Fashion Victims

July 1, 2007

Dear Investor:

Although large-caps finally are asserting their presence, the gap between large and small stock valuation remains vast. Whether by price to cash flow, price to earnings (prospective or trailing), or discounted cash flow valuation, large stocks look like the best buy of any asset class since…well, since large stocks at the end of 1994. The more asset classes change, the more they stay the same.

Why do asset classes seem to go in and out of fashion like wide ties or short hemlines? The truth for every asset rally begins with a seed of economic truth—but gets sustained by the psychological need to conform, a phenomenon well-known to every fashion designer.

In 1994, interest rates were rising in staccato steps and the market was rolling over. A higher rate climate was a rude awakening. But it was clear that large companies (those that were less dependent on capital markets and had better access to low interest lending) would be better prepared. This, combined with their reasonable valuations, led to a reallocation to the large-cap sector, which in turn moved those stocks, which in turn juiced the returns of large-cap funds—which in turn led to new money from investors encouraged by past performance.

The cycle became a virtuous one, perpetuating itself in that peculiar way that markets do. A few years later, the original economic catalyst was gone: the interest rate outlook had stabilized. If anything, rates looked to head lower due to controlled inflation. Strangely, large-cap stocks continued to head higher even though their valuations were now expensive and their story less interesting. They had come back into fashion and were flying off the rack. They were the stuff of cocktail party banter. It became gauche to be seen without them in your portfolio and money managers who were highly suggestible joined the crowd. The bubble was in full gear. Meanwhile small-caps were out, as chic as bell-bottoms in the eighties.

It wasn’t until 2000 that markets collapsed and then reversed. In the wake of the great crash of 2000-2, interest rates were plummeting as the Fed desperately tried to reflate the economy. The economic reality now heavily favored smaller companies. Once again, the seed of a rally had been planted, only to lead to the place we are now, where those small fry who once looked so promising are expensive, overbought, all-too-fashionable and heading into the head winds of higher interest rates.

Large-caps should hold up much better in a market break than small-caps. They also should lead the way for the next several years. This is why, despite shedding most of our small-cap and emerging market allocations, we’re holding onto most of the large-caps. We don’t know if history will look back upon higher rates as the economic reality that began this new cycle. But we do know that large companies are starting to come back into style.