Thursday, August 5, 2010

Weitz: Undervalued Large Caps

From the Weitz Quarterly Letter:

During the late 1990’s, large capitalization growth stocks—especially those with any connection to technology and the Internet—were stock market leaders. Investors were so focused on the largest 25-50 stocks that these stocks became over-valued (and the small- and mid-cap companies’ stocks languished at relatively cheap valuation levels).

Since then, the tables have turned. Over the past ten years, the small-cap Russell 2000 Index has risen by 3% per year (or 34% on a cumulative basis) while the large company-dominated S&P 500 has actually declined by -1.6% per year (or a cumulative -15%). During this period, many of the large- and mega-cap companies grew nicely, but their valuations shrank. For example, suppose a company earned $1 per share in 2000 and sold at 30 times earnings, or $30. If earnings tripled over the next ten years to $3 per share but the price-earnings ratio fell to 10 times, the stock would trade at the same $30 per share, even though its business was clearly more valuable ten years later.

There are a number of reasons for this reversal of fortunes. We believe that the most important is that "value matters" and since the large-cap growth companies entered the decade over-valued relative to the smaller companies (thanks to the tech bubble), it was natural that they under-performed in the subsequent ten years. Another factor was the shift in asset allocation by pension and endowment fund managers from U.S. (primarily large-cap) stocks to private equity and hedge fund "alternative investments" over the past ten years. Also, since all of these companies are global businesses, there is probably concern that the European debt crisis will depress their earnings. Finally, "performance chasing" investors probably helped carry this trend too far by selling their stock laggards and buying those that were "working." Whatever the reasons, the result is that a number of terrific companies with many good years of growth in front of them are selling at very cheap prices.

Yet another money manager with the view that some of the best large businesses are selling at very reasonable prices these days.


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