When everything looks expensive, what’s left to buy?, asks Lex. The answer may be “megacap” equities. Having been squarely out of favour for years, big stocks have kept pace with their smaller peers so far this year – and amid fears that the corporate profit cycle may be peaking it could finally be time for big stocks to outperform.
The world’s 120 largest companies by market cap, excluding financials, trade at 14 times 2006 earnings, a 15 per cent discount to the next 1,000 or so companies, according to UBS. Four years ago there was no discount, Lex notes.
Big public companies are “one of the last bastions of balance sheet conservatism,” with net debt at 0.9 times 2006 EBITDA, or 40 per cent less than their smaller peers. If the earnings cycle does weaken, this means reduced risk. “Alternatively, if there really is a new paradigm of high returns on capital and low interest rates, which in turn allows a step change in gearing, megacaps have the most potential to restructure their balance sheets.”
The most common complaint against megacaps is that their superficial attractions are largely explained by a skew to industries facing structural challenges. For example, energy, pharmaceuticals and telecoms account for about 40 per cent of megacaps’ market capitalisation, compared with 12 per cent for the next 1,000 companies.
Yet this skew has not led to sluggish fundamentals – megacaps have increased sales in line with smaller companies, although operating profits have grown slightly more slowly. Interestingly, UBS has found that in most sectors, megacaps are cheaper than their smaller peers and sectoral bias explains a small part of megacap’s overall valuation discount. And when it comes to earnings quality, global companies that dominate their sectors may be best positioned to sustain premium returns on capital.
“Megacaps are unloved and aloof from the buy-out frenzy. But they also look well positioned to perform as the bull market reaches maturity,” concludes Lex.