Valuing Large-Cap Stocks

By Will Ashworth AAA

Investors seeking to preserve capital in volatile markets might want to consider large-cap stocks, those companies with market capitalizations greater than $10 billion. Doing business globally, they tend to pay dividends, have solid balance sheets and exceptionally large amounts of cash. While perceived to be slow growing, many have the financial might to take advantage of business opportunities that smaller companies just can't. Whether you invest in individual stocks, mutual funds or ETFs, large caps ought to represent a portion of your equity investments.

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Why It Should Be Included In Your Portfolio
Conventional wisdom suggests that dividends account for approximately half a stock's total return. Some believe this number is as high as 90%. Clearly, whatever the percentage, dividends are an important weapon in any company's arsenal for rewarding shareholders. Because large-cap companies tend to possess greater free cash flow, their ability to increase the dividend payment each year is, also, greater. A rising dividend, combined with a multinational business possessing pricing power, which is the ability to raise prices routinely, provides investors with a certain amount of inflation protection that many mid- and small-cap stocks don't have. With operations in various parts of the world, large caps are able to go where the growth is, which is why you find many operating in the emerging markets of Brazil, Russia, India and China. In addition to geographic diversification, large caps provide investors with currency diversification. As the U.S. dollar weakens, companies are able to sell their products more competitively overseas. Smaller businesses are less likely to benefit because a majority of their revenue, often, is domestic in nature. Lastly, and most importantly, many large caps possess solid balance sheets with little debt and large amounts of cash. For many professional advisors, they are the core holdings in any portfolio. (For related reading on free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

Attributes of a Winning Large Cap
Profitability
Whatever the size of company, investors averse to risk should only consider those businesses making money now, and most probably in the future. While reported earnings is the most common way to assess the profitability of a company, there are other tools available to investors such as return on equity and return on capital employed. Whatever investors use, to assess profitability, it's even more important to determine the sustainability of those profits because that is what drives stock prices higher. Some guesswork is required. However, it's not as scary as you might think. Many large-cap stocks have been public companies for a significant number of years, possessing a track record of increasing profits. The goal, here, isn't necessarily to find a business with an unblemished profit record, but one that is consistent enough that you feel comfortable making a long-term investment. In the end, the best large-caps are, generally, those with good business models and significant competitive advantages over their competitors. Warren Buffett, one of the world's greatest investors, believes the purchase of stocks be made as if you were buying the entire company, not just a piece of paper. While the numbers are important, it usually comes down to quality. (We look at the Sage of Omaha's methodology for evaluating value stocks. For more, see Warren Buffett: How He Does It.)

Financial Health
Like any household, a large-cap's financial health is the key to success. It's not enough to be profitable, it should also own more than it owes and be bringing in more cash than it sends out the door. If it isn't doing this, profitability is fleeting. The balance sheet, which details a company's assets, liabilities and shareholder equity, is the first place investors look for an indication of financial health. The capital it employs, to grow its business, comes at a cost. Generally, debt tends to be less expensive than equity because the interest payments are tax deductible. As a result, large caps often have a lower cost of capital, due to easily obtained financing, providing an advantage over smaller companies. While debt can be advantageous to issuing stock, it can also put a business into bankruptcy if its debt gets out of control. Many investors look for a margin of safety, such as total debt less than shareholder equity. In addition to a company's capital structure, investors should concern themselves with free cash flow, the amount of cash generated after covering operational costs and capital expenditures. A good way to judge this is by calculating free cash flow yield. Similar to the earnings yield (inverse of P/E ratio), it measures free cash flow as a percentage of market capitalization. When comparing companies from different industries, it's wise to replace market cap with enterprise value, which takes into account differing capital structures. While there are definite exceptions, the strongest businesses tend to be those with high free cash flow and increasing shareholder equity. (For related reading, see Value Investing Using The Enterprise Multiple.)

Dividend Growth
Mentioned previously, dividends are an important component of a stock's total return. That goes double for large caps. Standard & Poor's has an exclusive club it calls the Dividend Aristocrats, a small group of companies that are part of the S&P 500 and have increased dividends for 25 consecutive years. Most of the businesses on the annual list are large caps. Interestingly, the top 10 companies on the S&P 500, all large caps, have historically accounted for half the total cash on the balance sheets of all 500 companies. Since cash is a vital component when paying dividends, investing in any one of those 10, while not a guarantee, is a good bet for obtaining annual dividends on a long-term basis. Furthermore, evidence suggests that companies that payout a greater portion of their earnings, in the form of dividends, end up generating higher earnings, which in turn generates even greater dividends. When evaluating large caps, it's advisable to seek out those companies whose dividends are large and getting larger. Growth is the key.

Reasonable Price
Every investor's definition of "reasonable" is different. Value investors tend to want to pay significantly less than a stock's intrinsic value. Growth investors will pay more than that in the belief that earnings will grow faster than average, creating a new, much higher intrinsic value. Those in the middle are "GARP" investors because they look for growth at a reasonable price. Whatever your philosophy is, it's also important to consider where large-cap stocks are in the current market cycle. Small caps have tended to outperform their larger brethren in recent years. Eventually, everything reverts to the mean. While it's important to determine what constitutes a reasonable price to pay for a stock, it's equally important to understand whether large caps, as a whole, are cheap, fairly priced or expensive. Once you've answered this question, simply identify those stocks that meet your criteria. (For related reading, see An Introduction To Small Cap Stocks.)

The Bottom Line
Often it's not so much a question of choosing one market cap over another, but, rather, how much to allocate to each. Investing in large-cap stocks is an excellent way to provide a core foundation upon which you build the remainder of your portfolio.

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