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Our Outlook for the Market

Why 'quality' has been lagging and what may turn it around.

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At the end of the third quarter, the overall song remains the same as it has been for most of 2010--the market overall is fairly valued, while mega-caps as a group look somewhat cheap, and some high-quality mega-caps look very cheap.

Since we at Morningstar have been singing the "quality is on sale" song for quite some time--and the asset class has not exactly been setting the world on fire--I thought it would be worth addressing the topic directly, in three parts.

  1. What's behind the continued underperformance of mega-cap/high-quality U.S. equities?
  2. What might need to happen to reverse this trend?
  3. Just how cheap are mega-caps, anyway?

Why Has 'Quality' Been Lagging?
I've seen all sort of theories floated to answer this question, but the one that makes the most sense to me is pretty simple: hindsight bias and performance chasing on a truly massive scale.

"Brand name" blue chips like  Johnson & Johnson (JNJ),  Coca-Cola (KO), and  Wal-Mart (WMT) have seen 10 years of steady multiple compression, and the investor tendency to gravitate away from underperforming asset classes is extremely well documented.

Marginal investment dollars are thus flowing into bonds, commodities, and emerging markets due to their superior performance over the past several years--and those dollars are coming out of domestic equities. I honestly don't think it's any more complicated than this.

I asked a few friends of mine in the brokerage community, as well as some portfolio managers at large fund shops, whether I was oversimplifying. They agreed that rearview mirror driving has been a huge factor. One wrote to me:

"A 10-year chart on these names won't be a great sales tool for a broker or a financial planner who sits down and shows them what the asset they are recommending has done for the last decade. This same effect probably explains at least part of the bond bubble that exists in the short/intermediate part of the Treasury curve. Sloppy money chasing yesterday's performance. In short--investors are 'blaming' these companies for what they did to them over the past decade, and they have sworn off a repeat."

You can see the underperformance of mega-caps in the chart below, which shows the excess returns of the S&P 100 relative to the S&P 500 over the past 20 years, for rolling 12-month periods. (Green=S&P 100 outperforming.) Except for a brief period of mega-cap outperformance in 2008-09 when risk aversion was high, the largest companies have underperformed the overall index pretty continuously since the late-'90s bull market.

This trend has continued so far in 2010, as you can see in the table below. I ranked the companies in the S&P 500 by their market cap on Dec. 31, 2009, and then looked at their year-to-date performance. The top deciles, with the biggest companies, have been clearly the worst performers, while the mid- to small-cap members of the S&P 500 have performed materially better. The difference in returns is nontrivial, with companies in the $2 billion to $5 billion market-cap range outperforming the behemoths by almost four to one.

 S&P Returns by Market Cap
S&P 500 Decile YTD Return
(%)
Median Market Cap
($mil)
1 1.0 91,431
2 2.8 31,917
3 2.0 19,284
4 3.6 13,547
5 9.6 9,993
6 8.4 7,892
7 12.3 6,484
8 6.7 5,009
9 8.0 3,856
10 8.1 2,439
Data as of 09-16-10

Circling back to the causes of mega-cap underperformance, the following chart shows the degree of investor aversion to equities quite clearly. It charts net flows into equity mutual funds minus net flows into bond funds, so it's a good way to see investors' collective preference for bonds or stocks in a single picture. As the saying goes, it's worth a thousand words.

The stampede away from equities and into bonds continues unabated. I find this especially striking given the very strong run off the bottom for equities since the first quarter of 2009.

Related to performance-chasing behavior, I think that investor aversion to large-cap U.S. equities has been reinforced by the increased availability of vehicles (mainly ETFs) that allow low-cost exposure to niche asset types. Since these asset classes--such as emerging markets and commodities--have posted strong recent performance, it's easy for financial professionals to position themselves as "adding value" for a client by steering dollars into these areas.

After all, if a financial advisor recommends J&J or  Cisco (CSCO), the natural client response is, "Why am I paying you for a stock idea I could have come up with myself, especially when that dog has gone nowhere for a decade?" So, the tendency is to push investors towards more "exotic" investments (Brazilian small caps or lithium ETFs, for example), which seem more sophisticated, and which are also linked to asset classes with good recent performance.

 

So, What Might Get the Mega-Cap Ship Moving?
There are a couple of ways to think about this, in my opinion.

One perspective is that out-of-favor assets don't start rising simply because people wake up one morning and do an "I should have had a V8!" head-slap. Investors need to exit the favored asset class(es) first, and that exit happens only after a sharp performance reversal. So, maybe what would need to happen is a rate spike that sends bonds into a quick tailspin, or perhaps a China slowdown that hits commodities and emerging-markets stocks harder than U.S. blue chips--either of which might shock investors into running for the relative safety of mega-caps.

Another perspective is that perhaps the shift is already occurring, but it just takes a lot of money to move a $7 trillion (the total market cap of the S&P 100) asset class. If you look at the portfolios of many of the largest hedge fund managers--from John Paulson to Stanley Druckenmiller--you'll see they're stuffed with plain old domestic mega-caps. And many of the quantitative hedge funds are algorithmic learning systems, so they will accentuate any modicum of positive outperformance that develops. But it may be that the asset class is so large that we need retail investors to join in before things really get moving.

And therein lies the rub. After being burnt badly two times in the past decade, what will renew investor confidence in equities? I wish I knew, but I'm afraid I don't.

Mega-Cap Valuations
What I do know is that given the option between a 10-year Treasury at 2.8% or a corporate bond at 4% or 5%, and any one of the scores of companies with free cash flow yields above 7%, I'm happy to put my money on the latter. In fact, I think that yield-based comparisons offer an interesting window into equity valuations right now, especially relative to bonds.

There are two types of comparisons I'd like to make. The first is between broad-based fixed-income yields and the free cash flow yields available for many equities, and the second is between specific companies' dividend and bond yields.

Putting things on a roughly apples-to-apples footing, let's compare cash returns (free cash flow divided by enterprise value) with fixed-income yields. The cash return--or free cash flow yield--of a business is the yield you would get if you bought a company lock, stock, and barrel, and pocketed the cash that it generates.

Of course, because we're looking at equities from the perspective of a minority shareholder, we need to build in some wiggle room to account for the fact that corporate managers are neither angels nor geniuses. They can misallocate capital by buying back shares at pricy valuations, reinvesting in value-destroying internal projects, or by making stupid acquisitions. Still, if a company is kicking out, say, $700 million or $800 million off a $10 billion enterprise value, there's room for some waste and you can still get a decent return.

So, I dug into Morningstar's database and screened for companies with market capitalizations over $1 billion and cash returns over 7%, and found 400 stocks. About 150 of these have market capitalizations over $5 billion, and about 100 are trading for a 20% or greater discount to our fair value estimate. Even allowing for the fact that the some of that free cash flow will be wasted and that free cash flow can be volatile--so not every company's trailing FCF is representative of a sustainable FCF--this simple screen highlights literally hundreds of companies with potential returns that are attractive on both an absolute and a relative basis. (You can  replicate this screen yourself with our  Premium Screener.)  

Further evidence of the disconnect between the equity and fixed-income markets resulted from another comparison I recently did, between dividend and corporate bond yields. I found over 30 companies with forward dividend yields higher than the current yields on the same companies' 10-year bonds. From  Clorox (CLX) to  Chevron (CVX) to  Altria (MO) to  Merck (MRK), I was surprised that fixed-income investors would accept such relatively low returns when these financially sound companies were offering better yields from their dividends--especially given that the bond coupons are fixed, while the dividends will rise over time. A table with some of these companies is below.

 Dividend vs Corporate Bond Yields
Company

Market Cap
($mil)

Forward Dividend
Yield (%)
YTW on 10-Year
Corporates
Spread (Dividend
Less Corp Yield)
Altria Group (MO) 48,868.99 6.48 4.81 1.67
Johnson & Johnson (JNJ) 162,099.07 3.67 2.96 0.71
Merck (MRK) 110,065.38 4.24 3.06 1.18
Clorox (CLX) 9,215.35 3.32 3.26 0.06
Procter & Gamble (PG) 171,358.73 3.19 3.06 0.13
Chevron (CVX) 155,318.36 3.73 3.02 0.71
Data as of 09-16-10

So, is the overall stock market screamingly cheap? No, it's not. But are there places to allocate capital that offer a reasonably attractive return? You bet. High-quality businesses with good balance sheets and strong free cash flows remain undervalued, especially relative to a fixed-income market in which demand seems to exceed supply.

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Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.