Unnerved by volatile markets, investors have been dumping equity funds. Large-cap funds have suffered particularly big withdrawals, according to Morningstar. During the 12 months ending in September, investors pulled $37 billion from large growth funds and $11 billion from world stock funds, which hold mixes of U.S. and foreign large caps. At the same time that shareholders sold large caps, they put money into small-cap funds. But instead of fleeing large-cap funds, investors should be buying. By many measures, large caps seem like relative bargains compared to small caps and other assets. “This is a time when you should lean toward large stocks with high-quality earnings,” says Stephen Wood, chief market strategist for Russell Investments.
Over the years, large stocks have regularly moved in and out of favor. In the late 1980s and early 1990s, large stocks lagged, and their price-earnings ratios trailed the figures for small stocks. By September 1995, the P/E of the small stocks in the Russell 2000 index was 18.4, compared to a multiple of 16.5 for the large stocks of the Russell 1000. Then large stocks took the lead in the bull market of the late 1990s. In September 2000, the Russell 2000 had a P/E of 15.9, compared to 26.2 for the Russell 1000.
In the past decade, large stocks suffered a period of severe underperformance. In the 10 years ending in September, large value funds returned 3.0 percent annually, while small value funds have gained 7.2 percent, according to Morningstar. In October 2011, the P/E of the Russell 1000 was 14.0, compared to 16.9 for the Russell 2000. The weak showing of large stocks is particularly noteworthy because the Russell 1000 has reported stronger earnings gains. During the past five years, the earnings of the Russell 1000 have grown 7.2 percent annually, while earnings of the Russell 2000 have increased 4.2 percent.
Make no mistake, it is hard to predict when large stocks will again dominate. Several years ago some analysts and portfolio managers pounded the table for large stocks — and the bulls were wrong as large stocks continued to trail. But now there are signs that large stocks are starting to move into the lead. For 2011 through Nov. 8, large growth funds returned 1.8 percent, while small growth lost 0.6 percent.
To own large caps, look for steady funds that avoid big losses in downturns. A top choice is T. Rowe Price Blue Chip Growth (TRBCX). During the past decade, the fund has outpaced the S&P 500 while delivering competitive results in up and down markets. Portfolio manager Larry Puglia wants only the best growth stocks. He favors companies with high returns on equity that rank first or second in their industries based on market share. The companies must be poised to grow consistently over long periods while taking market share from competitors.
Puglia is not willing to pay high prices. He typically favors companies with P/E ratios that are about the same or less than their earnings growth rates. “In this market, you can find companies with 13 percent growth rates that are trading for 11 or 12 times earnings,” he says.
A favorite holding is Apple. Earnings grew by 53 percent in the last quarter, but Puglia says that the shares only trade at 10 times his earnings estimate for 2013. The multiple is depressed because investors figure that the company has gotten too big to maintain its rapid growth. But Puglia argues that Apple can continue expanding.
Another steady large growth fund is TCW Select Equities (TGCEX). Portfolio manager Craig Blum holds a mix of different kinds of growth stocks, including defensive performers that excel in downturns, as well as stars that soar when the market climbs. The recipe enabled the fund to outdo most peers during both the downturn of 2008 and the rebound of 2009.
A growth star in the portfolio is oil services giant Schlumberger. The company will enjoy growing sales as more producers drill in deeper waters, says Blum. “Oil companies are spending heavily to develop offshore fields, and that requires more equipment and services,” says Blum.
Buffalo Growth (BUFGX) emphasizes premier U.S. stocks that derive a big percentage of their revenues overseas. On average, portfolio holdings obtain half their revenues abroad. Portfolio manager Dave Carlsen says that China and other emerging markets will deliver superior growth for at least the next 10 years. “We want companies that have the wind at their backs,” says Carlsen.
The fund looks for companies with rich profit margins that can grow faster than the market expects. A favorite holding is QUALCOMM, which makes chips for mobile phones. The sales should increase as phone sales continue climbing around the globe.
To hold large-cap value stocks, consider Becker Value Equity (BVEFX). The fund seeks growing companies that sell for less than the market multiples. Becker's portfolio has a P/E of 11, while the Russell 1000 Value index commands a multiple of 12.4. Portfolio manager Bob Schaeffer likes high-quality businesses that face temporary problems. A favorite holding is pharmacy giant Walgreens, which has a P/E of 10. Schaeffer says that the stock has slumped because of a dispute with Express Scripts, a pharmacy benefit manager that is a major customer of Walgreen. Investors fear that the customer may take its business elsewhere, says Schaeffer. “The stock is under duress because of the uncertainty, but Walgreens is a persistent grower with a very strong balance sheet,” Schaeffer says.
To hold a mix of U.S. and foreign stocks, consider Harding Loevner Global Equity (HLMGX). The fund searches the world for superior growth companies. To make the cut, a business must have strong growth prospects, high returns on equity and little debt. The portfolio managers start by developing a list of about 325 companies that meet the criteria. Then the managers search through the candidates, assembling a portfolio of about 60 stocks that appear undervalued.
Portfolio manager Peter Baughan is particularly keen on Coach, the maker of upscale leather handbags and accessories. The company is opening stores in North America and expanding rapidly throughout Asia. Baughan says that the market does not fully appreciate how fast Coach can grow. “They have the ability to target female customers in Asia,” says Baughan. “The business is on fire in China.”