Between 2000 and 2010, European large caps underperformed mid caps by 28% and lagged small caps by 47%.
And yet, the equity strategists at Morgan Stanley recommend investing in large caps in 2012. The decade of underperformance has been reversing. Relatively, anyway, as they go on to write…
However, over much of last year, there was a noticeable improvement in the relative performance of large caps, which outperformed by 8% vs mid caps and 13% vs small caps since June.
Historically, large caps have traded at a premium to their smaller counterparts. The big behemoths are not only perceived as less risky, but they also have the courtesy to be more liquid and to show up in all manner of indices, giving them a boost by making them the baseline metric against which the fund management industry has to judge its performance.
Morgan Stanley puts the size of the premium at two per cent (over mid and small caps) since 1982. As luck would have it, the analysts reckon that large caps currently trade at a discount of 11 per cent — one of the reasons why it could be a good time to invest.
But not in all sectors, mind you. Across all sizes of company, financials and cyclicals are probably not the best places to be. Note that both of those are over-represented in the small caps (50 per cent of Morgan Stanley’s small-cap index are cyclicals).
Now to further set the scene by returning to a couple of very depressingly familiar themes.
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We expect a multi-year period of deleveraging, from both the public and private sector. Large caps are likely to prove much more resilient in the face of this deleveraging process, given their stronger balance sheets, lower refinancing needs, lesser dependence on bank lending and lower weighting in cyclicals. Large caps have been the winners in prior periods of weak credit growth (2001-02 and 2008-09). In addition, we think an uncertain DM growth environment and restrictive credit environment are likely to keep M&A volumes muted, which has been one of the main drivers of small-cap outperformance over the last decade.
Respecting that this is a purely an analysis of averages, and there’s going to be a hell of a lot of variation between companies, here are the relative differences in the levels of leverage:
It looks like there’s about a 10 per cent differential between mid and large caps. It’s also the profile of that debt that matters, as this graph that captures near-term financing risks shows:
That is, small and mid caps have the most short-term debt, that will presumably need to be rolled, and these are exactly the companies that are being hit by the ice age of lending that we’re in.
This is a horrible time to try to convince your bank to roll-over your debt. Even if companies are lucky enough to get their loans extended, it could well be at a higher rate than before given that lower policy rates have not been feeding through to the real economy. As FT Alphaville has explained, the transmission mechanism for monetary policy is busted and the banks are distracted by trying to raise regulatory capital.
As for being able to afford those higher rates, the interest coverage ratios of small and mid caps are distinctly lower than their larger counterparts:
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#2 Exposure to flailing Europe
One of the big drivers of small- and mid-cap outperformance over the past decade has been significantly higher earnings growth. Post the earnings recession of the early 2000s, small- and midcap earnings grew by 60% more relative to large caps, through to 2009. With earnings set to fall by 8% this year in our base case, the earnings growth environment for small caps is likely to be much more challenging. Small caps generate 75% of their revenues from Europe vs just 50% for large caps, meaning that small caps are much more exposed to a European recession. Also, small caps have a significantly higher weighting in cyclical sectors. Despite this, we believe earnings expectations are still very unrealistic for small caps – consensus expects nearly 40% earnings growth in 2012 for small caps vs 9% for large caps.
The turn in fortunes is already becoming visible, as this graph shows:
Furthermore the recent upswing might have been a hell of a lot better if Fins and Utilities were taken out of the mix:
All of that said, it’s worth emphasising again that the discussion above is both on average and relative. Large caps are not immune to economic headwinds and political uncertainty, they just may not suffer as much as mid and small caps.
Just in case you were thinking FT Alphaville was sounding uncharacteristically optimistic, that is.
Related links:
When the deleveraging meets the real economy – FT Alphaville
Bailed-out Royal Bank of Scotland controls the fate of many British firms – The Guardian