Large-cap-growth stocks finally move center stage

At this stage in the market cycle, big and boring large-cap-growth stocks look like the place to be. Despite lagging behind smaller-company stocks since the March 2009 low point, the large-cap-growth category is due to gain favor, according to quantitative and historical analysis of the category.

“I am hearing from a lot of managers about all the values in the large-cap space,” said David Kathman, a senior mutual fund analyst at Morningstar Inc.

Granted, this theme has been in place for much of the past year as the biggest companies have cut costs, stockpiled cash and boosted earnings. And relatively speaking, the market has yet to reward large-cap companies for their efforts — and in part, that’s why they look promising.

Consider large-caps’ recent relative underperformance.

From the March 2009 low through the end of last year, the small-cap-oriented Russell 2000 Growth Index produced an annualized return of 57.7%, while the Russell Midcap Index had an annualized return of 56.1%.

By contrast, the large-cap Russell Top 200 Index gained 39.2% and the Russell Top 50 Index gained 35.1%.

A similar pattern prevails at the mutual fund level.

Last year, while the average mid-cap-growth fund gained 24.6% and the average small-cap fund gained 27%, the average large-cap-growth mutual fund tracked by Morningstar gained 15.5%.

The $1.1 billion T. Rowe Price New America Growth Fund (PRWAX), which was among Morningstar’s “analyst picks” and gained 19.3% last year, is an example of how some large-cap managers generated performance: It allocated 34.5% of its portfolio to mid-cap stocks and 3% to small-caps.

So why is now the time for large-caps?

“Typically, during the third act of a bull market, which is where I believe we are now, there are going to be swings in leadership,” said David Rolfe, chief investment officer at Wedgewood Partners Inc., a $900 million asset management firm.

Compare current and historical price-earnings ratios of stocks across multiple categories, and you may see where that leadership is headed.

According to J.P. Morgan Asset Management, the current 14.6 P/E of large-cap-growth stocks is 31% below the category’s 20-year average P/E, making it the most discounted of the nine style box categories. Perhaps not so surprising, small-cap-value stocks, which have a current P/E of 14 and a historical average P/E of 14.1, represent the most fairly valued category.

In a report last month by Grantham Mayo Van Otterloo & Co. LLC, the investment firm predicted that small-cap U.S. stocks would generate annual returns of -1.9%, adjusted for inflation, over the next seven years. The next worst-performing asset class, according to the report, will be international-small-cap stocks, expected to lose 1.4% a year.

The report had U.S. large-caps in general gaining 0.4% annually over the same period, and U.S. “high quality” stocks gaining 4.9% annually.

Ultimately, as Mr. Rolfe pointed out, the current valuations suggest that the market isn’t expecting much from large-cap stocks but is expecting too much from small-caps.

With history as a guide, it is usually better to go with the less appreciated investment category.

As illustrated by the Leuthold Group LLC’s research, even going with the second-best-performing asset class from the prior year is better than a pure momentum strategy of latching onto last year’s winner.

In comparing the performance of the best-performing sector to that of the second-best performer, or “bridesmaid category,” from 1991 through 2010, Leuthold found that owning the prior year’s best sector produced an annualized return of 5.5% the following year, while owning the bridesmaid sector, which outperformed the best-performing sector 14 of the 20 years, would have resulted in an annualized gain of 12.7%.

Bottom line: At this stage in the market cycle, it is likely that the pendulum has swung too far in the direction of small- and mid-caps, which means that financial advisers should be wary about letting clients chase last year’s winners.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].