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)
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