Large-Cap Growth: Can It Regain the Market Leadership?

    by Steve Norwitz

    In the bull market of the late 1990s, large-company growth stocks, and technology stocks in particular, enjoyed one of their most extended and significant periods of superior performance.

    Since that bubble burst in 2000, however, large-cap growth stocks have been perennial market laggards, trailing small-cap and value-oriented stocks in each of the past five years through 2004.

    During that five-year period, for example, the Russell 1000 Growth index of large growth companies had an annualized return of –9.3% despite the market rebound over the past two years. This compares with an annualized return of 6.6% for the Russell 2000 index of small-company stocks and about 5.3% for the Russell 1000 Value index of large-cap value stocks.

    Year-to-date through mid-June 2005, the Russell indexes showed large-cap growth stocks outperforming small-cap stocks (–0.17% vs. –0.65%), but lagging large-cap value stocks (up 3.1%). [AAII stock screen strategies have shown somewhat different results for 2005. See the AAII Stock Screens article in this issue, “Mid-Cap and Growth Pull Ahead in Mid-Year Review.”]

    No one knows when or if these performance trends may reverse, or if a reversal will be sustained. In addition, there are concerns that some blue-chip champions may no longer offer the superior growth prospects that they have in the past. Here are some reasons for optimism, as well as causes for concern.

    Growth Gets Cheaper

    While small-cap stocks have outperformed in recent years, larger companies have generally had better earnings growth, so their relative valuations appear attractive.

    Figure 1.
    Relative Valuation
    of Large-Cap Growth
    vs. Small Cap

    At the end of March, large-cap stocks on average sold at a modest valuation discount to small-cap stocks, with the price-earnings ratio of the Russell 1000 Growth index at roughly 84% of the price-earnings ratio of the Russell 2000 index. Since 1978, the long-term average relative price-earnings ratio of large caps to small caps is 110%. In contrast, at the end of 1999 during the market bubble when large-cap valuations were at an extreme, large-cap price-earnings ratios were almost two-and-a-half times (250%) those of small caps (see Figure 1.)

    Historically, small caps sell at a modest discount to large-cap stocks due to the greater risk, lower liquidity, and higher volatility. Now, their price-earnings ratios are slightly higher, so it’s hard to make a case that small-cap stocks are cheap relative to larger companies. This indicates that small caps could have a harder time outperforming again this year.

    Figure 2.
    Relative Valuation
    of Large-Cap Growth
    vs. Large-Cap Value

    Large-cap growth stocks are also relatively attractive compared with large-cap value stocks, which tend to include more economically sensitive companies. As indicated in Figure 2, the Russell 1000 Growth index has moved below its historical average price-earnings premium relative to the Russell 1000 Value index.

    In addition, the Leuthold Group, a market research firm, observes that large-cap growth stocks, with a price-earnings ratio of 20.0 in March, are 7% below their historical average price-earnings ratio, while large-cap value stocks (at 11.8 times earnings in March) are 18% above their historical average price-earnings ratio. On a price-to-book basis, large-cap growth stocks recently sold at 2.0 times that of value stocks—the lowest level since the Russell indexes were created in 1978. This compares with a historical average of 2.5 times.

    While stock market valuations have risen, the stocks of many consistent growth companies have moved up only moderately and still remain reasonably valued.

    Table 1 offers some specific examples of high-quality growth companies that have achieved superior earnings growth compared with the stock market on average, but trade at a discount to the market or at a relatively low premium.

    TABLE 1. Attractive Values From Strong Earnings/Weak Performance Growth Stocks
    (Data as of March 31, 2005)
    Company (Ticker) 5-Year
    P/E to
    S&P 500
    American International Group (AIG) -5.0 14 10.67 0.64 1.02
    Citigroup Inc. (C) 2 16 10.62 0.64 0.7
    Dell Inc. (DELL) -6.6 13 24.06 1.44 1.65
    General Electric Co. (GE) -5.3 5 19.91 1.2 1.22
    Home Depot Inc. (HD) -9.4 17 14.97 0.9 1.54
    Medtronic Inc. (MDT) 0.3 17 27.3 1.64 1.67
    Microsoft Corp. (MSFT) -12.7 7 18.81 1.13 1.72
    State Street Corp. (STT) -1.0 11 16.14 0.97 1.03
    Wal-Mart Stores (WMT) -1.7 13 18.36 1.1 1.37
    S&P 500 Index -3.3 4 16.66 1 1

    Although large-cap growth stocks have been disappointing, that has not necessarily been true of the companies themselves. In many cases, the performance of the company has been very good but the performance of the stock has not, resulting in a compression in price-earnings multiples.

    While the market may have afforded these high-quality growth stocks too high a price relative to their fundamentals leading up to the stock market bubble in 1999, current prices value these companies as if they are now only average companies.

    Put another way, the market currently has very conservative views of how fast growth stocks will grow vs. value stocks—it is only expecting growth stocks to grow 50% faster than value stocks now, whereas typically it expects them to grow about 70% faster.

    The Economic Cycle

    Another factor in growth’s favor is that, as the economic expansion matures and the rate of growth slows, history suggests that larger, more diversified companies tend to outperform stocks of smaller companies, which tend to be more economically sensitive.

    Small caps typically outperform in the early stages of economic and market recoveries, and that was especially true this time around. However, small caps are in the later stages of outperformance versus large caps.

    One of the reasons larger companies have tended to do better in the latter stages of an economic recovery is because they are more diverse. When profits begin to decelerate, investors become more concerned about the next downturn, about balance sheet leverage, and about the durability of a company’s competitive position. So, not surprisingly, when earnings begin to slow, higher-quality companies perform better than lower-quality companies.

    It’s also noteworthy that the earnings growth of larger companies has been buoyed to some extent by the steep decline in the value of the dollar relative to other currencies in recent years, which benefits earnings of export and multinational companies.

    The dollar has strengthened this year, and currency swings are impossible to predict. But given the U.S. budget and trade deficits, the currency is expected to remain relatively weak, so it may continue to help bolster earnings for some larger companies.

    Growth’s Changing Faces

    While an appealing case can be made in general for growth investing, managers agree that investors have to be more careful than usual in identifying companies that offer superior growth potential.

    There are increased concerns that some traditional growth sectors, such as pharmaceuticals and technology, as well as some companies that have been considered leading growth companies in the past, may face slower growth prospects in the future.

    Many of the areas that are well-represented within growth are facing some significant, long-term fundamental challenges. For example, various growth companies, such as those operating in areas like food and beverage, household products, and pharmaceuticals, don’t have the sort of growth prospects now that they once did.

    Technology is another sector that will not grow the way it has. It already accounts for 50% of total capital expenditures, compared with 10% in the past, so it is basically finished taking its share of such expenditures.

    In short, a lot of the companies today operate in ex-growth industries. The companies are huge, and these industries have already consolidated.

    Investors will have to be more selective and look for companies that haven’t already consolidated their industry and don’t have massive share of their market and very high (profit) margins already.

    That might include sectors like biotechnology, HMOs, or Internet-oriented companies—stocks like eBay, Yahoo!, Gilead Sciences, and UnitedHealth Group.

    Health Care and Technology

    Some sectors are also facing more challenging environments. The pharmaceutical sector, for instance, is one that is more challenging due to several issues—including patent expirations, generic drug challenges, the regulatory framework, and pricing pressure in the public and private sectors.

    Litigation is also much more of a threat. For example, Wyeth was hit with a $20 billion liability settlement on the phen fen diet drug litigation, and now Merck is embroiled in problems with Vioxx, its multibillion dollar arthritis and pain drug, and those safety issues could extend to Pfizer with their similar drugs, Celebrex and Bextra. While there have always been issues with litigation, they are now much more costly. Technology, another major growth sector, faces challenges of its own.

    Technology was the leadership industry of the 1990s, but it’s highly unlikely that it will be the leadership industry again, though certain companies will be leaders.

    Within technology, the pace of change is as rapid and dynamic as it has ever been. But the structure of the industry and barriers to entry have collapsed for a lot of the traditional players.

    In telecom, wireless is growing better than fixed line everywhere in the world. In software, dynamic change is just beginning with the whole open source movement, where engineers around the world are sharing their code to develop software. How can even a Microsoft, spending billions of dollars on software, compete with that?

    In media, new media (the Internet) is growing faster than old media (newspapers, broadcasters). Media is not a glacial-change industry anymore; it’s a dynamic-change industry, and the Internet is stealing growth from traditional media.

    For the first time, technology is not traditional media’s friend. For many years new technology expanded the consumption of media—for instance, we went from three broadcasters to cable to DVDs. Now, digital media migration to the Internet or satellite radio is threatening traditional media, particularly broadcasters. The pace of change is picking up in media and might change who the new winners are.

    What’s Next?

    What new sectors could turn into growth? For example, the materials sector, usually considered economically sensitive and comprising cyclical industries, may be the new growth industry. It can be viewed as a growth sector because of a dramatic change in demand from China and India that seems durable. Some of these are long-term supply-constrained industries, such as oil, energy, minerals, etc. Now you have a new demand structure that is growing and will become a secular trend.

    Growth always comes in new areas, and rarely are the leading growth companies consistent over long time periods. Table 2 shows how the face of growth has changed over the last 15 years. Time will tell what new faces will show up over the coming years.

    Table 2. Leading Growth Companies Change Over Time
    Companies With Best Five-Year Earnings Growth Rates in Russell 1000 Growth Index*
    For Five-Year Periods Ending:
    12/31/1990 12/31/1995 12/31/00** 12/31/2004
    Atlantic Richfield Campbell Soup Oracle eBay
    Wal-Mart Stores ConocoPhillips Colgate-Palmolive Yahoo!
    Merck Microsoft Microsoft Forest Laboratories
    Tenneco Automotive Intel Boeing Mattel
    Altria Group American Express Sun Microsystems QUALCOMM
    Tyco International Ltd. Motorola Cisco Systems McKesson
    PepsiCo Hewlett-Packard Boston Scientific Deere and Co.
    Coca-Cola Eastman Kodak Applied Materials UnitedHealth Group
    Abbott Laboratories Limited Brands Alltel Fox Entertainment Gp
    Procter & Gamble Gillette GAP Progressive Corp.

    Steve Norwitz is a vice president at T. Rowe Price and editor of the T. Rowe Price Report, published by T. Rowe Price Investment Services, an investment advisory firm that manages the T. Rowe Price family of mutual funds (

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