SB: Monday Morning Musings:  Mega-Cap ... Mega Pain!

05:48pm EDT 28-Apr-02 Salomon Smith Barney (Tobias M. Levkovich)

SALOMON SMITH BARNEY                                             Industry Note

 

Institutional Equity Strategy

Monday Morning Musings:  Mega-Cap ... Mega Pain!

 

April 28, 2002            SUMMARY

                          * Mega-cap carnage could be behind us

Tobias M. Levkovich       * Earnings are not as bad as some might think

                          * Sentiment remains awful and the market looks

                            oversold

                          * We are buyers in here

 

OPINION

 

 (*) An immediate family member of Tobias Levkovich holds a long positionin the

securities of Intel.

 

(*)An immediate family member of Tobias Levkovich holds a long positionin the

securities of Microsoft.

 

(*) Tobias Levkovich holds a long position in the securities of Viacom.

 

Investors have suffered incredible angst in the past few weeks as the markets

have chewed up all the gains from mid-February and "round-tripped" with some of

the biggest capitalization stocks getting stung quite hard.  In fact, in many

respects, it seems as if investors have been feeling particularly wounded this

earnings season by the impact of the widely-owned names being taken out and

shot.  As might be determined by looking at Figure 1, the forward

price/earnings ratio for the "mega-cap" stocks (defined as those stocks with

multiples above $100 billion) has come down sharply from its 1999 highs with

the premium multiple (relative to the market) peaking at about 50% to a slight

discount recently.  Thus, we can conclude that much of the gain from 1997

through to the 2000 peak, and, unfortunately, much of the pain since then seems

to have played itself out.  Moreover, the reason that we are so willing to

believe that the most of the pain is behind us relates to Figure 2 where we can

demonstrate that the mega-caps' market weight within the S&P 500 is now back in

line with their earnings contribution to the S&P 500.  Hence, unless the rest

of the market can grow much faster organically, the valuation does not need to

come down any further.

 

Note that Wall Street often has told investors to run to the bigger cap

stronger names in times of trouble since these "horsemen" are viewed as being

the ones that can and should be able to gain market share when they are left

standing and smaller and often less cash-rich competitors wilt under economic

pressure.  While this might be good advice from a company perspective, it may

not be as good from a stock perspective, and, indeed, it has proven to be the

wrong way to go as smaller cap and mid-cap names have outperformed.  But, we

are less certain that one should continue to jump on that momentum.  On the

other hand, the mega-caps might not lead either.  As we have noted before,

fundamentals are more important than style, and we continue to think

Industrials, Financials, Consumer Discretionary, select Materials and Utilities

should be able to lead the way out of this economic trough.  Indeed, names like

Caterpillar, Deere and Cummins actually climbed in Friday's market.

 

Figure 1

 

Source: SSB

 

Figure 2

 

Source: SSB

 

The General and the Infantryman

 

In a certain way, the equity market's confusing trend this earnings season may

be best described by attempting to sense how a foot soldier must feel like in

the heat of battle.  With bullets whizzing past and artillery shells landing

nearby, it is extraordinarily difficult for him to see above the haze of smoke

caused by the maelstrom of war.  The infantryman huddles in his foxhole unsure

if he will make it through the day, cursing those who could not settle the

dispute peacefully and longing for the time when he can see his loved ones

again.  On the other hand, the General, looking at the overall course of the

battle from the vantage point of a few miles back at HQ, often can better

understand the progress being made.  When the ricochets occur and the cries of

the wounded carry over the battlefield, many think that they are about to die

and cannot even conceive of the fact that the tides might be turning in their

favor.

 

When considering the tidal wave of earnings releases over the past two weeks

and the necessary quick judgments that must be made by analysts and portfolio

managers, one can imagine the pressure felt by that weary and somewhat

frightened foot soldier.  On the other hand, gaining perspective is critical to

determine if advancement is being made or wholesale retreat is appropriate.

 

In our view, the news flow, while erratic, is still trending better.  More than

235 companies within the S&P 500 thus far have beaten 1Q02 EPS expectations vs.

the 55 constituents that have missed; a sharp improvement on the trends

experienced over the last couple of quarters.  The fact that earnings are

likely to end the quarter down year over year was very much expected, despite

the sequential gains in GDP, with our sense that 2Q02 was going to be the

turning point for earnings anyway as industrial production begins to get even

year over year and allows for some favorable overhead cost absorption plus

companies reap the benefits of cost reduction efforts put in place in the past

year.

 

The problem to some extent is that many of the very large mega-cap (market

capitalization above $100 billion) companies including Microsoft and IBM missed

Street numbers, while Wal-Mart, General Electric and Intel could not motivate

investors either by simply making numbers.  Plus, Pfizer's downward guidance

was far from inspirational.  Mind you that others like 3M, Lockheed Martin and

Viacom did beat numbers so we would not be all that discouraging either.

 

Nonetheless, one can clearly see the impact of the dips of former larger cap

stock highfliers and the strength of the lesser-known and lesser-owned smaller

capitalization names by assessing the Russell 2000 vs. the S&P 100 (see Figure

3)  The only issue that must be understood now is that the S&P 500 is trading

at a lower multiple than the Russell 2000 currently.  Thus, it is less clear to

us that the style approach to investing will win out.

 

As we look to the markets now, the S&P 500 multiple has backed off to around

21x consensus 2002 EPS estimates, bond yields have backed off, the Fed is no

longer itching to raise rates, inflation seems muted, small businessmen are

still upbeat, earnings estimates are being beaten, the technicians are cautious

and sentiment stinks -- sounds like juts the kind of market that should be

bought, not sold.  It is time to think like a General!

 

Figure 3

 

Source: Factset

 

Companies Mentioned:

 

(*) An immediate family member of Tobias Levkovich holds a long positionin the

securities of Intel.

 

(*)An immediate family member of Tobias Levkovich holds a long positionin the

securities of Microsoft.

 

(*) Tobias Levkovich holds a long position in the securities of Viacom.

 

Caterpillar, Inc.# (CAT-$54.15; 3H)

 

Cummins, Inc. (CUM-$43.46; 1H)

 

Deere & Company# (DE-$44.17; 1H)

 

General Electric (GE-$31.50; 1L)

 

Intel Corporation (*) (INTC-$28.12; 1M)

 

International Business Machines# (IBM-$84.71; 1M)

 

Lockheed Martin Corporation# (LMT-$61.52; 1M)

 

Microsoft Corporation (*)(MSFT-$51.50; 3H)

 

Minnesota Mining & Mfg. (MMM-$124.40; 2H)

 

Pfizer# (PFE-$36.76; 1L)

 

Viacom Inc. (*)(VIAB-$48.20; 1M)

 

Wal-Mart Stores, Inc.# (WMT-$55.80; 1L)