The Large-Cap Portfolio: Value Investing and the Hidden Opportunity in Big Company Stocks

By Thomas Villalta

The practical guide to finding value and opportunity in large-cap stocks using investor behavior

Large-Cap is an abbreviation of the term "large market capitalization" and refers to the stock of publicly traded companies with market capitalization values of roughly more than $10 billion, like Walmart, Microsoft, and Ford. Because of their size, the conventional view is that these companies do not present investors with an ability to be opportunistic. The Large-Cap Portfolio + Website argues that, contrary to popular perceptions, significant opportunities exist in these stocks.

Written with a fluency that both the savvy amateur and professional investor will understand, the book fills a void in the market by offering the practitioner a methodology to identify and approach the major assumptions that underlie valuation, with an emphasis on issues that are more relevant to the analysis of large-cap stocks.

• Full of useful information on how to reap the rewards of stocks that most investors avoid
• Presents essential insights into understanding stock valuation
• Includes an actionable chapter devoted to portfolio management

Packed with timely instruction, Large-Cap Portfolio gives readers invaluable insights and examples of how to build portfolios that will out-perform broad market benchmarks.

• Language: English
• Publisher: Wiley
• Release date: Apr 12, 2012
• ISBN: 9781118282755

Book preview

Preface

I first thought about writing this book in 2010, when my friend Brian Bares and I were having lunch at a restaurant in Austin, Texas. Over Kung Pao chicken, I listened as Brian explained to me his reasons for writing a book on small-cap investing, The Small-Cap Advantage. In the end, he explained, it was about telling investors why he does what he does. He noted that he felt he had to write it. This really struck a chord with me and is the main reason why I wrote this book. I feel compelled to explain why it is that I see value in the active management of domestic mid- to large-cap stocks and how I go about identifying opportunities and researching opportunities. To Brian’s point, it would be pretty sad if I couldn’t articulate why I do what I do and how it fits into the broader investing landscape.

In addition, however, after some research, I found that there is really not a lot written about large-cap stocks. If one goes to Amazon.com or Barnes & Noble and searches for a book on large-cap investing or large-company stocks. . . nothing. True, there are a handful of books on blue-chip stocks, but there is really nothing on large-cap stocks as an asset class and investing universe. Moreover, blue chips generally represent a much smaller subset of the large-cap investing universe and are reflective of representativeness biases discussed in Chapter 5 of this book. They represent stocks that are of high quality, and as I’ll note numerous times in this book, there are problems with looking at stocks in this manner. So, in addition to feeling compelled to articulate my rationale and process for investing in this arena, I also felt that an important subset of the investing landscape was inadequately addressed in books and other mediums. In short, there is a need for information on large-cap stocks and large-cap portfolio management.

We all do things for different reasons. Some of us do what we do because we were raised to do it. Some of us do what we do because we’ve been trained to do it. Some of us do things reflexively, without ever questioning why. That’s not really the way I am. I’ve always been predisposed to ask why? I’m not sure everyone digs as deep into the broader question of why values exist in the realm of investing. Most investment managers and research analysts learn their craft by apprenticing for other managers, taking employment at one of any number of different investment outlets: investment management firm, insurance company, mutual fund, Wall Street bank, trust company, or the like. I started in the investment management industry in what I term a consultative capacity. I learned to evaluate other managers’ performance and processes. I examined many facets of traditional investment firms and recommended firms for use by our clients. I was struck, however, by the similarity of the message. It seemed to be We really get to know a company well or We look for undervalued stocks and then we look for a catalyst for a change in fortunes. These become very unsatisfying answers when you hear them over and over again, and ultimately the message seems to be We dig a little deeper than the next guy, and we’re smarter than the other million or so investors out there looking at stocks and evaluating stocks on a daily basis.

Practitioners are always looking for stocks that are cheap or stocks that trade for less than their intrinsic value. But, given the numerous analysts and portfolio managers weighing in on the value of stocks on a minute-by-minute basis, why do these values exist? Who’s making the mistakes that allow active management to succeed? In short, what are investors looking for? I think if you ask professional investors for the answers to these questions, you won’t get satisfactory answers. This becomes especially true when you try and link their processes to reasons why stocks trade inefficiently.

Without giving too much away, I would note that I believe one can add value in the active management of domestic mid- to large-cap stocks. I don’t think it’s easy to add value, but I do believe one can outperform passive benchmarks over time. This is not to say that I think investors can outperform indices in every period or over short time horizons. Indeed, it’s not clear what time horizon is pertinent. The nature of the market is such that strict definitions and determinations are extraordinarily difficult to make, and the consultants who make such decisions for individual and institutional investors have a very difficult job in this regard. One is faced with an infinite number of time periods from which to choose: 3-year, 5-year, 10-year, since inception, or periods in between. We can draw a line in the sand with regard to a time period, but I’m not sure it makes much of a difference. Different environments create different situations for different types of investors.

Indeed, this is a problem that all portfolio managers face at some point in time. We are looking for inefficiently priced stocks, but the market gives no clear indication as to when such inefficiencies are rectified. I’ll spend half of Chapter 6 on this issue and its relationship to active management. I do believe that over time a stock’s price converges on its intrinsic value, but as John Maynard Keynes is credited with conceding, The market can stay irrational longer than you can stay solvent.¹ Consequently, it may be a bumpy ride, and one necessarily needs patience in identifying and capitalizing on investment opportunities.

The volatility we’ve seen in the domestic stock market over the past few years has been both unnerving and challenging. More than ever, investors need a blueprint for keeping a course of action. Wild swings in individual common stocks can create opportunities, but they can also lead one to disastrous decisions. Knowledge is the key to success. One must be clear about why they are invested and have a rationale for holding each common stock in their portfolio. In the absence of a clear rationale, decision making becomes perverted and myopic. In this light, we can view market volatility as containing elements of danger and elements of opportunity—both are present. In short, understanding how opportunities in the market arise will hopefully allow one to take advantage of the opportunities and stay the course in volatile times. Market volatility is likely here to stay, and it’s important that one not become paralyzed by the extreme gyrations. Consequently, while Keynes’s words ring true to me, they present the glass as half empty rather than half full. I’m fonder of Warren Buffett’s wisdom, as he beckons investors to Be fearful when others are greedy, and be greedy when others are fearful.² Hopefully, by understanding where value lies in the large-cap universe, one is able to not only be opportunistic, but also stay true to Mr. Buffett’s words.

Parts of This Book

Broadly speaking this book is based on two important premises. The first is that markets for large-cap and mid- to large-cap stocks are inefficient. The wild swings we see in large-cap benchmarks such as the Standard & Poor’s (S&P) 500 Index are symptomatic of a market that fights to reconcile the passion that we as humans possess with an objective assessment of uncertainties. This is difficult in the best of circumstances but becomes most difficult in times of euphoria and times of despair.

The second premise that this book is largely concerned with is the source of opportunities. I propose that, unlike some types of markets (principally markets for micro-cap stocks, small-cap stocks, and emerging-market stocks), mid- to large-cap inefficiencies are driven by errors in investor behavior rather than what I term structural factors. This is a distinction that I can’t stress the importance of enough. One must be aware of what one is looking for, in order to determine if one has found it. Domestic mid- to large-cap stocks are not underresearched. Nor are they illiquid or subject to other structural factors. Domestic mid- to large-cap stocks become overvalued or undervalued due to errors in the assessment of uncertain assumptions that underlie their valuations. Identifying important assumptions that drive valuation and then determining the behavioral errors that investors make becomes the nexus for finding opportunities in the market.

To this end, understanding the heuristics—or short-cuts that we as humans make in our decision-making process—will allow us to better understand the errors we may be making in assessing important assumptions that underlie intrinsic value computations. In this regard, this book really straddles two very different realms of economic thought: behavioral versus classical assessments of market efficiency. This book acknowledges the importance of each of these characterizations of the market, and takes the view that they are not mutually exclusive. Rather, the investor should consider that markets ride a continuum of efficiency spanning egregious inefficiency to cold rationality. One should seek to invest in securities when their pricing is inefficient, but sell securities when their price converges on a more efficient assessment of a company’s merits.

The key element to this process is time. The time frame becomes the link between market efficiency and market inefficiency. Pricing in the market can be very inefficient at any given point in time, but pricing will gradually work toward, or converge on, objective, coldly rational efficient pricing. How long this takes is not known. Moreover, the time frame can become a manager’s undoing and an investor’s worst enemy.

This book is organized into three interrelated parts. Part I will discuss the state of the market for actively managed large-cap stocks. This will include an examination of the trends in passive investing and what such trends portend for the active manager over the long term. Part I will also include a chapter that discusses the difference between risk and uncertainty, an important distinction that will prove useful as we examine the errors humans make in approaching uncertainties.

Part II will start with an explanation of market efficiency and the theories that underpin this notion. With our understanding of how markets are understood to be efficient, we will next look at whether the market efficiently prices common stocks and empirical evidence of investor irrationality. We will then, over the course of two chapters, critique the three theories that support the broader notion of market efficiency, offering theoretical counterpoints to arguments that contend markets are efficient pricing mechanisms. Finally, I’ll end Part II by discussing the conventional view of market inefficiencies, and their relationship to both the efficient markets hypothesis and the three theories underpinning market efficiency. Importantly, much of Part II will focus on errors in judgment and the ways in which such errors pervert assessments of value.

Finally, Part III will discuss methods one can integrate into one’s investment process. These methods allow one to structure an investment process to conform with the opportunity set available to large-cap stock investors. Opportunities are available in the large-cap subset of the market, but one’s process must be attuned to take advantage of such opportunities. This will include some practical ideas for identifying large-cap stock opportunities as well as analyzing large-cap opportunities. Additionally, Chapter 10 provides a case study on a timely investing opportunity in the constructs of the ideas presented. Part III will end with some thoughts on managing large-cap portfolios and the challenge one faces in structuring portfolios to outperform broad market benchmarks.

It’s worth noting that there is a companion web site that is available to readers of this book, www.wiley.com/go/villalta. This web site offers tools that help the reader implement the methods discussed in Part III of this book.

While this book is largely focused on the need to incorporate behavioral insights into one’s process, I hope that the reader does not take this as a recipe to forgo extensive research. I will time and again speak to the need to balance one’s research emphasis. However, while I note that one is not likely to find hidden secrets in a company’s 10-Ks or investor meetings with management, this is not to say that one shouldn’t undertake extensive research and analysis. It is to say that one should balance one’s research with a broader understanding of human behavior and the ways in which decision making can be perverted. This is a unique perspective on stock research and one that I believe will serve the large-cap portfolio manager especially well.

Notes

1. This quotation is often credited to John Maynard Keynes. However, as Jason Zweig explained in early 2011, we don’t have definitive proof that he said as much. At any rate, whether Keynes said it or not, it does ring true to me. Jason Zweig, Keynes: He Didn’t Say Half of What He Said. Or Did He? wsj.com, February 11, 2011.

2. Warren Buffett, Buy American. I Am. New York Times, October 17, 2008.

PART ONE

The Large-Cap Opportunity and Challenge

CHAPTER 1

Trends in Large-Cap Investing and the Opportunities They Present

Why am I focusing on mid- to large-cap stocks? Because this investment terrain is being abandoned. Opportunities exist where others fear to tread, and increasingly it appears that money managers and investors fear to tread in the pool of actively managed mid- to large-cap stocks. Over the past 20 years we’ve seen a paradigm shift in investment management where active management of large-cap domestic common stocks, once considered a legitimate exercise, is now held as futile. Passive strategies have gone from being niche products to being a significant part of many investment portfolios.

It’s not just that indexed equities have grown as a proportion of investments. A logical, rational case has been made that active investment is devoid of value. This case, generally made in the context of market efficiency, is buttressed by empirical research purporting to show that time and time again, year after year, active managers fail to add value.

But is this really the case? Is active management devoid of value in the large-cap arena? As we continue to learn from economic research into investor behavior, and witness the market’s volatile gyrations, it’s difficult not to accept that large-cap stocks trade as inefficiently as stocks in other subsets of the market. However, that’s not to say that large-caps are not different. Large-cap benchmarks are less diversified than benchmarks for other subsets of the market. This presents challenges for the large-cap investor that one doesn’t find in other areas of the market. As the investing landscape has changed, as the proportion of money invested in passive large-cap strategies has ballooned, so has the proportion of active managers who’ve simply chosen not to compete. I will propose in this chapter that the failure of active management to deliver value-added results is deliberate. A large and growing subset of active managers is simply hugging benchmarks too closely, removing any ability to outperform passive index strategies. Finally, I would argue that trends in passive investing and closet indexing over the past 20 years are setting the stage for greater inefficiencies in the large-cap arena. While I think that a case can be made that now is a very opportunistic time to invest in actively managed large-cap stock strategies, the larger point that I’ll make throughout this book is not one that is of a limited time frame.

What I propose in this chapter is based on longer-term trends and an evolution in the view of active management. Actively managed large-cap portfolios can add value if constructed properly. Having a complete understanding of what drives inefficiencies in the large-cap subset of the market is of paramount importance in constructing an investment strategy to add value in this space. This book will move in this direction, but we’ll start with a broader perspective on the state of large-cap investing. Just as understanding the state of any industry gives us insights into that industry’s long-term prospects, understanding the state of large-cap investing will give us insights into what can be expected as time moves on.

This chapter will start by explaining what a large-cap stock is and how it relates to benchmark indexes like the Standard & Poor’s (S&P) 500 Index. I’ll then describe two concurrent trends in investing: the wide acceptance of passive benchmark index investing and the growth of closet index investing strategies. I’ll end the chapter with some thoughts on the ramifications of these trends.

Defining a Large-Cap Stock

What is a large company? There are many ways to define large in the context of America’s largest companies. Moreover, there are really two questions that an analyst must answer in terms of size:

1. What is the arbiter of size?

2. What is the cutoff in terms of delineations of large and small?

Let’s consider the first question to begin with. There are a multitude of data points that could be useful in determining a company’s size. From an economic and societal perspective, the number of people a company employs could be considered a very good indicator of size. This measure provides one sense of the impact the company has on the overall economy, as the wages paid by the company trickle down to other segments of the economy. Moreover, the more individuals a company employs, the greater the company’s impact on the livelihoods and happiness of many in society. Fortune magazine, in their yearly Fortune 500 rankings, provides a number of characteristics on which one can view companies that are domiciled in the United States. In terms of employees, Table 1.1 provides a list of the 10 largest employers ranked by 2010, year-end employee count. Some of these companies, such as Kroger, may not strike many as being a large-capitalization enterprise. Others likely fit squarely in our minds as representative of this subset of the market.

TABLE 1.1 10 Largest Companies in the United States—Based on 2010 Number of Employees

Data source: CNN Money, Fortune 500: Our Annual Ranking of America’s Largest Corporations 2011 (http://money.cnn.com/magazines/fortune/fortune500/2011/full_list/index.html).

Alternatively, we could consider the company’s impact in the marketplace. It is logical to conclude that the more goods a given company sells, the larger the company is. To this end, revenues are a good indicator of company size. If we look at the largest companies in the domestic market, by revenues, the top 10 would be as found in Table 1.2.

TABLE 1.2 10 Largest Companies in the United States—Based on 2010 Revenues

Data source: CNN Money, Fortune 500: Our Annual Ranking of America’s Largest Corporations 2011 (http://money.cnn.com/magazines/fortune/fortune500/2011/full_list/index.html).

Still, while revenues give us one indication of size, one could also make the case that a company’s profitability is more important and a better indicator of size. Profits level the playing field, as they are a true indication of a company’s impact on an underlying society. For example, if I’m a company that resells imported goods, making a modest marginal profit on each good, what impact do I have on my society or economy as a whole? One could argue that if I resell enough goods, then the impact is sizable. However, if I sell a large amount of goods, but my overall profit is small, then the impact is more minor. This would be especially true if the goods were imported from another country or were manufactured by another company. In short, profits are the most important arbiter of success and are arguably a very good indicator of the size of a company. The top 10 companies in terms of 2010 profits are provided in Table 1.3.

TABLE 1.3 10 Largest Companies in the United States—Based on 2010 Profits

Data source: CNN Money, Fortune 500: Our Annual Ranking of America’s Largest Corporations 2011 (http://money.cnn.com/magazines/fortune/fortune500/2011/full_list/index.html).

Finally, we could also look at market value, as found in Table 1.4. Conceptually, market capitalization should not only account for the company’s current earning power, but its growth prospects as well.

TABLE 1.4 10 Largest Companies in the United States—Based on Market Capitalization

Data source: CNN Money, Fortune 500: Our Annual Ranking of America’s Largest Corporations 2011 (http://money.cnn.com/magazines/fortune/fortune500/2011/full_list/index.html).

There are still more ways in which we could look at a company’s size. We could look at total assets on the balance sheet, we could look at book value of equity, or we could look at enterprise value (debt and equity). In short, there are a number of ways in which to classify a company as large, and while there is some commonality among various ranking schemes, as can be seen in Tables 1.1 through 1.4, there are also significant disparities. Some companies, such as ExxonMobil Corp., would be considered one of the 10 largest companies in the United States, regardless of the metric used to define large-cap. Other companies, such as AT&T and Kroger, are less consistently represented within various definitions of large company.

From a benchmarking and asset allocation standpoint, the standard generally used is market capitalization. Most indices, such as the S&P 500 Index, the Nasdaq Composite, the Russell 1000 Index, and the Wilshire 5000 Index, are weighted by market capitalization. In short, the index represents a summation of the market value of all of the stocks that comprise the index (more on this in the next section). As a consequence, the largest companies have a larger impact on the performance of the index.

From an investment management standpoint, as we are always evaluating the efficacy of active management in relation to a benchmark index, it makes sense to use benchmark indices as the basis for determining both the universe from which one is selecting as well as the definition of what constitutes a stock in the context of what an index represents. Thus, as the Russell 1000 Index is an index of domestic mid- to large-cap stocks, its definition of mid-cap and large-cap stocks is a definition with considerable weight.

As to the second question pertaining to the cutoff for classification purposes, there are, again, a number of opinions on what constitutes a large-capitalization stock, a mid-capitalization stock, or a small-capitalization stock. Russell Investments, the creator and publisher of the Russell family of indices, has made a fairly encompassing and reasonable assessment of various market capitalization spectrums. The Russell 3000 Index, a broad market benchmark, is comprised of two other Russell indices: the Russell 1000 Index, a domestic mid- to large-cap index; and the Russell 2000 Index, a small-capitalization benchmark. The Russell 1000 Index itself consists of two Russell indices: the Russell MidCap Index, which is the 800 smallest issues in the Russell 1000 Index; and the Russell Top 200 Index, which is the 200 largest issues in the Russell 1000 Index. One definition of large-capitalization or large company stocks could be the 200 largest companies by market capitalization in the domestic stock market. Note, however, that this is simply one index provider’s take on what constitutes a large-capitalization stock.

There can be, and there are, considerable differences between various indices representing the same asset class groupings (large-cap, mid-cap, and small-cap). For example, the range of market capitalizations for the Russell 1000 Index and the S&P 500 Index are very different. As one would expect, the Russell 1000 Index, holding more stocks, based on market capitalization, will generally have a higher proportion of its overall index in what Russell considers middle-capitalization stocks. In truth, this distinction is minor, as the index is weighted by market capitalization—more on this next.

Understanding the S&P 500 Index

While this section will focus on the S&P 500 Index, the construction of widely used benchmark indices all follow a similar methodology. The S&P 500 Index is explained here, as it’s a widely used index for both passive investing purposes and as a benchmark for evaluating domestic mid- to large-cap stock strategies.

Like the Dow Jones Industrial Average (DJIA), the S&P 500 Index is not all-encompassing. It is not the 500 largest companies in the United States, although the vast majority of companies in the index are pulled from the 500 largest companies. Professional investment consultants prefer benchmarks that represent the opportunity set from which a money manager or mutual fund is selecting securities, such as the Russell and Wilshire indices. These two index families are rules based and not formed by committee. For example, the Russell 1000 Index is comprised of the common stocks of the 1,000 largest companies in the United States. The rule, with respect to the Russell 1000 Index, is market capitalization, or a company’s number of common stock shares outstanding multiplied by the company’s common stock price. According to Russell Investments, the Russell 1000 Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment.¹

The S&P Index Committee at Standard and Poor’s, the company that publishes the S&P 500 Index, does not rely singularly on rules for selecting securities for the S&P 500 benchmark. While I think that Standard & Poor’s recognizes the benchmark value of the S&P 500 Index and its use as both an investable benchmark and an evaluation benchmark, the index was originally constructed to be representative of the U.S. economy. Standard & Poor’s describes the S&P 500 Index as being comprised of 500 leading companies in leading industries of the U.S. economy.²

The S&P 500 Index, like many leading benchmark indices (Russell and Wilshire included) is a market capitalization weighted index. This means that the larger the company in the index, the greater that company’s effect on the performance of the index.

An index value for the S&P 500 is calculated on a daily basis. This calculation is the sum of the value of each company in the index, where value is defined as the free-floating value of the common equity of the company—the price of the stock (Pricei) multiplied by the number of shares outstanding (Sharesi) multiplied by the proportion of shares that are tradable by the general public, the investable weight factor (IWFi). Most indices also scale this resulting number (which could be in the trillions) by dividing the sum by a divisor. The formula (1.1) used to calculate the value for the S&P 500 Index is provided below:

(1.1) 1.1

The Index Value is then used to calculate day-to-day price returns for the benchmark. To calculate the total return for the index, a sum of the dividends paid for each stock paying a dividend on a given day are divided by the divisor and added to the Index Value. This augmented index value is then used as the basis for calculating the total return for a given day.

The calculations are only important in so far as they show that the larger the company in the index, the greater that company’s performance will impact the return for the total index. There are other methods for calculating index values. Some indices are price weighted (the DJIA, for example), and some are equal weighted (variations of S&P and MSCI indices). Market capitalization–weighted indices are often justified on the grounds that they represent the market portfolio, an important element to the capital asset pricing model (CAPM) and modern portfolio theory. The S&P 500 Index is also, in practice, used as the market portfolio for risk assessment in the valuation of specific companies.³,⁴ For whatever reason, there is no mistaking that market capitalization–weighted benchmarks are the preferred bogeys for money manager and mutual fund performance evaluation. Moreover, the S&P 500 Index in particular is the preferred investable index for domestic mid- to large-cap stocks.

Examining the Growth of Indexed Equities

Wells Fargo & Company, now one of the largest diversified financial firms in the United States, started the first index fund in 1971, when the Samsonite Company pension fund engaged the bank to manage $6 million in assets in a passive NYSE portfolio. This set the stage for what would eventually become a significant proportion of institutional and retail portfolios.

While index investing played a relatively minor role in most investors’ (institutional and retail) portfolios in the 1970s, as we moved into the 1980s, a burgeoning movement began at a number of institutions. By the 1990s, with the advent of exchange-traded funds (ETFs), passive investments started to comprise a larger and larger percentage of both institutional and retail investment positions. An annotated history of passive investing in stock market indices is provided in Figure 1.1.

FIGURE 1.1 The History of Passive Investing in Market Indices

Sources: Richard A. Ferri, All About Index Funds: The Easy Way to Get Started, 2nd ed. (New York: McGraw-Hill, 2007); Frank J. Fabozzi, The Handbook of Financial Instruments (Hoboken, NJ: John Wiley & Sons, 2002); Eric Falkenstein, Finding Alpha: The Search for Alpha When Risk and Return Break Down (Hoboken, NJ: John Wiley & Sons, 2009).

While most equity mutual funds remain actively managed, there is no question that passive strategies have grown quickly, and now constitute a material portion of the equity mutual fund universe. At the end of 2010, index mutual funds made up roughly 14.5 percent of total equity mutual fund assets, up more than 50 percent from a decade ago (see Figure 1.2). Within this group, the largest single index fund strategy is S&P 500 Index replication.

FIGURE 1.2 Equity Index Funds’ Share of Equity Mutual Fund Assets

Source: Investment Company Institute, 2011 Investment Company Factbook.

It’s worth noting that in spite of significant net outflows from domestic equity mutual funds from 2007 to 2010, passive strategies continued to grow as a proportion of overall consumer portfolios. The Investment Company Institute data provided in Figure 1.2 is buttressed by Morningstar data that shows that passive strategies have grown from 11 percent of mutual fund and exchange-traded fund