The Capitalization Conundrum
By Milton Ezrati
February 22, 2011
Within equity portfolios, there certainly is good reason to lean toward larger capitalization issues. Standard cyclical timing would point toward larger capitalization issues anyway, and small capitalization stocks, having led in the rally by a wide margin so far, now carry less favorable valuations than they once did. What is more, when retail investors at last return to the equity market, they will likely favor larger, better-known names. Still, in taking advantage of these circumstances, it would be a mistake to abandon small cap issues altogether. They often extend their momentum as recoveries mature and could also benefit this year from the likely increase in merger and acquisition (M&A) activity.
So far in this market cycle, the small/large balance has followed true to historical patterns. Small cap stocks led large cap stocks out of the market’s recessionary trough, as they have in the first 12–18 months of just about every recovery on record. This time, small cap stocks led by an even wider margin than usual. It was in anticipation of just this pattern that Lord Abbett, in 2009, placed an emphasis on smaller capitalization issues. But history gives a less clear picture of what happens as recoveries mature. Often, large cap issues take over the lead in the second or third year of recovery, but sometimes smaller capitalization issues retain that lead for an extended period. This scenario alone, though it strongly suggests a diversification toward larger cap issues, makes an argument that the bias should not occur to the exclusion of all small caps in an equity portfolio.
There is, of course, no denying that valuations favor larger capitalization issues. While the large cap S&P 500® Index remains 12% below its October 2007 highs, the S&P SmallCap 600 Index has just about regained its former peak, and the S&P MidCap 400 Index has actually surpassed its former peak. Accordingly, price-to-earnings multiples look much more attractive for large cap stocks than for small cap stocks. Indeed, small caps as a group carry a multiples premium of 20% over large caps, which, by some measures, amounts to an extreme.
While such consideration should foster a large cap equity portfolio bias, the huge amounts of cash held on corporate balance sheets offers an additional reason for some continued small cap weighting. According to the Federal Reserve, cash and cash-equivalents held among non-farm, non-financial corporations amounted to some $1.6 trillion as of the final quarter of 2010 (the most recent period for which data are available). That figure equaled a high 6.1% of total assets and a remarkable 11.9% of overall corporate liabilities. A contrast with average past cash allocations implies a cash surplus approaching $500 billion. When companies undoubtedly put these funds to work, as seems likely in a continued economic recovery (even a slow one), M&A activity will likely pick up as well, and M&As typically target smaller capitalization firms. On this basis, too, small stocks, despite their high relative valuations, retain enough of an attraction to deserve a portfolio allocation within the general larger capitalization equity bias.
 The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
 The S&P SmallCap 600® Index is comprised of 600 small-cap companies that meet specific inclusion criteria to ensure that they are investable and financially viable.
 The S&P MidCap 400® Index measures the performance of the mid-size company segment of the U.S. market.
Milton Ezrati, Partner and Senior Economist and Market Strategist, has been widely published in a wide variety of magazines, scholarly journals, and newspapers, including The New York Times, Financial Times, The Wall Street Journal, The Christian Science Monitor, and Foreign Affairs, on a broad spectrum of investment management topics. Prior to joining Lord Abbett, Mr. Ezrati was Senior Vice President and head of investing in the Americas for Nomura Asset Management, where he helped direct investment strategies for both equity and fixed-income investment management.
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