Grab a tape recorder and repeat after me: “The cheapest stocks in the U.S. markets are large cap multinationals.” Now rewind, play the clip, and repeat. Over the past 6 months, this statement has been repeated throughout countless newspapers, interviews with well known/respected investors (Bill Miller and Jeremy Grantham here), blogs, and television broadcasts (ie CNBC). These same companies are the ones that are now popping up on 2011 recommendation lists all over SeekingAlpha. While the idea has started to sink in (with most names moving up 10-20% over the past 6 months), it still looks like there is resistance among investors (fear of quality?). Today, you can buy Wal-Mart (NYSE:WMT) at 13.5x trailing earnings, IBM at 13.3x trailing earnings, Johnson & Johnson (NYSE:JNJ) at 13x trailing earnings, and Microsoft (NASDAQ:MSFT) at 12x trailing earnings. Why the inefficiency in the market? And what will lead to the realization of value for investors?
In my opinion, there are two factors that stand out as potential catalysts for driving returns in large cap multinationals. The first is pension fund activity; from a peak in the mid 2000’s, pension funds cut their exposure to equities from nearly 70% of their money to roughly 45% of their funds as of July 2010. Corporate pension funds manage more than $2 trillion, meaning that $500 billion vanished once fund managers decided to turn away from stocks (only viable strategy for parking an investment with that amount under management is usually large caps).
In addition, state and local government pension funds (which hold more than $2.8 trillion in assets) cut exposure to equities, although not to the extent of corporate funds. The issue now is that plans are underfunded, and low interest rates are squeezing bond returns, which have cannibalized a significant portion of investment funds formerly held in stocks. Looking forward, pension funds will never meet expectations of 6-8% per annum by investing in treasuries and safe corporate debt (for example, KO and JNJ have issued ten year bonds paying 3.15% and 2.95% coupons, respectively); at some point, they will have little choice but to return to names like Wal-Mart and IBM.
The other catalyst is a change in investor sentiment towards well known large caps; a ten year dry spell has left some investors convinced that the names above are dead money. Take your pick between the names mentioned above and the results aren’t pretty. The best you could have done was IBM, which has returned 56% to investors who bought shares ten long years ago (not including dividends); the results for the rest are even more deflating. Mix this with the recent economic troubles, and individual investors have changed their perceptions in the recent run to safety.
KO, WMT, and IBM were replaced by treasuries and the bond offering of KO, WMT, and IBM, which pay less than the respective companies’ dividends. The reasoning was such: Why would you buy companies that didn’t make investors any money over the past ten years when you can have the safety of a bond? That’s a great question for the people who loaded up on names like KO, JNJ, and WMT at 30-50x earnings at the turn of the century. The idea of paying 50x earnings for a company with a market cap in excess of $100 billion is a recipe for disaster, and investors paid for their disregard for valuation. Unfortunately for most of these investors, they will probably wait for confirmation before pulling the gun, and end up playing the same role this time around.
In 2010, investors are left with an opportunity in large caps that was delivered by irrational (and temporary) changes in asset allocation. When will these names receive the valuations they deserve? Who knows? It could take 6 months or it could take 6 years. More importantly, who cares? As you sit around waiting, the business you are a proud owner of will (based on years of continued success, even through the recession) keep growing, expanding EPS, and paying a dividend yield that trumps treasury and debt yields. For individual investors, now is the time to stop listening and start doing. Take advantage of the long term opportunity to load up on the Johnson & Johnson’s, PepsiCo’s (PEP), Microsoft’s, and Wal-Mart’s of the world.