For the past 6 years, I have been dining monthly at the same time and place with some fellow investment professionals. My friends got a real kick out of my thoughts earlier this week, finding it strange how excited I sounded by companies that even my parents know well. Yes, I find Large-Caps to be incredibly cheap. he last time I was this excited was two years ago.
Don't get me wrong, I don't mean to imply that Large-Caps will do better than Small-Caps, it's just that I believe that this is a time when even the laziest of investors can probably make money by investing in the largest companies that require the least due dilligence.
In the summer of 2006, I noticed that Large-Caps, which had been lagging the broad market significantly subsequent to the 2002 bottom, were extremely cheap on a relative basis and not so bad on an absolute basis. This chart isn't exactly accurate, as it is the current S&P 500 (Large-Cap) compared to the current S&P 600 (Small-Cap), but I think it generally illustrates my point:
Again, this isn't exactly representative of reality at the time (since the composition of the indices has changed), but the 2nd panel shows the absolute PE over time - 14X sure seemed cheap two years ago! The 3rd panel illustrates the erosion of the value of Large-Caps relative to Small-Caps over time. Note that the end of the Bear Market saw a slight correction of the trend that began at the end of 2000, but the move from 2003 to 2006 was all in the favor of the little guys. The 4th panel shows how the relative PEs have trended. While the relationship has been relatively steady, the valuation discount ended up maxing out in the middle of 2006 and narrowed a bit subsequently, partially attributable to the weakening of the dollar over that time-frame.
So, now we have a 13PE two years later, with the prices not too different from where they were then. Are we supposed to just buy Large-Cap? While that certainly might work, I have an even better idea: The Rydex Russell Top 50 ETF (NYSEARCA:XLG):
This ETF, with a very low expense ratio of 0.2%, allows the investor to purchase a market-cap weighted basket of the top 50 stocks in the Russell 1000. It typically trades 70k shares per day. A visit to the Rydex website will give you all the details you need. Note that the dividend yield is 2.5%. I calculate a forward PE of just 12X. The P/B is 3X, while the P/S is about 1.5X. In the chart above, you can see the round-trip over the past two years. The bottom panel illustrates that the largest stocks have lagged the S&P 500.
In summary, then, the largest of the Large-Caps, the Mega-Caps, appear to be extremely undervalued. XLG is an efficent, low-cost vehicle to quickly grab exposure to the top end of the market. My guess is that the return over the next three years will be 30-40% - a little PE expansion and some EPS growth.
Disclosure: No position