Why Blue Chips Are Due

By Daniel Kadlec

Bet you didn't know we've been in a bull market for six years. It's true. Despite the burst bubble, most stocks are up 75% or more since the end of 1999. They're probably not the ones you own, though. Big-name companies like GE, Pfizer and Microsoft--which investors and mutual-fund managers tend to gravitate to--have been flailing since the bust. That's why the popular market gauges that those stocks dominate (Dow Jones industrial average, Standard & Poor's 500) still languish below their old highs. Yet the time may have come to stock up on the U.S.'s most recognizable corporate logos.

We're at a point in the economic cycle that tends to favor the biggest of the big. Short-term interest rates are up, which is especially hard on small companies that do not enjoy the same access to cheap borrowing as large ones. As higher rates slow the economy, earnings at small firms should decelerate quickest. And as earnings slow, the dividends that blue chips pay will become increasingly attractive.

Those are solid, fundamental reasons to give big stocks another look. But the most compelling argument has to do with how fads come and go on Wall Street. Large-cap companies (generally defined as those with a market capitalization, or value, of more than $10 billion) have been all but forgotten. The S&P 500 (big firms) is down 13% since the end of 1999. Yet since then, the S&P small-cap index is up a breathtaking 92%.

The small-stock craze made sense for a while. Large caps were runaway winners in the late 1990s, before the group became insanely overpriced and ultimately collapsed. But now it's the small caps that "have gone about as far as they can go," says Andrew Engel, a portfolio manager at Leuthold Group.

On the basis of expected earnings this year, the 25 largest companies in the S&P 500 are cheaper than any other broad section of the market, says Stan Nabi, chief investment strategist at Silvercreek Asset Management: "They now have far more potential than risk." One of Nabi's favorites is Home Depot, whose profits have been soaring and should grow an additional 14% this year. Yet the company's shares sit 39% below their level of six years ago. Other depressed blue chips include Intel, Dell, J.P. Morgan, Wal-Mart, Coca-Cola, Verizon, Citigroup, AIG and UPS.

So far there has been no whiff of a reversal. Small stocks are up twice as much as large stocks since Jan. 1, and some who hope to see the big boys regain market dominance are worried that it may take years to play out. There is precedent: large stocks did next to nothing for the 14 years ending in 1982.

Still, "we've seen this many times in the past," says David Nelson, director of market analysis at Legg Mason Capital Management. "No one believes it will turn. But then it does turn, and it all starts when valuations go to extremes." Like now.

Nelson's favorites include technology blue chips Intel, Dell and Microsoft, which he believes are becoming more shareholder friendly by buying back stock and cutting back on options for executives and should benefit from an expected surge in capital spending. He also likes banking giants Citigroup and Bank of America, whose profit margins should expand after the Fed stops raising interest rates, which is expected this spring.

At a minimum, now is a good time to rebalance: sell some of your small stocks or small-stock funds that have done well and beef up your exposure to large caps. But be careful: not all big stocks are bargains, no matter how far they may have fallen. GM, for example, could end up in bankruptcy. And be patient: stocks that are out of favor rarely turn on cue. But they do turn. The trick is being there when they do. [This article contains a table. Please see hardcopy of magazine.] Large-Cap Funds Worth a Look Fund Returns 1 year Returns 2 year Tocqueville 16.94% 8.76% Neuberger Berman Partners 17.50% 6.87% Cambiar Opportunity 8.36% 6.67% Managers AMG First Quad 18.81% 5.23% Neuberger Berman Guardian 11.66% 4.01%

Source: Morningstar * Annualized