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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Bill Nygren: Are Large-Cap Stocks Less Risky Than Smaller Companies?

Bigger doesn't always mean better

There is a commonly held belief that larger companies are inherently less risky investments than smaller ones. The logic behind this belief is fairly simple to understand - people trust that the big, established brands they see all around them will continue to exist and make money, and that these brands have a better chance at continued success than less well known businesses. But does that mean investors should prefer larger-capitalization stocks? In a recent letter to investors of his Oakmark Funds, portfolio manager Bill Nygren (Trades, Portfolio) cautioned against such sweeping generalizations.

A growing trend

Nygren drew attention to a growing trend in equity markets - one where capital is flowing into businesses that have much lower revenues than the companies that are falling out of favor with investors:

"The large-cap universe, which refers to the 250 stocks with the highest market capitalizations, is getting smaller. There were 40 newcomers to the large-cap universe in just the past year and they are much smaller businesses than those that exited. The median level of sales for these new additions was just under $2.4 billion. Compare that to the companies that exited the large-cap universe: only two of them had sales below $2.4 billion and their median sales was nearly $14 billion."

Nygren went on to say that while the newest additions to the large-cap club are being valued at almost 13 times sales, the companies they have knocked out of that group are trading at 1.4 times sales. Investors have shown a willingness to pay much more for a dollar of sales of Square (NYSE:SQ) than for a dollar of sales of Phillps 66 (NYSE:PSX).

Of course, one factor that can be attributed to this trend is the companies being knocked out of the large-cap group have had their businesses severely disrupted over the course of the last year - Nygren names Southwest Airlines (NYSE:LUV) and Dollar Tree (NASDAQ:DLTR) as two examples of these "fallen from grace" businesses. It's easy to understand why an airline and a brick-and-mortar retailer have not done well in 2020. By contrast, the companies that are growing in market capitalization are relatively new businesses with growth potential - for instance, Zoom Video Communications (NASDAQ:ZM).

But just because a business has a large market capitalization doesn't mean that it is inherently less risky than a smaller business. Nygren points out that Zoom has a market capitalization of $134 billion - it is valued at 100 times trailing sales. Does anyone really think that paying 100 times trailing sales is a good value buy? Good investors don't assume the big will continue to get bigger. Instead, they look beneath the headline numbers and do good valuation work, and only then decide whether the market is correctly valuing a business.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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