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Maybe It's Time to Try Large Caps Again: Well-Known Names Catch Manager's Eye

Posted on: Monday, 20 February 2006, 03:03 CST

By Kathleen Gallagher, Milwaukee Journal Sentinel

Feb. 20--Big is bound to be better is the rallying cry of one Wisconsin money manager.

After six years of small company stocks outperforming the broader markets, John C. Thompson says it's time for a change.

Thompson had half his Thompson Plumb Growth Fund in small company stocks six years ago. He now has 91% of all the fund's assets in large and very large company stocks, he said.

"In general, that's where we're finding our best ideas," said Thompson, co-manager of the fund and vice president at Thompson Investment Management LLC in Madison. Small caps, because of their six-year run, have gotten to the most expensive level relative to big company stocks that they've been at in more than 25 years, Thompson said.

Indeed, small company stocks are trading at about a 10% premium to large company stocks, based on their price-to-earnings ratios, according to The Leuthold Group LLC in Minneapolis. The last time they got that much more expensive than big caps was in 1983, according to the Leuthold Group's data.

There is a pervasive view among many investors that small company stocks over time are much better performers than big company stocks. That's true if you take a broad look at investment performance over the last 100 years, Thompson said.

But if you take out the years between 1975 and 1983, when small company stocks showed dramatic out-performance, the two groups provide much more comparable returns over time.

The relatively low valuations of big company stocks have attracted Thompson to the shares of many well-known names:

So-called "old media" companies with television and cable properties have been overlooked investors who are worried that Google is "going to take over the world," Thompson said.

He says the situation is analogous to the period in the late 1990s when many thought Amazon.com was going to put all the established booksellers out of business.

"Booksellers like Barnes & Noble have done well since then, and we think it will be the same with the old-media companies," Thompson said.

Companies such as Time Warner Inc. (TWX, $17.78), Viacom Inc. (VIA, $42.94) and Walt Disney Co. (DIS, $26.91) should be able to increase revenue and profits at double-digit rates, which would make the stock prices rise over time, he said.

The P/E ratios for big oil companies such as Exxon Mobil Corp. (XOM, $60.55) and Chevron Corp. (CVX, $57.17) have been cut in half during the last couple of years, while those of the smaller oil producers and oil service companies have remained constant, Thompson said.

"Going forward, we think the multiples on the big companies deserve a premium to the smaller ones because their returns on invested capital are much higher, especially in bad times," he said.

Coca-Cola Co. (KO, $41.79), Atlanta, is trading at about 18 times estimated 2006 earnings -- its lowest level since the early 1990s. Yet the company increased the number of gallons of syrup it sold in 2005 nearly 4%, Thompson said.

"The big driver for them is the growing personal incomes in China, India, Russia and Brazil, where roughly half the world's population lives (and) where they are seeing very rapid volume growth," Thompson said.

Tyco International Ltd. (TYC, $41.79), Pembroke, Bermuda, is also cheap relative to its peers. The company has said it plans to split up its three major divisions in health care, electronics, and fire and security alarms.

"We think the value of those three combined is 30 percent to 40 percent higher than where the stock is trading today," Thompson said.

Microsoft Corp. (MSFT, $26.70), Redmond, Wash., is trading at its lowest-ever free cash flow multiple, he said. The giant software maker and marketer, the third-biggest company in the Standard & Poor's 500 index, trades at about 14 times its estimated 2006 free cash flow, he said.

"We think it's very, very cheap," Thompson said. The stock has shown an average annual stock price decline of 7.8% over the five years that ended Jan. 31, according to Bloomberg.

Microsoft has what Thompson calls a "phenomenal" balance sheet, with about $30 billion of cash and no debt.

The company has a strong market position that should get even stronger over the next few years as it rolls out its new Vista software. Vista, a powerful program that should prompt Intel to redesign its chips, is likely to jump-start an entire upgrade cycle over the next five to seven years, Thompson said.

"2012, I would guess virtually all PCs will have to be upgraded," he said.

Microsoft also said last week that it has plans to introduce an improved version of its software for hand-held phones that would offer a cheaper option to Research In Motion's Blackberry wireless e-mail devices.

"That's their modus operandi. They figure out how to do what someone else is doing a lot cheaper and sell it to the masses," Thompson said.

He said he also believes Microsoft's X-Box videogame system, which has been a drag on the bottom line, has a chance to break even in the next few years.

The biggest risk to Microsoft is the threat that a wide number of PC users would adopt the Linux operating system, but Thompson said he isn't particularly worried about that. Microsoft has such a huge share of the market that programmers write a lot more programs that are compatible with its software. Also, users typically want to buy the system that has the most software options available, he said.

Thompson has owned Microsoft in client accounts for several years and has full positions. He said that he would buy these shares up to $28 and that they could go as high as $40 in the next 12 months.

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Copyright (c) 2006, Milwaukee Journal Sentinel

Distributed by Knight Ridder/Tribune Business News.

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NASDAQ-MF:THPGX, NASDAQ-NMS:GOOG, NASDAQ-NMS:AMZN, NYSE:BKS, NYSE:TWX, NYSE:VIA, NYSE:DIS, NYSE:XOM, NYSE:CVX, NYSE:KO, NYSE:TYC, NASDAQ-NMS:MSFT, Unknown:SDP, NASDAQ-NMS:INTC, NASDAQ-NMS:RIMM,

Source: The Milwaukee Journal Sentinel

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