"Are Large Cap Stocks Attractive?"

Sydney M. Williams

Thought of the Day

“Are Large Cap Stocks Attractive?”

June 1, 2011

We all know that companies are born, mature and eventually die – some early while others last for centuries. Today, when one looks at a few darlings from a decade ago, one can easily conclude that the highway to the graveyard for elephants has become crowded. Ten household names – Microsoft, Intel, Pfizer, Merck, JP Morgan, Cisco, Home Depot, GE, Citigroup and United Airlines – have, in aggregate, lost more than 40% of their value over the past ten years. All of them are lower than they were then. Granted, it was a difficult decade for stocks. The S&P 500 gained a mere 6%, and the NASDAQ remains more than 46% below its all-time peak in March 2000.

To be clear, we do not provide any fundamental research on the ten companies mentioned above. My comments are merely empirical observations. My interest is more in the exogenous reasons for their price declines and what the price of the stocks may be saying about the behavior of investors today.

The last ten years included two enormous shocks. The first was the collapse of the tech-internet bubble that peaked in March 2000. By the time the bottom finally appeared in October 2002 an estimated $6 trillion of equity value had been lost. Then, six years later, the credit collapse in 2007-2008 precipitated a 58% decline in the S&P 500. Despite the end of the tech bubble, the attack on 9/11 and the near collapse of the financial markets, over the decade GDP rose 46% and household net worth increased 38%. Neither number has been inflation adjusted, so the real gains were pretty anemic. (Inflation, as measured by the CPI, reduced the value of the Dollar by about 27% during the past decade.)

Ten years ago tech stocks were expensive and Microsoft, Cisco and Intel were no exception. The most extreme case, Cisco at its peak of $82 sold at 170 times earnings. Over the past ten years earnings compounded at 14% and the stock now sells at just over ten times the $1.60 consensus estimate for 2011. Less dramatically, the same was true for the other companies. Jack Welch was CEO of General Electric for twenty years, resigning in 2001. During his tenure this conglomerate of industrial equipment, household products and financial services reported remarkably smoothed earnings. Once he resigned, the multiple began to contract as the blind faith in Mr. Welch’s accomplishments was replaced with agnosticism. But it wasn’t until the credit crisis hit that the risk embedded in GE Capital surfaced. Current CEO Jeff Immelt has spent the last few years in damage control. But the essence of their business is still the same; revenues over the decade have risen from roughly $100 billion to $150 billion and the stock now sells at fifteen times the 2011 consensus estimate, less than half the multiple the stock sold for ten years ago.

The high cost of developing new drugs, a more restrictive FDA and the unknown consequences of Obamacare have weighed on drug companies. Both Pfizer and Merck are half the price they were ten years ago. Both are now selling for less than ten times earnings and each provides a dividend yield of about four percent.

Warren Buffet famously pointed out a few years ago that airlines, in all the years they had been public, collectively had lost money. However, at dinner Sunday night with Steve Kroll from our office and two well-known, influential large cap buyers, it was pointed out that in four of the last five years airlines such as United had generated sizable amounts of free cash flow – and that, despite very high oil prices. According to Yahoo Finance, today United Airlines’ operating cash flow provides a 30% yield.

All of these companies are international, so one should expect that they will benefit from continued economic growth overseas. In particular, the two banks on the list should benefit from returns to stability domestically and from growth in emerging markets. Additionally, the opportunity for income exists as dividends are restored (Citigroup) or increased (JP Morgan.)

When stocks are cheap, the main reason is fear. When they are dear, greed dominates. It’s hard to argue that there is much fear in the market today, though skepticism is certainly prevalent. But, similarly, greed is not visibly present. There are exceptions, though. Currently trading at $81.58, Linkedin is selling at 26.3X trailing twelve month revenues. However, the unique opportunities that existed in the aftermath of the credit collapse, especially in High Yield Bonds and small cap stocks, are no longer there. It is large cap stocks, such as the ones mentioned, that appear to be the wall flowers of the current era.

Apart from valuation, the avoidance of large cap stocks reflects larger trends. Forty years ago, the market was dominated by individuals who bought “good” companies and happily held them, collecting dividends. Over the past three or four decades, mutual funds largely replaced individuals; today professional money managers are the dominant factors in the investment process. On balance, they tend to be faster to respond to improving fundamentals or deteriorating financials. The better ones have no trouble holding management’s feet to the fire when conditions dictate. On the other hand, some professional managers encouraged the use of options, determining it would align management’s interests with shareholders. The unintended consequence, though, was that such options enriched managements at the expense of shareholders. Additionally, too many money managers fall victim to the malady of momentum, soaring this way and that like flocks of Starlings.

Both large cap managers with whom Steve and I had dinner on Sunday are investors, not traders. They agreed that dividends are more important than stock buybacks and that the most significant risk to markets is uncontrolled spending in Washington. In retrospect, market moves are logical responses to conditions. The trick is understanding where we are today. I don’t pretend to know. In his recent letter to investors, Howard Marks of Oaktree Capital wrote, “There’s nothing more risky than a widespread belief that there’s no risk.” That attitude, in my opinion, permeates Congress and the White House. There is a crisis brewing over the nation’s debt; yet the Administration and many Democrats seem more concerned with increasing borrowing limits than with addressing the cause of the debt.

But every environment provides opportunity. Knowledge of the past can be helpful in what it can tell us about human behavior. Investors are often like lemmings, following one another off a cliff. The corollary to Mr. Mark’s observation is that nothing provides opportunity like potential ignored. With the above ten stocks selling at an average multiple of 10.3X forward earnings and with an average yield of 2.3%, there appears to be limited risk and upside potential in many large cap stocks. Keep in mind, these comments are mine and are not based on our firm’s research.