American International Group Inc (AIG), Ford Motor Company (F), General Motors Company (GM): The Time To Rotate Into Mega-Cap Stocks Is Now

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In the summer of 1990, the U.S. economy was quickly losing altitude. By the fourth quarter, the nation’s GDP had fallen by nearly 4%. Unemployment began to rise, and the economic weakness would eventually cost George H.W. Bush a chance for a second term.

By Oct. 1 of that year, the Russell 2000 small-cap index had fallen to just 119. Yet just 16 months later, it surged past the 200 mark, reaching 250 by September 1993. Investors shouldn’t have been surprised. Small-cap stocks always do well when the economy is in a funk, but investors sense that better days lie ahead.

American International Group Inc (NYSE:AIG)Well, it’s happening again.

Although the U.S. economy has posted a halting and unimpressive recovery, investors have again embraced seemingly risky small caps. The 200% gain in the Russell 2000 since the markets bottomed out in March 2009 surpasses the S&P 500’s gain by a whopping 50 percentage points.

Yet for a host of factors, it’s time to trim your exposure to small caps and go big. Mega-cap stocks, which are the 100 largest companies in the S&P 500, haven’t held this much appeal — relative to small-cap stocks — in quite some time.

Analysts at BMO Capital Markets took a look this issue in a historical context and concluded that “Although mega-cap stocks have traditionally underperformed during the first few years of bull markets, the degree of underperformance in the current cycle is quite exceptional.” They add that “this is typically the part of the (economic) cycle where mega-cap outperformance begins.”

Before we delve into the reasons why mega-cap stocks should soon rotate into favor, it’s helpful to know why they traditionally underperform in the early stages of economic recoveries. The simplest explanation: Small-cap companies tend to feel the painful effects of an economic recession more deeply (as was the case in the early part of 1990), and as a result, have the potential for the most robust earnings rebound as the economy stabilizes.

Mega-cap stocks, on the other hand, don’t typically suffer from severe profit droughts when the economy slows, and are instead like ocean liners steaming ahead at a constant pace in all cycles.

In fact, that relative dullness can work against mega-cap stocks when markets are moving higher at a rapid clip. “These stocks have a reputation of being the most predictable and thus least interesting area of the market (e.g., the perception that better performance opportunities exist elsewhere),” noted BMO’s analysts.

Perhaps the greatest appeal of mega-caps right now is the relative valuations. The recent phase of underperformance has left many of them with price-to-earnings (P/E) ratios below the S&P 500 average of 16.

And these relatively low P/E ratios have two implications. First, these stocks are likely to be spared from indiscriminate selling if investors look to shed pricey stocks in a falling market. And they have more room for multiple expansions if the market moves higher.

The Foreign Factor
Mega-cap stocks have also underperformed because they have relatively greater exposure to global markets. Though it’s hard to pinpoint the specific numbers for mega-caps, the typical company in the S&P 500 derives roughly 46% of sales from abroad, which is roughly twice the level of small caps. And much of the foreign sales are derived from European affiliates.

Yet at some point, perhaps as soon as the next few quarters, the European drag will abate, and soon thereafter become a tailwind as European spending (especially in terms of capital equipment) starts to make up for lost time.

The United States: Safety And Upside
Of course, these mega-caps still derive the bulk of their sales in the U.S., the world’s largest economy. Though economic growth has been underwhelming thus far in 2013 (expanding 1.1% in the first quarter and 1.7% in the second quarter), most economists anticipate a steady strengthening led by consumer spending. If they’re right, a firmer economy will enable these mega-caps to generate decent (albeit unspectacular) growth in sales and profits in coming years.

But what if the economists are wrong and the U.S. economy starts to sputter? (Bespoke Investment Research notes that two straight quarters of sub-2% GDP growth yields a 70% chance of a recession in the next 12 months as the economy hits “stall speed”). Well, mega-caps are the place to be in such a scenario. BMO’s analysts found that the return on equity of mega-caps “never dipped below 15% throughout the entire financial crisis.” That’s a claim the small caps can’t make.

Bulletproof Balance Sheets
One of the hallmarks of the recent era is the stunning rise in cash balances at almost every major U.S. corporation. By one estimate, mega-caps’ cash balances now account for 16% of their total asset base. That figure is below 10% for the bottom 400 companies in the S&P 500. Equally important, the global rivals to these mega-caps have not had the luxury of building up such robust cash balances. And greater financial strength should allow domestic mega-caps to go on the offensive and pursue global market share as the global economy mends.

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