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Small Caps vs. Large: Managers Make Their Pitch

Why big may be beautiful.

Ryan Leggio, 11/18/2010

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U.S. large-cap stocks have had a tough decade. Vanguard 500 Index VFINX is flat over the past 10 years through Oct. 22. Meanwhile, its smaller-cap sibling, Vanguard Small Cap Index NAESX, is up 6% per year over the same period.

Why have large caps trailed small caps? Valuation explains much of the discrepancy. In the 1990s, large-cap stocks trounced small caps with their 18% annualized gain versus small caps' still-healthy 14%. A decade of outsized returns pushed large-cap stocks' valuation multiples to all-time highs by 2000, just prior to the two-plus-year bear market that began that March. Ten years ago, the large-cap indexes traded at a lofty price/earnings ratio of 25. A smaller gain during the 1990s left small-cap indexes at a 14 P/E multiple.

Fast-forward 10 years. A decade of no gains for large caps has improved their relative valuation. As of Sept. 30, the trailing P/E ratio of the Vanguard 500 was 16 compared with 25 for the Vanguard Small Cap Index.

Now that the valuation tables have turned, many managers think large caps will deliver better returns than small-cap stocks in the decade ahead. Here is what we've been hearing from a few prominent managers on the subject.

Buy Big Dopey
In a recent interview with Morningstar, Ben Inker of GMO, the subadvisor to Wells Fargo Advantage Asset Allocation EAAFX, said, "As we see it, large caps look cheap relative to small all around the world. And big value looks cheap relative to small value. And big growth looks cheap relative to small growth. We have spent a lot of time overweight small caps. We loved them from the late 1990s to the early to middle part of this decade, but now they're expensive, and the big dopey blue chips are a lot cheaper."PAGEBREAK

Opposites Attract
FPA Crescent FPACX manager Steven Romick said, "In the late 1990s . our fund was heavily tilted toward smaller-cap, high-quality companies because they were cheap. These companies were at 20% discounts to large-cap stocks in 1997, which was historically wide. They went to a 40% discount in 1999-2000, a new all-time high, and they stayed there for two years. Now we're at the opposite point in the cycle, and large-cap stocks are cheap by comparison--much cheaper than they've ever been versus small caps."

Same as It Ever Was
Bill Miller of Legg Mason Capital Management Value LMVTX thinks U.S. large-capitalization stocks represent a "once in a lifetime opportunity" to buy the best-quality companies in the world at bargain prices. He recently observed that one of the fund's holdings, ExxonMobil XOM, has a dividend yield greater than the 10-year Treasury, trades at a multiple well below the market's, has returns on capital above the market's, and has grown its dividend more than 9% per year the past five years.

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