Are Large-Cap Stocks Really Undervalued?

Wouldn't it be great to know in advance what market sector would outperform over the coming year? For instance, if large-cap stocks were poised to do better than small caps, all you'd have to do is dump your money into a bunch of big companies and capture some natural diversification benefits (at least by industry) by building a randomly selected portfolio of well-known companies. Then you could roll all of your wealth into the next "winning sector" 12 months from now and repeat. Voila, you're an investing genius.

Lately, the market sector capturing a fair amount of buzz has been large cap--specifically mega-cap--stocks. Over the past month or so, Barron's, The New York Times, and BusinessWeek, among other publications, have run substantive articles making a seemingly strong case for big blue chips to make a comeback in 2005. The argument centers on two basic tenets: 1) Large-cap stocks have underperformed small- and mid-cap issues over the past several years, implying that they're destined to stage a comeback, and 2) Big-cap stocks are trading at a P/E discount to their recent historical averages, and it's time for them to revert to the mean. One prominent market strategist was boldly quoted as saying, "The large caps have underperformed by so much that there is a 95% probability that they will turn around."

Unfortunately, like most claims of near-certain investing success, this one looks less and less like a "can't lose" proposition the deeper one digs. To take a stab at whether a sector bet based on market cap looked like a surefire winner, I combined a top-down look at the market with a bottom-up exercise, considering how attractively priced stocks are within each category. In other words, I wanted to consider that even if the market data held true--that large caps as a group were looking like values--there wasn't some justifiable, underlying reason for this.

I won't dispute that some of the market data looks compelling, at least at first glance. On a P/E basis, 20 of the 30 largest-cap stocks traded in the U.S. are at levels below their five-year averages, and 19 of these 30 are also trading at a discount to Morningstar's fair value estimate. Using Morningstar's Market Valuation Graph, it's also apparent that wide-moat firms are the only category on our site that trade at a discount to our analysts' assessment of their prospects, with a price/fair value ratio of 0.97, meaning these stocks as a group are modestly underpriced. (No, a wide moat doesn't necessarily mean large capitalization, but 124 of 149 Morningstar wide-moat stocks do have above-average market caps compared with our coverage universe.)

Plus, for those who claim the entire market is too pricey--which our analysts collectively do--bigger-cap names might look interesting, at least on a relative basis. For instance, New York Stock Exchange issues that we cover--which are typically larger-cap firms--are priced more favorably than Nasdaq stocks, with price/fair values of 1.08 and 1.12, respectively.

However, the bull case for blindly favoring large-cap investing falls apart once you start looking at stocks on an individual basis and try to discern where the best values are. This exercise shows that great investment ideas are spread very evenly throughout the market. By splitting Morningstar's coverage universe in half, using our median market cap of about $3.4 billion as the dividing point, our top investing ideas are spread very evenly throughout the market. As of Feb. 1, 20 of the 41 stocks earning 5-star ratings sit above this market cap, and the other half fall below it. Extending this to either 4- or 5-star stocks, larger-cap names have a slight edge, with 105 earning one of our top two ratings versus only 87 firms below our median market cap.

Digging even deeper, it also becomes apparent that mega-cap stocks aren't where much of the action is. Although mega-caps--which consist of household names such as  General Electric (GE),  Intel (INTC), and  ExxonMobil (XOM)--might be trading modestly below their intrinsic worth as a group, there are few deep values in this category. Among the 30 largest-market-cap stocks, just two-- Coca-Cola (KO) and  Novartis (NVS)--currently earn a 5-star rating.

So yes, it's possible that there is money to be made by investing in large caps, just as there's potentially money to be made in small caps, mid-caps, micro-caps, and maybe even  Red Hat . However, when taking a bottom-up look at the prospects of individual stocks--rather than where they arbitrarily are lumped by market cap--it becomes evident that there's no reason to blindly favor large companies versus small instead of seeking out the best individual names, wherever they may be found.

The moral of this exercise: A portfolio is the sum of its component parts. I'd much rather have a portfolio made up of the best parts I can find bought at the cheapest price, regardless of where the stocks happen to fall on the market-cap spectrum.

Still, there's no reason to ignore large-cap stocks when the price is right, and here's 15 that are compelling enough to earn our 5-star rating as of Feb. 1:

 Accenture  (ACN)
 Anheuser-Busch Companies (BUD)
 Apollo Group 
 Cadbury Schweppes PLC ADR (CSG)
 Coca-Cola (KO)
 Fifth Third Bancorp (FITB)
 IAC/InterActiveCorp (IACI)
 Mellon Financial 
 National City 
 Novartis AG ADR (NVS)
 Paychex (PAYX)
 Royal Ahold ADR 
 Sysco (SYY)
 TransCanada (TRP)
 Tribune