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 America's addiction to all things grandiose and excessive seems
to have come to a head in recent months.
This multi-decade long generational shift in personal and societal preference
was apparent through many different samplings of human lifestyle choices.
When McDonald's opened in 1955 the largest soda was 7 fluid ounces.
Today,
a small soda is 16 ounces, and a child's soda is 12 ounces. And what was once considered a normal adult meal is now a child's
portion. Additionally, American's historic obsession with the automobile
migrated to become a decade-plus long love affair with beastly SUVs. Hummer's
entrance into the mainstream more or less called a top in this market,
of which our society now scorns those earth-hating, tree-killing, ozone-depleting,
environmentally-ignorant SUV drivers (including yours truly).
Fast-forward to today.
Declines in home prices and retirement savings, increased uncertainty,
decreased investor confidence and the sudden realization of the debt burden
held by many individuals will surely lead to an extended period of belt
tightening and frugality. With "austerity and financial prudence" replacing "luxury
and extravagance" as the new cultural mindset, a realignment of "excessiveness" will
surely occur. Moderation is the new Mega.
Nevertheless, we encourage you to make one exception. No, I don't
mean the 44-ounce Super Big Gulp or Super-Sizing your McDonald's
Fries. We're not talking food servings, cars, credit card limits,
or the size of your house. That's so 2008. We're talking about
your investment portfolio -- specifically, the size of companies in
which you invest. And we don't just want you to go big. We want you
to go Mega -- as in Mega Caps.
Super Size Me
What is a "mega cap" stock? Typically, stocks with market caps
(shares outstanding multiplied by share price) above $50 billion.
Mega Cap stocks are probably the most recognizable stocks to the general
public. These companies have brands which transcend sociological class
structures, income levels and geographical regions. Take a quick gander
around your environment -- there's a high probability that the
items in your immediate vicinity were produced or sold you buy one of these
companies.
For the Baby-Boomer readers, the "Nifty Fifty" investment
strategy from the 1960's and 70's may ring a bell. This investment
tactic encouraged investing in the 50 popular large cap stocks on the New
York Stock Exchange, with a buy and hold mindset. But that was a different
period, as investors were chasing growth, strong balance sheets, and industry
leaders.
Today, we are also attracted to mega caps for their strong balance sheets,
but also for the attractive valuations they sport. Considering the current
environment, and in a somewhat contrarian viewpoint of typical recession-rebound
plays (small caps), we think these industry giants will be best poised
to lift our economy, and your portfolio, out of the market's downturn.
Land of the Giants
The popularly followed Standard & Poor's 500 Index, for example,
is really just a subset of a larger index, the S&P 1500. The following
graphic shows the full breakout of each of the seven main S&P indices
ranging from the S&P 600 (small caps) to the S&P 100 (large/mega
caps)
Too often investors look at the market through a singular lens, with the
greatest level of differentiation made between stocks and bonds. But it's
important to have an appreciation of the sub-sectors of the market, as
there can be large performance, valuation and growth differentials between
various groups.
Today, there are 29 stocks in the S&P 500 with market caps above $50
billion mark, accounting for just under 6% of the index on an equal weighted
basis. That said, if you sum the market cap of these 29 companies, they
account for 42% of the entire S&P's market capitalization. It
goes without saying that a small subset of the index can heavily impact
its performance.
As mentioned, there can be significant performance differentials between
these indices. As valuations between small, mid and large cap companies
shift with in the marketplace, due in part to investor risk appetites and
other macro-driven factors, these return differentials can be significant.
Lynx-eyed readers will notice the healthy levels of outperformance enjoyed
by the mid and small cap sectors of the market over the last five and ten
year time frames. And even sharper-eyed readers will immediately see the
rationale for this outperformance when viewing the following graphic:
As illustrated above, in the 1998 time frame, mid and small cap companies
were very attractively valued relative to larger cap stocks, as investors
got caught up in the internet bubble -- pushing companies like Microsoft,
Cisco, Juniper, Nortel and Pets.com to astronomical levels, leaving small
and mid cap stocks far behind.
As the dot com crash ensued, investors began seeing the attractiveness
in small and mid cap stocks, and invested heavily in them over the next
decade. We think that tide is about to turn.
Referencing the above chart again, you can see that large cap companies
are now more attractively valued when compared to their small and mid-cap
peers.
 In yet another example, the following graphic (right) breaks down the
S&P 500 by Mega Cap companies (with market caps above $50 billion),
and compares some common valuation metrics to the rest of the index.
In addition to attractive valuations, there are a few further points that
draw us to this part of the market:
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Strong Balance Sheets
- Many large & mega cap companies are flush with cash, and continue to
generate additional cash flow each quarter. As most of these companies
are in their "cash cow" phases, the market will be attracted
to these companies ability to both generate excess cash, and use that cash
to take advantage of the economic downturn (grow market share, purchase
smaller competitors, etc.)
-
Relatively stable business models
-
Large and mega cap companies are not being pressured to rapidly expand
their businesses, as much as small and mid-sized companies are. Instead,
investors and analysts expect these businesses to be properly managed,
and provide predictable and consistent rates of returns.
-
Less of a need for external funding
-
Considering the "cash cow" component of many of these business,
many -- though not all -- large and mega cap companies are "self
funding," meaning they don't need to issue debt or additional
stock to fund their business. In the current market environment, with credit
markets seized up and extremely tight lending standards, companies with
the ability to self fund are extremely attractive to investors.
-
Ability to weather economic downturn
-
Put together their strong balance sheets, stable business models, self
funding business models, and you have businesses that will be able to weather
the worst of economic storms.
David vs. Goliath, Round Two
Though it's a nice populist story of the "little guy" winning,
we think the data presented above favor the proverbial "Goliath."
In round two, it isn't David (think small & mid caps) slinging
rocks at Goliath (think large and mega caps). Now, instead, the market
is throwing boulders at both of them! In this scenario, we like Goliath's
chances of survival and success.
From the backlash against performance enhancing drugs in professional
sports, to the sharp increase in sales of high mileage hybrid vehicles,
to more health conscious servings at our local fast food restaurant, these
real life anecdotes will mold together to help define a new cultural and
generational shift in consumer habit and behavior.
As we all observe, appreciate and/or participate in this phenomenon, we
encourage you to buck the trend in one-regard -- your investment portfolio.
-- Bryan Keller, Research Analyst
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