The Capitalization Conundrum
Lord Abbett
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[1] remains 12% below its October 2007 highs, the S&P SmallCap 600 Index[2] has just about regained its former peak, and the S&P MidCap 400 Index[3] 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.
[1] 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.
[2] 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.
[3] 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.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing including those related to currency fluctuations, foreign, political, and economic events. These risks can be greater in the case of emerging country securities. The value of fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Debt securities are also subject to credit risk, which is the risk that the issuer will fail to make timely payments of interest and principal. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.
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