September 2005
Many investors believe that a buy and hold strategy of a diversified portfolio of stocks of large, "best of breed" companies will always produce decent investment returns. Whenever people start thinking of something as a slam-dunk, it is usually the right time to think again. In fact, over the last five years stocks of companies like GE, Disney, Coca-Cola, and Wal-Mart have been truly lousy investments and they've had their investors singing the Big-Cap Bias Blues.
But there is good news. Finally, the prices of many of the blue chip companies have sunk to levels that are attractive to value investors like us. In my opinion, it is now much safer to think bigger.
Client Management, Not Money Management
Early in my career as a portfolio manager in a typical bank trust department, I was told more than once that "your clients won't fire you if you lose their money in stocks of companies that they know". It was kind of hard to believe at first, but in fact, I found that to be the case.
The logic is that clients are very forgiving of mistakes that they could make on their own. It is the creative mistakes or losing money in stocks that they don't know that are simply not tolerated. And it is one of the reasons many trust companies tend to own same group of large-cap stocks - it's just easier that way.
Besides the focus on managing their clients' perceptions rather than managing their clients' money, there are two other related reasons that many investment managers gravitate toward recognizable large company stocks; (1) a false sense of familiarity and safety and (2) the trend of closet indexing.
Confusing Stocks and Bonds
People are less critical of mediocre returns if their money is invested in stocks with names like Colgate Palmolive or McDonalds that they know and love. If they like the product, they think the stock will be a good investment. Many times that is not the case.
Also, you often hear people say, "they will be around in 20 years", as if that is what matters in deciding to own a stock. Now, if they were talking about investing in Colgate's or McDonald's bonds that mature in a decade or so, then I could better understand the logic. But for the stockholder, the probability of bankruptcy should always be extremely low. This kind of thinking causes investors to pay more, and therefore, earn less.
Closet Indexing: Find The B- Student.
Many equity mutual fund and other institutional investment managers are guilty of big-cap bias. These large-company stocks are a big part of the popular stock market indices. Almost always, portfolio managers' results are compared to these benchmarks. So, like a student sitting for a test that they haven't really prepared for but really need to pass, they can just cozy up to a consistent B- student and kind of look over his shoulder. That, in essence, is a closet indexer.
More and more portfolio managers have become closet indexers and have moved more in the direction of incorporating a permanent large-cap strategy within other investment styles to ensure that the returns of their mutual funds or clients' portfolios are at least close to the relevant index.
The Price / Quality Tradeoff
To be fair, big-cap stocks often trade at higher prices than their smaller, lesser-known competitors because their economics are better. These companies tend to be leaders in their respective industries and are able to achieve higher profit margins and returns on capital. They normally have more of a global presence so their revenues and earnings are less volatile from year to year. Their balance sheets are usually in good condition and they have the ability to easily attract additional capital if needed.
To get these benefits, investors have had to pay up for companies like General Electric and Coca-Cola even when their prospects were less than exciting because of the perceived safety of size. Ironically, paying up often erases the positives. There is no better way to lose money than by paying too high a price. The dismal performance of blue chip stocks since the late 90's once again proves the point.
A Good Portfolio Gone Bad
We looked at a group of stocks that included the many of the ones mentioned above as well as Pfizer, Citigroup, Intel, IBM, Cisco, 3M, Microsoft and Johnson & Johnson. One would think that a portfolio made up of these 12 best of breed companies would have done relatively well over a five-year period of time that was marked by an improving economic environment when sales and earnings were growing. However, actual results were far less than expectations.
Since 2000, the sales and operating earnings of these companies have grown at an average rate of 36% and 47%, respectively. Despite those good results these stocks have dropped by an average of just over 30% during that period of time. OUCH!
It's certainly true that all 12 companies are still in business. It's also likely true that very few portfolio managers were fired because they owned these stocks and lost money for their clients. Who can honestly argue with 40% growth in earnings in 5 years? But still, price is the great equalizer in the investment world! Their premium valuations turned into discounts to reflect their lower growth rates than what they had achieved in the past.
Better Days Ahead For Big-Caps
Today, the prices of many big company stocks are looking cheap - not coincidentally when many are shunning them for their dismal past performance! This year was supposed to be a good one for the large-cap stocks, yet many of these stocks now languish near their 12-month lows. Investors no longer have to pay up for their quality. For the first time in a long time value investors like us are getting interested in a number of these corporate icons like Cisco Systems and Wal-Mart.
As corporate earnings growth slows over the next year we think investors will once again be interested in these large and steady growers. As is usually the case when the price is right, we think the investment returns of many of these stocks will be surprisingly good.
John W. Gudritz, CFA
john@frontstreet.com