Sometimes Bigger Is Better
Those who like to invest in the largest stocks believe size equates to stability and safety, while opponents believe smaller companies offer superior growth potential.
There’s truth on both sides of the argument, but here are some facts about the largest stocks that every investor should know:
• The average trailing price/earnings ratio of the 50 largest stocks in the S&P 500 Index is 16, 11% below the average for all stocks in the index. Since 1990, the largest stocks have averaged an 8% premium.
• The 50 largest S&P 500 stocks averaged a 12-month return of 19.0% in rolling periods since 1990, versus 12.8% for the average S&P 500 stock. Based on median returns, which tend to be less affected by outliers (unusually high or low returns), the top stocks averaged 14.2% returns, five percentage points higher than the index average. Mega-caps also delivered superior risk-adjusted returns.
• On average, the 50 largest stocks earn Quadrix® Overall scores of 73 and Value scores of 69, versus Overall scores of 64 and Value scores of 62 for the average stock in the S&P 500. While the big stocks have historically earned higher Overall scores, they typically have had lower Value scores.
Right now, the biggest of the big are looking pretty good, with solid fundamentals and attractive valuations. The table below lists the 50 largest S&P 500 components, of which we recommend 11 for purchase. Three intriguing options are reviewed below.
Abbott Laboratories’ ($47; ABT) largest drug, Humira, generates about one-third of the company’s revenue as a treatment for rheumatoid arthritis, Crohn’s disease, and psoriasis. But Abbott continues to broaden a product portfolio that stretches from pharmaceuticals and nutritional supplements to medical devices and diagnostic equipment. Abbott is now pushing into branded generic drugs, which are especially popular in emerging markets, where counterfeit and low-quality medications are more common. With patients willing to pay a premium for a trusted name, branded generics offer better profit margins than traditional generics.
Abbott has grown per-share earnings at an annualized rate of 10% over the last five years, more than double the average rate of 4% for the 11 pharmaceutical companies in the S&P 500 Index. The consensus projects that Abbott will continue to outpace most of the index’s drugmakers over the next five years, delivering annualized profit growth of nearly 10%. For 2010, Wall Street expects Abbott to boost per-share profits 12% on 15% higher revenue. Given the favorable growth outlook, the shares seem unduly cheap at 11 times estimated year-ahead earnings, 31% below the five-year average forward P/E ratio. Earning a Quadrix Value score of 77, Abbott is a Buy and a Long-Term Buy.
Despite its size, Hewlett-Packard ($43; HPQ) is delivering solid growth. H-P’s per-share profits rose at an annualized rate of 17% over the last three years, supported by solid 7% sales growth. The company’s operating momentum should continue, with per-share profits expected to rise 14% in the second half of fiscal 2010 ending October and 11% in fiscal 2011. H-P is bolstering its sales force to support a push into China, India, Brazil, and other emerging markets.
Deriving about 65% of sales from computer hardware, H-P is leveraged to personal-computer demand trends, which are now strongly positive. H-P already sells a wireless printer capable of downloading and printing documents sent from smart phones and other portable computing devices, and in June the company said it would add Internet capability to all of its printers.
Acquisitions have helped H-P grow beyond its established businesses. The company spent nearly $18 billion on three major acquisitions in the last two years, expanding its presence in outsourcing, corporate data centers, and portable consumer devices.
H-P earns an 89 in Value and 89 Overall. At 10 times trailing earnings, the shares trade 36% below the five-year average P/E ratio. By comparison, the median trailing P/E of computer-hardware stocks in the S&P 1500 Index is more than 18. H-P’s stock also trades at a discount to historical norms for price/sales and price/book ratios. H-P is a Buy and Long-Term Buy.
Among U.S. stocks, Wal-Mart Stores ($49; WMT) ranks sixth in market capitalization but first in sales. It reported revenue of $408 billion in the year ended January, more than the gross domestic products of Belgium, Columbia, or Malaysia.
Scale has its advantages. Wal-Mart is pushing to control the delivery of products to its distribution centers and stores by using its own fleet of trucks and hiring independent contractors. Wal-Mart anticipates the strategy will make the supply chain more efficient and ultimately lower its cost of goods sold.
But scale can also make growth tougher to find. Wall Street projects 10% higher per-share earnings in fiscal 2011, powered largely by opportunities overseas. In the U.S., Wal-Mart’s sales rose just 1% in fiscal 2010, and same-store sales have declined in four consecutive quarters. Among the few remaining domestic expansion opportunities are in urban centers. Chicago approved a site for the city’s second Wal-Mart store, potentially paving the way for 19 more stores.
The retailer generated $7.23 billion of free cash flow in the 12 months ended April and has historically shared a lot of its cash with stockholders. A dividend increase in March marked the 37th consecutive annual hike, and stock buybacks have reduced the share count by more than 8% over the last three years. Wal-Mart is a Long-Term Buy.