Sometimes, big is both beautiful and profitable!
One of the longest-running debates between investors is the 'big cap versus small cap' argument.
Dinosaurs don't run
Many investors, particularly in their early years of investing, are drawn to invest in small companies, largely because of their potential for strong growth. What's more, while it's certainly possible for a £10 million company to rise to become a £100 million firm, 'multi-bagging' doesn't often happen to blue-chip businesses.
Time and again, this argument is summarised as 'elephants don't gallop' or, as I prefer, 'dinosaurs don't run'. However, there is one powerful counter-argument: mega-cap dinosaurs rarely go bust, while the extinction rate for small businesses is dizzyingly high.
In nearly 25 years as an investor, I've made my very largest gains from solid blue chips. Alas, my biggest losses (all into six figures) have come from investing in small-cap companies worth under £50 million. Hence, I can easily see the attractions of the 'big is beautiful' brigade!
Big doesn't have to be boring
At present, I have no small-cap shares in my portfolio. What's more, I am a direct shareholder in only one FTSE 100 firm: pharmaceutical giant GlaxoSmithKline (LSE: GSK). However, I do have exposure to the wider stock market through holdings in low-cost index-tracking funds.
As I write, GSK's share price is 1,404p, against its closing price of 1,171p on 4 February 2011. In other words, GSK's stock is up a fifth (20%) in a year, versus the Footsie's near-3% fall. What's more, GSK has a higher dividend yield than the wider market. Hence, it has delivered a total return of nearly 26% in the past 12 months. Not bad for a 'boring', long-established business, agreed?
Six lessons
My family and I have constantly owned shares in GSK since the late Eighties. Here are six reasons for keeping this core holding:
1. Buy what you know
Investment guru Warren Buffett argues that it makes sense to concentrate your portfolio by adding to your best holdings, rather than buying second-best. What's more, the Oracle of Omaha suggests that, to beat the market, your portfolio should contain no more than, say, 10 to 15 shares.
Buffett also urges investors to look for shares within their 'circle of competence'. With family ties to GSK going back decades, this is one company I know really well.
2. Invest for income
Investments that produce a steady, reliable income tend to be easier to value than those generating no cash, such as gold. For me, this income stream provides not only regular cash returns (in the form of quarterly GSK dividends), but also demonstrates the underlying financial strength of a business. Almost all FTSE 100 firms pay dividends, versus only a small proportion of small-cap firms.
3. Seek liquidity
Liquidity is a measure of how easy it is to buy into, and sell out of, an investment. Cash is the most liquid asset, as it can be used to pay for anything. On the other hand, a large commercial property is highly illiquid. Of course, most blue chips have near-perfect liquidity for small investors, whereas getting out of small-cap shares can be a nightmare, especially during market downturns.
4. 'Fortress' balance sheets
Businesses with weak balance sheets and poor cash flow live in constant peril of going bust. Hence, when seeking candidates to add to my watch list, I always look at a company's assets and liabilities and, in particular, its net debt.
While GSK had net debt of £9.5 billion as at 30 September 2011, this is easily manageable, being a mere 13% of the drug firm's market value of £71 billion. What's more, this rock-solid balance sheet allows GSK to borrow money cheaply and buy back tens of millions of its own shares each year.
5. Good dividend cover
As some of the UK's biggest businesses and brands, most British blue chips generate very strong cash flow, earnings and dividends. Even so, when looking at the future for a company's dividend, I always check its dividend cover, which is the earnings yield divided by the dividend yield.
Right now, GSK has a forecast earnings yield of 8.1% and a projected dividend yield of 4.9%. Thus, with dividend cover approaching 1.7, future cash payouts look safe -- for now, at least.
6. Buy on weakness
Lastly, if you're convinced of the merits of a business but Mr Market sends its share price tumbling, then this may indicate an uncoupling between the value of the business and the price of its shares. Often, these periodic market dislocations provide excellent buying opportunities for patient investors looking to increase their holdings of well-run businesses. For the record, I'd be happy to add to my holding in GSK at the current price.
Which side of the 'big cap versus small cap' debate do you take? Please tell us in the comments box below.
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More from Cliff D'Arcy:
> Both Cliff and The Motley Fool own shares in GlaxoSmithKline.
