Large-cap, high-quality stocks: has the market shift begun?

By Norman F. Klopp, Jr., CFA, Partner

The story described the five-year history of underperformance by large-cap stocks, and the valuation disparities between not only large-cap vs. mid and small cap, but also between high-quality and low-quality stocks.

In the months since we wrote that analysis, there have been numerous articles in financial and investment publications on this subject.

Updated analysis

We thought it timely to update our analysis and see if there is any recent evidence of the shift we predicted, and if the valuation disparities still existed.

In the fourth quarter, large-cap stocks, as represented by the Russell Top 200 Index, performed about in line with the market (S&P 500 Index) and outperformed the S&P Small Cap Stock Index (see table below). While the time frame is short and the variance modest but growing, we could be seeing the first indication that the shift we expect is starting.

Our summer report noted that large-cap stocks were significantly undervalued (21%), based upon their average 10-year median price/earnings ratio (P/E ratio). Even with the recent positive price performance, the large-cap stocks are now more undervalued (27%), because their earnings in the most recent quarter have grown significantly faster than their stock price. Note: the P/E Ratio is calculated using the last twelve months reported earnings. Mid-Cap and Small-Cap under-valuations are 3% and 10% respectively, very modest compared to large-cap stocks.

Excellent value available

The final measure of value was a calculation of the P/E ratio of the highest quality 20% and lowest quality 20% of stocks in the S&P 500 Index and the Russell Top 200 Index to see if there was a value advantage to top quality stocks. In summer, the top quality stocks had an average P/E ratio 34% to 36% lower than the lowest quality stocks. In the top quality sector of the market, that P/E ratio discount has widened to 51%. There is excellent value available in the highest quality stocks in the market today.

What can we conclude?

First, there are early signs that the market is shifting to favor large-cap, high-quality stocks. Secondly, the valuation discount for the large-cap quality group of stocks has in fact widened since June.

We continue to believe — and emphasize — that an unusual long-term opportunity is unfolding in the large-cap, high-quality sector of the stock market. Our clients can be confident that those stocks remain the focus of our investment management style.