Finally, blue chips back in the pink

If 2011 was any indication, blue chip investors have finally reached the promised land. For more than a decade, small-cap stocks had trounced large, but last year was finally the big boys' chance to shine. Standard & Poor's 500-stock index eked out a 2.1 percent gain (including dividends) while the Russell 2000 Index fell 4.2 percent. Meanwhile, the giants in the Dow Jones Industrial Average delivered a solid 8.4 percent gain. Small caps have started the year strong, but money managers such as Ben Inker, director of asset allocation at GMO, which manages $100 billion, expect big caps to retake the lead. Inker's instinct is rooted in history, as big, stable companies (and their stocks) tend to hold up better when the economy is weak. "Small caps are trading at a high price-earnings ratio at a time when we think earnings growth over the next few years may well be negative," Inker says. "So they make us very nervous." There are always historical exceptions, of course, as in the 2000-02 bear market, when the Russell 2000 beat the S&P 500 by a wide margin. That's because during the 1990s dot-com bubble, large caps so outperformed their smaller brethren that a significant valuation gap emerged. By the end of 1999 the biggest of the blue chips had an average price-earnings ratio of 35 compared to small caps' 16.5, according to the Leuthold Group. So during the crash that followed small-caps, which were more reasonably priced, fell less. Today, however, big caps are beggars while small caps carry princely p-e's. The Leuthold Group calculates a forward-looking p-e of 10.7 for the 50 largest stocks vs. the small-cap universe's 16.3. (For the 300 largest stocks, the forward p-e is 13.) Such tempting valuations on big caps helped them overcome strong headwinds in 2011. “The big banks had a really bad year last year, and large caps were still able to outperform despite it,” says Inker. Small caps will lag large caps by 1.9 percentage points annually over the next seven years, Inker predicts. And he expects small caps, adjusted for inflation, to deliver no return at all. High-quality blue chips with low debt and stable profit margins will deliver the best numbers, Inker argues, outperforming small caps by 5.8 percentage points a year. That would exclude over-leveraged big banks and instead include big food, beverage, tech and health-care companies. Opposing Views Not everyone agrees. “In 2011 we saw a real flight to quality,” says Craig Hodges, co-manager of the $200 million Hodges Fund, which can buy any size stock, and the $90 million Hodges Small Cap Fund. “The Street is really preaching, 'Get out of your risky assets and get into high-quality dividend-paying blue chips.' We've had so many fund outflows from equities of all sizes into bonds that as the pendulum swings back towards stocks, small caps, being more volatile than large, will do better. They are the first to perform well in an economic recovery.” David James, director of research at James Investment Research and co-manager of the James Balanced Golden Rainbow Fund and the James Small Cap Fund, thinks large-cap stocks will win out in 2012, but small caps will triumph over the next five years. In an economic recovery, James says, small caps win, and he believes the economy will gradually recover. If 2012 is destined to be a banner year for big caps, it could spell trouble for actively managed mutual funds. It's harder to ferret out values among blue chips that are well covered by analysts, and the largest 50 stocks in the S&P 500 constitute half of the benchmark's total capitalization. That's part of the reason why over the past 15 years, the passively managed, low-expense Vanguard 500 Index Fund has beaten 63 percent of its actively managed peers in the large-cap blend fund category. By contrast, the Vanguard Small-Cap Index Fund (NAESX) has beaten a far lesser percentage of its actively managed peers -- 38 percent -- over the same period.