As investors we have learned the hard way that it is not sufficient to identify an attractive investment opportunity. It is also crucial to get the timing right. Some naive investors will say that timing doesn't matter, but that is incorrect. Having to wait too long for a payoff forces investors into any number of psychological knots.
Now Ian MacDonald and Gregory Zuckerman in the Wall Street Journal reiterate a story that has been written for quite some time now: megacaps are now attractive and should outperform small caps. We have hear this story before – many times, fact. Their reasoning is indeed correct, and there is evidence that relative performance may have shifted towards the megacaps. Their evidence is solid:
Big stocks are attractive on various valuation metrics. The S&P 100 trades at 14.8 times its components' estimated per-share earnings for the next year, and has a dividend yield of more than 2%, according to Harris Bank. By comparison, after hitting an all-time high Friday, the Russell 2000 trades at more than 24 times expected earnings for the next year and sports a dividend yield of just under 1%. Historically, megacaps have traded at richer price/earnings multiples than smaller stocks, Mr. Ablin notes.
The challenge is that the relative valuation case could have been made for quite some time. One can see this in the market valuation graphs available at Morningstar.com. Megacaps have been attractive for at least a year. That has not deterred Morningstar's chief equity analyst:
"Given valuations and yields, I think the case for large caps is as strong as it's ever been," says Patrick Dorsey, head of stock analysis at Chicago researcher Morningstar Inc. "At this point, it's not unlike the case for small caps and REITs back in 1999 because they were just too cheap."
There is unfortunately no sure cure for the problem of mis-timing an investment. Trends can trend longer and farther then any one expects. This could be due in part to the changing investment management industry. DealBook looks at the changes that have been wrought by hedge funds going mainstream. Some have speculated that hedge funds have been keeping small caps aloft in an attempt to generate some alpha from the under-researched part of th market.
More sophisticated investors often use a variety of systems or models when looking at a stock in large part to avoid this problem of "dead money." That is stocks that do nothing to add value to the portfolio for long periods of time. Diversification can make sense for a portfolio as well as the models used in the actual portfolio construction.