Seeking Shelter From The Storm? Consider Mega Caps

Includes: IOO, OEF
by: Russ Koesterich, CFA

Last week I discussed how, with the possibility of the fiscal cliff looming, I believed mega cap equities, municipal bonds and international stocks are good places to be. I’d like to elaborate on mega caps, which, in addition to potentially providing some insulation to the impact of the fiscal cliff, are attractively valued as well.

First, some context. Immediately following the results on Tuesday, the market wasted no time in selling off. Stocks lost more than 2% on Wednesday and pushed the major indices down to their lowest level since August. Clearly, the risk for the market is that divided government raises the likelihood of going over the fiscal cliff. I expect that concern to continue, and stocks to remain under pressure.

What would help things improve? Ideally, the market would like to see a framework for a long-term resolution on tax and entitlement reform to resume its risk on rally. But for the time being, investors would probably settle for a short-term plan that prevented the majority of tax hikes and spending cuts from taking effect on January 1. So for now, the market is likely to remain hostage to the political negotiations in Washington.

Given this environment, one theme we would re-emphasize is mega caps. Year-to-date, this strategy has worked well. During the first 10 months of the year, US mega caps gained 13% versus 11.5% for mid-caps and 10% for small-caps.

Yet, despite the outperformance, this style is still cheaper than either large, mid or small cap. Currently mega caps are trading at 13x trailing earnings versus 14x for large caps, 18x for mid caps and nearly 20x for small caps (see below). In addition, mega cap companies remain the most profitable segment of the market, with a return on earnings of 23.5.

Finally, given the environment, perhaps the most compelling reason to consider an overweight is that mega caps, along with large caps, have historically been more resilient to slowing domestic growth than small and mid cap companies.

Smaller companies derive the overwhelming majority of their sales from the United States. Not surprisingly, investors tend to reward and punish small and mid cap companies more when growth is expected to rise or fall. Historically, expectations for growth are insignificant for valuing mega-cap companies. This is not unreasonable given that many of these firms derive the majority of their sales from outside the United States. The impact of the domestic economy is slightly more significant for large caps, but is still fairly small. However, expected growth explains nearly 20% of the variation in small cap valuations and over 25% of that for mid cap companies.

If the economy continues down the slow growth lane - or worse, the fiscal cliff pushes us back into a recession - mega caps may prove more resilient. Potential solutions for investors would be the iShares S&P 100 Index Fund (NYSEARCA:OEF) or the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).

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