'Megacaps' Now More Attractive - SmartMoney.com

The market's biggest stocks have been laggards for most of the past 12 years. It might be time to give them a fresh look, experts say.

Stocks generally fall into one of three categories, based on their market value: small capitalization, midcap or large cap. At the top of the large caps are the "megacaps," generally companies with a market value of more than $100 billion.

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In the 12 years since the March 2000 market peak, the Standard & Poor's 100-stock index, which has an average market cap of $114 billion, has lost about 0.4% annually, counting dividends, according to Morningstar (MORN) . Over that period, the small-cap Russell 2000 has returned an annual 4.2%, the S&P MidCap 400 7.2%, and the S&P 500 index of large caps 0.9%.

At first glance, the strong rally since last fall seems to confirm the pattern. During the first four months after the market's Oct. 3 lows, the S&P 100 megacap index returned just 22%, while the Russell 2000 returned 37%.

But with the rally slowing now, megacaps look better. While the Russell 2000 has dropped 2.5% during the past month, the S&P 100 has gained 1.8%. For all of 2012, megacaps and small caps are essentially even.

Megacap strength is likely to continue, says Chris Verrone, chief technical strategist at Strategas Research Partners. "The largest stocks have been in purgatory for the last decade," he says. "But they've repaired the damage and are well positioned for future gains."

Megacaps' chronic underperf! ormance has left many investors with the impression that small caps are where the action is, says Doug Ramsey, chief investment officer at Leuthold Weeden Capital Management. But shorten your time horizon, and small caps look far less attractive, Mr. Ramsey says. During the past five years, the Russell 2000 has returned 10.6%, just 1.8% more than the S&P 100. And during the past 12 months, megacaps have jumped 6.9% while small caps have lost 0.9%.

That is partly because valuations now favor megacaps. At the end of February, the S&P 100 had a 12-month forward price/earnings ratio of 12.1, while the Russell's multiple was 15.4. That means investors are paying 27% more for small caps based on valuations. Since 1999, when the premium was greater than 25% at month's end, megacaps have outperformed small caps by an average of 3.7 percentage points over the following 12 months.

"When valuations are so skewed in one direction, that becomes all that matters in the long term," Mr. Ramsey says.

What's more, with the market likely to oscillate between periods of fear-inspired selling and all-is-well buying, megacaps are likely to provide investors with a smoother ride. During the past five years, megacaps have been only about three-quarters as volatile as small caps.

"There will be tricky, higher-volatility days like we saw this week," says Jim Russell, chief equities strategist at U.S. Bank Wealth Management, of Tuesday's 1.5% loss for the S&P 500. "There's a comfort level with megacaps."

That doesn't mean small caps won't have their moments. The Russell 2000 gained 7% in January, its best start of the year since 2006, and a decline is often the natural side effect of such a steep rise. After dropping as much as 3.5% since Feb. 3, small caps could take the lead if the market begins to charge ahead again, as is the typical pattern.

"January was an incredible run," says Lori Calvasina, small-cap strategist at Credit Suisse (CS) . "It's natural for small caps to pare back gains."

But small caps are near record highs already. The Russell 2000 hit a record high 10 months ago, and came within 4.2% of a new one on Feb. 3. The S&P 100, meanwhile, still is nearly 26% below its March 2000 record, leaving it with plenty of room to rally, says Mary Ann Bartels, a technical research analyst at Bank of America Merrill Lynch.

Some megacaps that look good right now include Microsoft (MSFT), Bristol-Myers Squibb (BMY) and Intel (INTC), says Mr. Verrone of Strategas. But the easiest way to play megacaps is with an exchange-traded fund like the iShares S&P 100 (OEF), which tracks the 100 largest stocks in the U.S., and has an expense ratio of just 0.2%.

For investors looking for active management, the Fidelity Mega Cap Stock fund has returned 3.8% annually during the past 10 years, more than a point better than the return from the S&P 100 ETF.

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