I seem to be hearing the same refrain everywhere these days: In print, on TV and all over the Internet, pundits are screaming that big-cap stocks are cheap. Buy the blue chips, buy the dividend payers -- they are on sale right now. This has puzzled me as very few large-cap stocks are showing up in any of the screens I run on a regular basis. I can only assume that the pundits and gurus are looking at these stocks on a comparative or relative scale of value.
I do not really care how stocks look compared to five years ago or relative to analysts' forecasts. Cheap means a stock is trading below book value, has a single-digit PE ratio or a low price-to-free-cash-flow based on the current conditions. I decided this was worthy of further investigation and some back-of-the-envelope testing to see if the large-cap stocks were indeed cheap on an absolute basis.
I first looked at the mega-cap stocks. There are 12 stocks with market caps over $200 billion according to my screener. None of them trade below book value. Two of them have single digit PE ratios. Both are energy companies as one might expect given weakness in the sector. Royal Dutch Shell (RDS.A) and Chevron (CVX) both have a PE of 7 and might be considered cheap on that metric. None of the Big 12 trade for less than 5x free cash flow. Only three stocks, Royal Dutch, AT&T (T) and Petro China (PTR) have a dividend yield in excess of 4%. Even on a relative basis, these giant companies are not really cheap. Only Petro China and Apple AAPL have a PEG ratio less than 1. Mega-cap stocks clearly fail the cheap test.
So let's move down a little in size and see what we find. There are 483 stocks with market caps between $10 billion and $200 billion. The results look a little better in this group. I found 68 stocks, or 14% of large-capitalization stocks, that are trading with a single-digit PE ratio. Of these, nine are major banks in Europe, Japan and Latin America, six are large financial institutions and 17 of the companies are in the energy business. Looking at the list one concludes the Europe, Brazil , energy and major banks are cheap on a PE ratio basis. However, there are more large-cap stocks with PE ratios above 25 (74) than below 10.
Only 18 stocks in the large-cap space trade for less than 5x free cash flow. Of these, only Dell (DELL) is not a Chinese or financial company. Looking at fee cash flow, we can conclude that financials, especially insurance companies, look cheap, but the asset class of large-cap stocks is not particularly cheap compared to free cash flow.
When I look for large-cap stock with decent dividends, I find 78 stocks have yields above 4% and 78% of these stocks fit my definition of high yielding. A deeper look shows that 30 of these are utilities or telephone companies, which are traditionally higher yielding issues. Once again, we see that banks and energy companies are well represented. 14 of the high yield stocks are energy companies and 11 are banks. More than half the high yielding issues are foreign companies. Half of the foreign stocks are European companies.
There are 60 stocks that trade below stated book value. More than half of these (33) are financial companies. The majority of the stocks trading below book value (35) are foreign companies, while 14 are European and 14 are either Japanese or Korean. With only 12% of large-caps stocks trading below state and book value, I can't see a case for big stocks being cheap on an asset basis.
So the assertion that large-cap stocks are cheap just does not hold up to a close examination. I cannot even find solid evidence that they are cheap relative to expectations. Of the 495 stocks with market caps over $10 billion, only 17.5% (87) have PEG Ratios below 1. What I have found is that banks, energy companies and European stocks are cheap on the numbers, but the broader market of large companies is fairly overpriced on an absolute basis.
Test everything, especially if you hearing it everywhere.