Look for large-cap stocks to rebound

BOSTON — As markets continue to founder, conventional wisdom suggests the place to be once a turnaround takes hold is in stocks of small companies.

History shows that typically volatile small-cap stocks are "first in, first out" — they run into trouble first when markets begin faltering, then outperform large companies when things get back on track.

But many mutual-fund managers warn against taking that as gospel truth this time around.

If the market does eventually gain traction for a sustained comeback, large-cap stocks are more likely to offer a decent return for years to come, the contrarians say. They cite an apparent shift from a nearly decade-long cycle in which investors held small-caps — generally defined as companies with a market value of $300 million to $2 billion — in greater favor than large-caps. The large company Standard & Poor's 500 index has lost an average 2.6 percent per year over the past 10 years, compared with an average annual gain of 3.9 percent for the S&P Small Cap 600 index.

"Small-caps seems to have had their relative day in the sun during the first half of this decade, and valuation currently favors large-caps," said Robert Sharps, who manages growth stock portfolios for T. Rowe Price's institutional clients, including the company's Institutional Large Cap Growth Fund (TRLGX).

One of T. Rowe Price's other large-cap managers, Larry Puglia of the $7 billion Blue Chip Growth Fund (TRBCX), says large companies are in better shape even if a sustained turnaround doesn't happen anytime soon and credit markets remain tight. Puglia cites large company attributes he thinks will be strengths: product and geographic diversity, and greater financial resources that leave large companies less reliant on financing when credit is hard to come by.

"It's fair to say small companies are more dependent on the banking system," Puglia said.

It may be unsurprising that large-cap fund managers are more bullish on large-caps than small-caps these days. But some who manage money across both categories are giving larger companies an edge.

Uri Landesman, head of global growth at ING Investment Management, noted that small-cap stocks haven't performed worse than large-caps so far in this bear market, contrary to what normally happens in a downturn. The S&P 500 was down about 49 percent from its Oct. 9, 2007 peak through Wednesday's close. During that span, the small company Russell 2000 index is also down 49 percent. And so far this year, there's also little difference in the performance of the indicies, both down around 13 to 15 percent.

So Landesman reasons large-caps have more room to rebound, particularly in tight credit markets that can hurt smaller companies more dependent on borrowed cash.

Large corporations "are going to have access to what little liquidity exists in the system," said Landesman, who declined to say whether ING Investment Management is shifting into large-company stocks.

If shares in large companies outperform when markets rebound, it would be out of synch with history. Small-caps have outperformed large-caps coming out of 12 of the 15 bear markets since 1932, according to The Leuthold Group, an institutional research firm based in Minneapolis. The research examined the performance of both categories in the 12-month periods after bear market lows were reached. Small-caps on average gained nearly 71 percent in those periods, compared with nearly 44 percent for large-caps.

But Sharps, of T. Rowe Price, says longer-term trends argue in favor of large companies this time around. He cites data showing small-caps outperformed large-caps from about 1998 to 2007, when the tide begin shifting in favor of large-caps before the market plunged.

In recent decades, one category or the other has generally held favor with investors for periods of six to nine years, in cycles. Sharps thinks once markets rebound this time, large-caps' resurgence will continue a few more years, in keeping with the duration of past cycles in which one category outperforms the other.

"Once it does set in, it's likely to run over a relatively long period of time," he said.

Of course, plenty of managers out there believe otherwise. Rob Arnott, who manages the Pimco All Asset Fund (PASAX), said the this bear market has deflated stock prices so much that many formerly large-cap companies no longer hold that label as their market values have plunged. While he doesn't see stocks as a good bet anytime soon compared with bonds, Arnott thinks small-caps are in better position than large-caps.

The sharp decline in the market values of many large companies has saddled the small-cap index with a lot of really hard-hit, distressed companies, said Arnott, who believes a market turnaround is at least six to 12 months away.

"Those are precisely the companies that are likely to do well when the market turns," said Arnott. And smaller companies that have been struggling all along through the recession "are likely to rebound handily when the market does turn."

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