Big Stocks Discount to Small-caps (zt)

Big Stocks Lure Perkins, Grantham With Discount to Small-caps

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By Charles Stein

April 27 (Bloomberg) -- Thomas Perkins beat 94 percent ofhis mutual-fund rivals in the past decade by investing inmidsize companies. He now prefers giants such as Cisco SystemsInc. and Wal-Mart Stores Inc., and his $12.4 billion Perkins MidCap Value Fund is almost at its limit for big-company shares.

“These stocks have gotten so cheap that they shouldoutperform for the next several years,” Perkins, the 65-year-old fund manager at Perkins Investment Management LLC, said inan interview in Boston. His Mid Cap Value fund returned 12percent annually over the past 10 years, compared with the 7.6percent average of peers, data from Morningstar Inc. show.

With big stocks trading at the steepest discount to smallcompanies since at least 1982, the list of investors who sharePerkins’s view includes Jeremy Grantham of Grantham Mayo VanOtterloo Co. and Donald Yacktman of Yacktman Asset ManagementCo. They are among the best-performing bargain hunters of thestock world, value managers who scoop up companies they thinkothers have overlooked.

Large-capitalization stocks, as tracked by the Standard &Poor’s 500 Index, lost an annual average of 0.7 percent in the10 years ended March 31, according to data compiled byBloomberg. The S&P 100 Index, made up of the biggest of thebunch, fell 2.2 percent annually.

Those returns trailed annual gains during the same periodof 6 percent by the S&P Midcap 400 Index, a proxy for midsizestocks, and 3.7 percent by the Russell 2000 Index, a benchmarkfor small companies.

It’s “nearly certain” that the highest-quality largestocks, known as blue chips, will outperform the market in thenext seven years as more investors come to consider themunderpriced, Grantham wrote in his January newsletter. Herepeated his outlook last week in the April edition.

‘Sky-High’ Valuations

Large stocks had “sky-high” valuations in the 1990s,David Herro, manager of the $5.3 billion Oakmark InternationalFund in Chicago, said in an e-mail. It’s taken a full decade formany of them to return to attractive levels, said Herro, 49,whose fund has outperformed 92 percent of its peers in the pastyear, according to Bloomberg data.

The premium investors are paying today to own small-capitalization stocks versus their large counterparts is thebiggest in at least 27 years, said James Floyd, senior analystat Leuthold Group LLC, a research firm based in Minneapolis.Leuthold defines large stocks as those with a market value ofmore than $9 billion and small stocks as those from $300 millionto $1.4 billion.

Painful Wait

At the end of the first quarter, small stocks sold for anaverage price-to-earnings multiple of 18.6 compared with 15.7for large stocks. The 18 percent gap between the two is thewidest since Leuthold began gathering the data in December 1982,Floyd said. In 2000, small stocks sold at about a 40 percentdiscount to large stocks, he said.

As Grantham and the others wait for the turn, large capscontinue to underperform. The Russell 2000 more than doubledfrom the market bottom on March 9, 2009, through April 23, whilethe S&P 500 returned 84 percent, including dividends.

“It has been a painful trade,” said Michael Mullaney, whobegan shifting more money into the 100 biggest U.S. stocks inthe middle of 2009 and helps oversee $9 billion as a portfoliomanager at Fiduciary Trust Co. in Boston.

Since stocks hit their 12-year low, the $15.2 billion GMOQuality Fund has returned 52 percent, and Perkins Mid Cap Valueis up 82 percent, both trailing the S&P 500. The $2.2 billionYacktman Fund has more than doubled.

Cold Shoulder

Mutual-fund investors remain cool to large-cap stocks, datafrom Chicago-based Morningstar show. In the first three monthsof 2010, investors pulled $8.9 billion from U.S. large-capequity funds. They added $3.3 billion to mid-cap funds and $3.8billion to small-cap funds.

John Schonberg, manager of the $1.2 billion RiverSource MidCap Growth Fund, said it’s premature to bet on the biggeststocks.

“They will come back, but we have a ways to go before thathappens,” he said in a telephone interview.

Schonberg said the U.S. is in the early stages of aneconomic expansion and that small- and mid-cap stocks usually dowell in such an environment. Those same stocks will benefit aslarge companies use their cash to make acquisitions, he said.

In an April letter to the shareholders in his mutual funds,Yacktman pointed out that some of his top holdings, includingAtlanta-based Coca-Cola Co. and Pfizer Inc. in New York, sellfor lower prices than they did at the end of 1999.

Quality Merchandise

His Yacktman Fund returned 14 percent annually in the past10 years, better than all but 13 of more than 3,000 diversifiedU.S. funds, according to Morningstar.

Yacktman, the 68-year-old co-chief investment manager ofhis Austin, Texas-based firm, looks at stocks as if they werebonds and measures the future returns a company will generatecompared with its current price. That exercise leads him to“quality stocks,” market leaders with predictable performanceand high returns on capital.

“We like to buy quality merchandise when it is in thediscount bin,” he wrote to shareholders. In a telephoneinterview, Yacktman said that investors “are not being paid totake more risk” with lower-quality stocks.

Grantham, 71, wrote at the end of March that “high-quality” U.S. stocks would return 6.1 percent a year above therate of inflation for the next seven years compared with a lossof 1.2 percent for small-cap stocks. Quality stocks have high,stable returns on capital and low debt, Grantham wrote on GMO’sWeb site.

Microsoft, Johnson & Johnson

The largest holdings in the GMO Quality Fund includeRedmond, Washington-based Microsoft Corp. and New Brunswick, NewJersey-based Johnson & Johnson. Both have higher returns onequity and a lower ratio of total debt to equity than theaverage for the S&P 500, Bloomberg data show.

Grantham, chief investment strategist at Boston-based GMO,is best known for his gloomy, and often accurate, long-termforecasts. In 2000, he predicted that U.S. stocks would losemoney in the coming decade.

Grantham and his colleagues come up with their valuetargets by assuming a long-term average price-to-earnings ratiofor stocks and applying it to a long-term average for profitmargins.

“Quality stocks are pretty damn cheap right now,” saidBen Inker, director of asset allocation at GMO in a telephoneinterview. Because they are more stable and better able towithstand shocks, blue chips will outperform by an especiallywide margin in turbulent times, said Inker.

“If Greece blows up, will that drive Coke intobankruptcy?” he asked.

EMC, Berkshire

The $3.2 billion GMO Global Balanced Asset Allocation Fund,which Inker runs and Grantham advises, had 31 percent of itsmoney in U.S. quality stocks as of Dec. 31, according to the GMOWeb site.

Perkins, whose Perkins Investment is a Chicago-based unitof Janus Capital Group Inc., cites Grantham’s notion that assetprices “revert to the mean,” or return to their historicalnorms, to make his case for large-cap stocks. At the moment,small stocks are expensive compared with large stocks, based onprojected earnings and cash flows, Perkins said.

Like Grantham, Perkins sees large stocks as more stable,less risky and more likely to thrive should the stock marketsuffer a setback. If the rally continues, Perkins said, bigstocks may lag behind.

Perkins’s large-cap stock holdings include EMC Corp., atechnology company based in Hopkinton, Massachusetts, with amarket value of $41 billion and Omaha, Nebraska-based BerkshireHathaway Inc., with a market value of $196 billion.

Small stocks benefited from momentum as investors chasedreturns, Perkins said.

“That momentum has taken on a life of its own,” he said.“We might be ready for a shift.”

To contact the reporter on this story:Charles Stein in Boston at [e-mail]

Last Updated: April 27, 2010 00:00 EDT