Recently 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 to 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 1st. 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.