Stocks of the biggest companies worldwide recently witnessed a resurging interest by investors. This trend could persist as the state of the stock market cycle favors these mega caps.
This article is not about a headwear supplier or a sport nutrition supplement known under the same name. It is about a stock market term. In the financial field, mega caps comprise companies with a particularly high market capitalization. Typically, these are stocks with a market value of more than $100 billion, whereas large caps weigh in at least US$10 billion. Companies with a market capitalization of between $2 billion and $10 billion are classified as mid caps, which means that every other stock with a capitalization of less than $2 billion is considered small cap.
The group of mega caps is led by the likes of Apple ($597 billion), Google ($353 billion) and Exxon Mobil ($331 billion). Although the group also consists of other well-known names, the stock prices of these mega caps as a whole did not develop extraordinary well. Strictly speaking, since the turn of the millennium, the big names have lagged behind the overall market, but a consistently better performance of small and mid caps is not a natural law. As the analysts of Bank of America Merrill Lynch explain, there were also times in the past, such as in the 1980s or during the second half of the 1990s, when blue chips fared better.
There are signs a similar phase might be imminent, as more recently mega caps and large caps have shown a better performance than small and mid caps. This trend should continue because there are good reasons why mega caps could perform better than the market overall. First of all, the timing seems to be right, if the assumption is correct that we are currently in the second half of the bull market that started in March 2009 and not already in the making of a new bear market. In the past, the heavyweights often demonstrated an outperformance in the second phase of a stock market upswing.
The cycle sticks to the script
Until now, everything has gone by the book. The theory that first- and second-tier stocks reverse their roles applies exactly to the current cycle, according to Thomas Grüner, CEO at the German asset manager Grüner Fisher Investments GmbH. “It is typical for the first part of a bull market that the small and more economic sensitive growth companies get off to a dynamic running start and keep a performance advantage until the beginning of the more mature phase of the bull market. Big companies instead look inert at the beginning, but kick into gear in the second half.”
The better performance of mega caps is typically jump-started by the market entrance of new buyers. For these investors, the hunt for high returns is not the most important factor. They concentrate more on safety aspects instead. “Predestined for such investments are the big companies with a strong market position, a high degree of brand awareness, solid growth perspectives and sustainable attractive dividend yields,” explains Grüner. On top of that, mega caps score with an above average creditworthiness and comparatively low stock price fluctuations. It is equally significant that these traditional strengths are currently more important since the valuation of large and mega caps is not as elevated as that of small and mid caps.
Relative valuation advantage
In this context, investment strategist Ed Yardeni from Yardeni Research points out that the usual valuation premium of second- and third-tiers can be attributed to their higher growth rates. However, doubts have emerged as to whether these relative dynamics can be maintained in the short and medium term. Small and mid caps may have run out of air recently, Yardeni notes, because without this growth advantage a valuation premium is hard to justify.
The analysts at Ned Davis Research take a similar view. In their opinion, considerations of dividend yield and earnings yield (the inverse of the price earnings ratio) favor blue chips. Consequently, Ned Davis Research favors large caps over small and mid caps for the first time in more than two years.
In addition, according to Bank of America Merrill Lynch, mega caps have another decisive advantage in the case of rising interest rates because they don’t depend as much as smaller companies on cheap borrowed capital, given their often stronger balance sheets and more flexible financing alternatives.
But even without any interest rate turnaround in sight, the conditions are changing at the expense of smaller companies. The recent weakness of second- and third-tier stocks in Europe has to do with the strengthening dollar, since big companies with their larger presence abroad benefit more from that development too.
Private equity with buying interest
After the recent rise in volatility, the biggest question will be whether blue chips can achieve positive growth in their stock prices, or whether it will only be a better performance compared to small and mid caps on a relative basis. One thing is clear: If the recent losses are the forerunner of a bear market, even mega caps will not be able to escape the downward spiral. Smaller losses compared with peers would only be of little consolation.
At least one other reason that has emerged only recently indicates a better development on a comparative basis. Private equity firms have started to search for investment targets among the blue chips. That could be a new trend, which could become an important share price catalyst for the “big fish.”
Altogether, there are several good arguments that justify paying greater attention to mega and large caps. To play this trend, one can invest in big names like Apple, Google, Berkshire Hathaway, Microsoft or Roche. While the story of the mega caps sounds convincing, there is of course no guarantee that the strategy really pays off. Potential investors should therefore always work with loss protection measures and never put all their eggs in only one basket.