 for U.S. stocks are near historical lows (25–30% versus their roughly historical average of 45%).15 But he believes that payout ratios have the potential to return to such levels given the strong balance sheets and corporate liquidity that companies have today.
One wild card in this scenario is the federal tax treatment of mega-cap subsidiaries that have benefited mightily from a cheap dollar and massive exports, but keep the proceeds offshore, where taxes are much lower. While it may be a longshot in the current political environment, imagine what would happen if the U.S. government allowed U.S. corporations to repatriate such profits with sharply lower taxes for a certain period as the U.S. Chamber of Commerce and two mega-cap tech companies proposed last year. "In that scenario, we could get more productivity and higher returns, which would certainly make [the parent company] more attractive," said Rick Ruvkun, Lord Abbett Partner & Director of Calibrated Equity Management.
But what if tax rates rise next year? By way of historical perspective, Fetch pointed out that dividend payout ratios were considerably higher in the early 1990s, when dividends were fully taxable as opposed to the current 15%.16
Meantime, some experts suggest investors shouldn't worry too much about higher dividend taxation if most of their retirement funds are in tax-deferred accounts, especially if they focus on less-expensive stocks that have room to boost their payouts.17 As Josh Peters, editor of Morningstar's Dividend Investor newsletter, put it, "Even if taxation for dividends becomes less favorable, shareholders will look for and want to own the companies that are paying good dividends."18
Mega-cap Tech: Shades of the Late 1990s?
In a recent portfolio strategy article, Empirical Research Partners (ERP) described mega-cap technology stocks as a "winning combination of profitability and yield."
While some mega-cap investors might draw comparisons to the late 1990s, when the top 10 U.S.-based technology companies accounted for more than two-thirds of the sector's capitalization and about half of revenues, ERP concluded that increased skepticism about mega-cap tech stocks is "overdone and exploitable."19
ERP analyzed the attributes of the current top 10 tech companies looking for excesses, and said they proved hard to find.
"These are high-ROE20 businesses, earning an average of 28%," ERP said. "Besides that, the top 10 have generated revenue growth that's averaged around +20% lately, also an encouraging statistic given where they're priced. In the 1990s, when they had financial characteristics comparable to today's, they offered free cash flow yields21 of 1.5% to 2% versus the current ones of 7.5% to 8%."
Still, Bob Fetch advises some caution. "I doubt 20%-plus revenue growth at some companies is very sustainable, if for no other reason than the law of large numbers," he said. "That's not likely to last for very long."
For his part, O'Halloran acknowledged that 20% revenue growth is difficult to sustain, but noted that there are areas within technology, such as cloud computing, that are expected to grow that fast over the next five years.
"Technology is the sector that offers the best growth potential, but also the greatest risk of obsolescence, so complacency is dangerous when dealing with tech stocks," O'Halloran said "A meaningful deceleration in revenue growth is often a reason to sell a stock. But 20% revenue growth is currently 10 times the growth rate of the general economy, so this pace of growth offers an opportunity for superior returns."
The bottom line? While record profitability may falter and valuations in some sectors may be stretched, active managers with rigorous research discipline should continue to find opportunities in high-quality mega caps with sustainable EPS growth and higher net profit margins.
As a recent report by The Leuthold Group put it, "In the last few years, these companies have shown a remarkable ability to extract costs from their operations and have maintained record-high margins despite the headwinds."22
"You probably won't see the small or mid caps outperform until you get another reacceleration of the economy, and that may be a while," said Frascarelli. "We've got to get past the lame-duck Congress, past the 'fiscal cliff,' and the question of when earnings will reaccelerate. Pending such uncertainty, large caps [including mega caps] should continue to outperform through 2013."
"If we're deleveraging as a society and still in a muddle-through economy and we don’t have a dramatic economic expansion, I think [mega caps' run] will have extended legs," added Ruvkun. "On the other hand, if GDP [gross domestic product] were to accelerate, a mega-cap strategy would favor those that emphasize income or risk aversion."
—Reported by Steve Govoni
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
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