Why you should buy large-cap stocks in 2012
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Associate Editor
David Stevenson Jan 20, 2012
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When buying shares for the first time, should you stick to big household names that you know and trust? Or are you better off with smaller firms that have the ability to grow more rapidly? Below we take a look at the long-term performance of both large caps and small caps – and which end of the market looks best value right now.
The appeal of blue chips
‘Large caps’ or ‘blue chips’ describe the shares in the biggest companies listed on a stock exchange. In Britain, oil and gas major Royal Dutch Shell (LSE: RDSB) is currently in pole position. With a market value of £145bn, it accounts for more than 9% of the FTSE 100 index.
For many investors, it’s the sheer size of these blue chips that’s the main attraction. The firms often run a range of diversified businesses, so sales and profits should be fairly predictable, making them less risky.
They have large floats – more shares are available to buy – and are owned by larger numbers of shareholders, which makes them more liquid (easier to trade in) than smaller firms. Big firms also tend to be keenly aware of the importance of the dividends they pay to major shareholders, such as Britain’s pension funds. Managements thus try to keep annual payouts on a steadily rising trend.
Blue chips are also well researched by analysts. In theory that should cut the chance of nasty surprises – although not eliminate them, as BP’s Gulf of Mexico disaster showed.
Small caps have their place too
Small-cap stocks – as the name suggests – are at the other end of the scale. Most analysts use the term to describe companies with a market value between £150m and £1bn (below that and they’re referred to as micro caps).
When you compare the relative importance of large and small caps, you start to realise why stockbrokers’ analysts concentrate their resources on large caps – that’s where most of their commission comes from. Take the FTSE All-Share index. It consists of 630 stocks. Yet just 150 of these account for more than 90% of the index’s worth. That leaves the remaining 480 firms valued at just over £150bn – only a little more than Royal Dutch Shell’s market cap.
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However, this focus on large caps means that many small caps are under-researched. This can lead to lower valuations (because they are less well understood), which in turn means there’s more scope to pick up a stock cheap because it’s been ignored by the market.
Small-cap companies can also grow faster. It’s easier to pick up ‘market share’ when you’re only a minor player in an industry. Single product businesses can expand sales and profits more rapidly than big groups with hundreds of product lines. Potentially higher reward comes with more volatility and risk. A small cap’s single product line is clearly more vulnerable than a large cap’s widely diversified output.
Which is best?
The best longer-term data on the relative performance of the two types of share comes from America. And it favours small caps. As John C Bogle notes in Common Sense on Mutual Funds, between 1926 and 1997, “the compound annual return on [US] small-cap stocks was 12.7% compared with 11% for large cap stocks”. This may not sound much of a gap, but over 71 years that stacks up to a small-cap total return three times greater than that of their bigger brethren. More recently, it’s been a similar story in Britain. Since 2000, British small caps have outperformed their larger peers by around two-thirds.
So should you buy small caps now? It’s not that simple. While US small caps have done much better overall than large caps, it hasn’t been the case for all time periods. From 1925 to 1964, small and large caps provided similar returns. In the following four years, the small-cap return was almost double that of large caps. But much of that outperformance was lost in the next five years. In Britain, meanwhile, small caps outran large caps by nearly 150% from the start of 2000 until the market peak in 2007, only to lose most of that outperformance by end-2008. The early-2009 market rally then propelled small caps to a 75% relative gain by mid-2011. But large caps have since outrun small caps by some 20%.
What should investors do? In the long run, it’s worth having exposure to small caps. In recent months, we’ve highlighted several small-cap funds with good track records. In Britain, we like Investec UK Smaller Companies (tel: 020-7597 2000) and Standard Life Investments UK Smaller Companies (0131-225 2345), while the F&C Global Smaller Companies (0800-136420) takes a worldwide view. But for now, small caps on the whole look pricey. In Britain, they’re on an average p/e of more than 17, according to FTSE data, compared with an average multiple of just over ten for large caps.
With the global outlook uncertain, it makes sense to play safe. Mobile phone operator Vodafone (LSE: VOD) is one of Britain’s largest quoted businesses, worth around £90bn. In today’s climate, the p/e of 11 and 5.2% prospective dividend yield look great value.
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