Large caps a safe bet

Serious money:Beleaguered pharmaceutical companies and embattled consumer brands like Coca-Cola are turning the corner and offer investors considerable growth opportunities

America's "Goldilocks" economy continues to limp forward unconvincingly, with GDP expanding by a paltry 1.3 per cent during the first quarter, the lowest rate of growth since the first three months of 2003 and the fourth consecutive quarter of sub-par performance.

It is no surprise that corporate profitability is under pressure. Nevertheless, bears remain conspicuous by their absence as stock prices continue their upward march, with the Dow exceeding 13,000 for the first time and small and mid-cap indices reaching all-time highs.

The short, sharp shock delivered to stock prices just weeks ago appears to be a distant memory as investors' love affair with lower quality issues and disregard for risk persists.

Unlike the euphoria that gripped stock markets towards the end of the 1990s, which centred almost exclusively on large-cap growth names, the current four-year upswing in stock prices has been focused on size and value. Small and mid-cap indices have outpaced their large-cap counterparts across growth and value investment styles, while value has trounced growth within each size classification.

Seven consecutive years of superior performance means the outsized gains recorded by large-cap growth have been erased. Indeed, small and mid-cap stocks and value names enjoyed a significant advantage in the past 10 years, amounting to roughly six percentage points per annum for the former and 2.5 points for the latter.

It is well documented that value beats growth over long horizons as investors pay too little for the former and too much for the latter. Similarly, small to mid-cap stocks beat their large-cap counterparts in the long term for the same reason. But current valuations are removed from historical experience and appear to be divorced from reality.

The premium afforded to growth stocks on price-to-book multiples has dropped to less than 30 per cent, despite a more than three percentage point profitability advantage that is inherently less volatile and more sustainable. Similarly, small and mid-cap stocks trade at a valuation premium to their large-cap counterparts that is close to a record high, which makes little economic sense, given the greater variability in underlying cashflows, not to mention the reduced ability to trade shares in size.

Irrational exuberance is apparent in value and small to mid-cap segments of the market, but several factors suggest that this particular party is at an end.

Both fundamentals and valuations, as highlighted last week, suggest that growth should handily outpace value from here and the arguments can easily be extended to large-cap names.

The dramatic decline in the market's earnings momentum, a downward sloping yield curve, the rising yield premium required on corporate debt and the narrowing of market-beating performance to ever fewer names all point to large-cap growth. Additionally, the recent divergence of global growth from the sup-par performance of the US economy to robust figures in Europeand the recent acceleration in China support the case for large-cap growth names, given their international exposure.Furthermore, growth and interest rate differentials are moving against the US, which has precipitated dollar weakness and provided further impetus to large-cap growth.

The credentials in favour of large-cap growth stocks are hard to dismiss, but where should investors look for investment opportunities in the current environment? Traditional growth sectors such as pharmaceuticals and consumer brand names are natural ports of call. The much-beleaguered large-cap drug companies seem to be turning the tide and several names such as Merck and Schering-Plough have reported upside earnings surprises for several quarters. Similarly, embattled brands like Coca-Cola appear to be back on track as years of erosion in returns on equity appears to be at an end.

Investors should also consider the dividend paying credentials of large-cap growth stocks, which is a well-established, market-beating strategy. None come better than Altria, the producer of Marlboro cigarettes, which sports a dividend yield more than twice that offered by the market. In a similar vein, the dramatic performance of lower quality stocks sees the immensely profitable Coca-Cola offer a higher than average dividend yield as too do several pharmaceutical names.

Opportunities abound in large-cap growth and as the cola giants might say: "It's the real thing." Investors should look to large-cap growth for market-beating performance.