Sometimes Bigger Is Better
The adage “everything shrinks with age” does not seem to apply to the stock market.
At the end of January 1990, a stock-market value of $90 million earned a Quadrix® score of 50 for market capitalization, while a market value of $3.09 billion earned a score of 95. In other words, one half of U.S.-traded companies had market values of less than $90 million, and only 5% had market values of more than $3.09 billion. Since then, the market values that correspond to both Quadrix scores have more than quadrupled, illustrating two important lessons about the stock market:
First, the stock market’s long-term trend is upward. Equity values tend to rise over time as companies grow. History suggests that if you take a long enough view, stick to a diversified portfolio of quality stocks, and do not panic, your portfolio should increase in value.
Second, large-caps are not what they used to be. In early 1990, only about 200 U.S. stocks had market values exceeding $3 billion. Today there are nearly 700, of which 273 have market capitalizations of more than $10 billion.
In the 166 rolling 12-month periods since October 1994, the 50 largest stocks in all S&P 500 Index averaged a 12-month total return of 9.0%, versus 9.6% for all S&P 500 stocks and even higher returns for smaller stocks. However, the big boys’ median return of 7.9% exceeded the 6.8% median of all S&P 500 stocks, the 6.5% median of S&P MidCap 400 stocks, and the 4.8% median of S&P SmallCap 600 stocks.
By definition, the median divides a set into two equal-numbered groups. A relatively small number of unusually high or low returns can affect an average. But such outliers have less effect on medians, and our study suggests the largest stocks were more likely to generate solid returns than smaller stocks, though they were less likely to generate extremely high — or extremely low — returns.
Large-cap stocks tend to have better fundamentals, as measured by the Quadrix Overall score. The 50 biggest stocks in the S&P 500 have averaged Overall scores of 64 since 1990, versus long-term averages of 57 to 59 for stocks in the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes.
Today, about 40% of the 50 largest stocks in the S&P 500 earn Quadrix Overall scores of more than 80, versus 26% for the broader S&P 500. Bigger stocks also generally earn higher scores in Quality (long-term growth rates, earnings consistency, and returns on equity, assets and investment) and Financial Strength (debt levels, interest coverage, and profit margins). Such fundamental superiority often warrants a premium valuation, and the largest stocks tend to have lower Value scores than smaller stocks.
Of Dow Theory Forecasts’ 36 recommended stocks, 24 have market caps greater than $10 billion, as shown in the table below. We review three of these stocks below.
CVS Caremark ($34; CVS) is big and getting bigger, managing sales growth of at least 15% in each of the last five years. CVS generated revenue of $87.47 billion last year, behind only Wal-Mart Stores ($51; WMT) among U.S. consumer companies. CVS operated 6,999 stores at the end of June, 10% more than year-earlier levels, while retail selling space jumped 18% to 67 million square feet.
Despite its aggressive expansion in recent years, CVS hasn’t abandoned its base of established stores. On the strength of the pharmacy department, same-store sales have climbed more than 3% in each of the past six quarters, including 6.1% growth in the June quarter.
The balance sheet has held up well for a company so active on the acquisition front. CVS has purchased three companies since July 2008, yet cash holdings have nearly doubled to $1.23 billion in the past year, while long-term debt has declined 12% to $7.31 billion.
CVS continues to post strong results in pharmacy-benefit management. Revenue from pharmacy services (47% of sales) increased 15% in the first half of 2009. Also rising are Wall Street estimates, with the consensus projecting per-share-profit growth of 19% this year and 14% in 2010. CVS Caremark is a Focus List Buy and a Long-Term Buy.
Like many companies, IBM ($118; IBM) has countered lower sales during the recession by slashing expenses to drive profit growth. Unlike many companies, IBM averaged quarterly gains of 15% in per-share earnings over the past year.
Continuing its push into the higher-margin software business, IBM announced two acquisitions in July. For $1.2 billion in cash, IBM agreed to buy SPSS ($50; SPSS), which makes behavior-predicting software used to identify credit risk and improve customer retention. Research firm IDC estimates the market for this software, called business analytics, will grow 4% in 2009 to $25 billion as companies seek new ways to control costs. IBM also purchased Ounce Labs, a privately held company that provides compliance and security software.
IBM’s market capitalization of $154.2 billion ranks sixth-highest among stocks in the S&P 500 Index. Among tech stocks, only Microsoft ($24; MSFT) is bigger. As of Aug. 18, IBM shares had gained 40% for the year, roughly quadruple the return of the S&P 500 Index. Yet IBM trades at less than 13 times trailing earnings, 19% below the five-year average. With Quadrix scores above 90 for Quality and Overall, IBM is a Focus List Buy and a Long-Term Buy.
With a stock-market value of nearly $165 billion, Johnson & Johnson ($60; JNJ) is half-again the size of its largest U.S. rival. The pharmaceutical business alone is bigger than 82% of companies in the S&P 500, based on sales in the most recent fiscal year.
New growth will likely sprout from the drug segment. The pipeline could produce seven new drugs this year. J&J hopes these promising products will offset pressure from older drugs that have lost patent protection and renewed competition for the Cypher drug-coated stent.
The consensus projects per-share profits will slip 1% to $4.52 in 2009, but J&J has topped expectations in each of the last eight quarters. Up less than 1% this year, the stock lags the S&P 500 Index’s 9.6% gain. But J&J appears to have room to run. Shares trade at 13 times trailing earnings, well off the five-year average of 17. The company holds cash of $14.72 billion, or $5.29 per share — more than double the $6.54 billion in long-term debt. J&J is a Focus List Buy and a Long-Term Buy.