Analysis: Investors pine for big caps as smallcaps outperform

By Chuck Mikolajczak

NEW YORK (BestGrowthStock) – With economic growth in the U.S. expected to shuffle along at a growth rate of about 2 percent, some investors believe the time is ripe for a move into large companies with a broader revenue base.

Smaller names outperformed large-caps after markets hit 12-year lows in March of 2009, typical during the early stages of economic recovery. Many Wall Street analysts predicted 2010 would see investors shifting to larger names as the economy gained more stable footing.

That hasn’t happened. So far this year, the S&P SmallCap 600 index has gained 13 percent and the Russell 2000 index rose 13.4 percent while the S&P 500 has added 6.3 percent.

Still, enthusiasm for large-caps over small-caps has not been sated. It’s a frequent refrain among investors, albeit one that has not panned out: The S&P 600 and Russell 2000 have outperformed the S&P 500 in every year but one since 2001.

“The only scenario where we see small-caps outperforming is if the economic data continues to come in on the strong side arguing for a better GDP than what is expected now,” said Daniel Breslin, portfolio manager of the Lazard U.S. Small-Mid Cap Equity Portfolio in New York.

Bank of America-Merrill Lynch SmallCap Strategist Steve DeSanctis has noted future estimates for small-caps appear to be high in light of the slow growth environment.

As small-caps derive an estimated 70 to 80 percent of their revenue domestically, smaller names may be hurt by weaker-than-expected earnings in light of slow U.S. growth.

“We’ve been in a strong recovery from the depths of the recession but reality is going to start setting in now because we are in a period of slow growth,” said Edward Hemmelgarn, chief investment officer at Shaker Investments in Cleveland.

“The options for people to make earnings look a lot better than they have are growing more limited.”

Recent developments tilt in favor of large-cap companies. Overseas growth has remained stronger, especially in Asia. Valuations are more favorable — the S&P 500’s forward price-to-earnings ratio, a key metric in valuing stocks, is 12.87, compared with 18.04 for the Russell 2000.

Earnings for large-caps have outperformed smaller names in the third quarter. As of October 27, 81 percent of S&P 500 companies reporting earnings topped Wall Street estimates according to Thomson Reuters data.

By comparison, 73.7 percent of the companies reporting so far in the S&P SmallCap 600 index exceeded expectations through October 22, according to data from Brown Brothers Harriman and Thomson Reuters.

These developments have helped large-caps of late. They’re still lagging, but not as much. Since October 1, the S&P 600 and Russell 2000 have gained 5 percent against a 3.9 percent advance for the S&P 500.

M&A SAVES THE DAY

Smallcaps have also been lifted by the emergence of merger and acquisition activity, which has ticked up this year, a development that generally favors smaller companies.

Mergers and acquisition activity is up 2 percent over last year, with the total value of those deals up 21.6 percent, according to Thomson Reuters data.

“There is sort of this perpetual bid under any number of pieces I’m seeing — who can be next — and the list is pretty long,” said Rick Campagna, portfolio manager at 300 North Capital LLC in Pasadena, California.

“The M&A deal is not underneath the large caps — nobody is going to take out Wal-Mart.”

With 177 S&P 500 names and more than 500 from the Russell 2000 posting results this week, a clearer picture should emerge as to which group has done a better job of weathering the current period. Large-caps will always have their fans, but small-caps have been more reliable over the years.

“We are still optimistic that the small caps will continue to do well because their multiples aren’t that high and they look cheap to us,” said Gary Bradshaw, portfolio manager at Hodges Capital Management in Dallas, Texas.

(Editing by Chizu Nomiyama)

Analysis: Investors pine for big caps as smallcaps outperform