0large vs small bernstein

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Vadim Zlotnikov (Chief Market Strategist) • [email protected] • +1-212-756-4663

Ann Marie Larson (Senior Analyst) • [email protected] • +1-212-756-4235

Lin Lin • [email protected] • +1-212-756-4082

Yiling Chen • [email protected] • +1-212-969-6385

Carmen Torruella (Quant Product Specialist) • [email protected] • +1-212-969-6294

See Disclosure Appendix of this report for important disclosures and analyst certifications.

Quantitative Research: Prospects for a Large Cap Comeback

Highlights

Large capitalization stocks and high profitability companies have underperformed for years and currently trade at historically high discounts to small caps (Exhibit 1). In fact, returns in the last decade have been the worst for the 50 largest stocks in nearly seventy years (Exhibit 5).

In our view the causes of this prolonged size disparity are at least partially structural. The last ten years have seen a huge increase in the popularity of exchange traded funds (ETFs), which disproportionately benefited small and mid cap. stocks (Exhibit 6-Exhibit 7), as did the increase in high frequency and risk driven trading (Exhibit 8-Exhibit 9).

Hedging also played a role in penalizing large names as short interest changes in highly liquid bigcapitalization stocks nearly quadrupled following sharp market declines, while the short interest changes for the small cap universe increased by only 40% during the same time periods (Exhibit 11).

Current valuations of large vs. small cap stocks are highly attractive on most metrics both overall and within sectors (Exhibit 2-Exhibit 4).

We believe that near-term performance prospects strongly favor larger companies, given their superior earnings revisions (Exhibit 12), the likelihood of decelerating earnings growth for the market, stronger pricing power and a lower profitability differential vs. smaller names (Exhibit 13-Exhibit 14).

Current large capitalization opportunities are concentrated in energy, technology and healthcare (Exhibit 15).

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Details

In this report we look at the historical performance of large vs. small cap stocks, the market environment and stock characteristics that contributed to their historical return patterns, and our views about the future prospects for these groups of stocks. We define mega capitalization stocks as the largest 50 U.S. stocks, which in current terms translates to stocks with market values in excess of $97 billion. The large cap group consists of stocks 51-450 when ranked in descending order by capitalization, and that currently translates to market values of above about $10 billion. Stocks 451-1500 fall into the small and mid capitalization universe. The size cohorts are rebalanced on an annual basis at the end of each year so as not to bias the results by repeatedly placing winners into the larger cap categories every month.

Large capitalization stocks and high profitability companies have underperformed for years and currently trade at historically high discounts to small caps (Exhibit 1). Although not as extreme as the forward P/E ratios, this relationship holds true for other current valuation metrics such as EV-to-EBIT as well as deep value measures like price-to-book (Exhibit 2-Exhibit 3). We also find the same pattern within sectors, as the largest cohort is significantly cheaper relative to history than the smaller stock groups (Exhibit 4). In fact, the returns in the last decade have been the worst for the largest 50 stocks in nearly seventy years (Exhibit 5).

Exhibit 1High ROIC and large-capitalization stocks are trading at a discount

Source: Compustat, First Call, IBES, Bernstein analysis

0.8x0.9x

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

Price-to-Forward EarningsLarge vs Small Cap, High vs Low ROIC

Cap-Weighted, Top1500 Universe,1969 - April 2011

Large vs Small Cap High vs Low ROIC

Nifty-Fifty

Post Tech Bubble

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Exhibit 2Although not as extreme as the forward P/E ratios, large caps remain undervalued relative to smaller companies on price-to-book value…

Exhibit 3…and enterprise value–to-EBIT

Source: Compustat, Bernstein analysis Source: Compustat, Bernstein analysis

Exhibit 4Within sectors, we also see mega capitalization names selling at historically low multiples

Source: Compustat, First Call, IBES, Bernstein analysis

0.8x

0.9x

1.0x

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1.2x

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1968

1971

1974

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1983

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1989

1992

1995

1998

2001

2004

2007

2010

Lar

ge

Cap

Meg

a C

ap

Largest 1500 StocksPrice-to-Book

1968 - April 2011

Mega vs. SmallLarge vs. Small

0.6x

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Largest 1500 StocksEnterprise Value-to-EBIT

1968 - April 2011

Mega vs. Small

Large vs. Small

History-Relative Valuations by Cap CohortJanuary 2001 - May 2011As of End-May, 2011

Size CohortCurrent

Valuation

Current Sector-Relative

Earnings Yield

Historical Standard Deviation:

Sector-Relative Earnings Yield

Z-Score: Current Sector-Relative Earnings Yield

History-Relative Percentile:Sector-Relative Forward P/E (1=Cheap, 100=Expensive,

Relative to the Last 10 Years)

Max Market

Cap($ Mil)

Min Market

Cap($ Mil)

Smallest 17.7x (1.13%) 0.71% (1.60) 96 2,000 5572 19.3x (1.32%) 0.61% (2.15) 97 7,000 2,0013 18.0x (1.20%) 0.55% (2.21) 94 20,000 7,0014 15.5x (0.15%) 0.21% (0.71) 83 100,000 20,001

Largest 13.2x 0.52% 0.25% 2.09 8 433,390 100,001

Price-to-Forward Earnings

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Exhibit 5Returns in the last decade have been the worst for the largest 50 stocks in nearly seventy years

Source: CRSP, Bernstein analysis

What's been weighing down large capitalization stocks? We believe that the causes of this prolonged disparity are at least partially structural. The last ten years have seen a huge increase in the popularity and assets under management of exchange traded funds (ETFs), which disproportionately benefited mid cap. stocks in particular as those tracking broad indexes were required to buy into these names in much larger numbers than usual (Exhibit 6). When we examine the flows into some large representative ETFs such as iShares, we can confirm that increases in their shares outstanding are negatively correlated with the performance of large capitalization stocks (Exhibit 7).

Exhibit 6Mid cap names benefited disproportionately from the rise of ETFs

Exhibit 7Flows into ETFs are negatively correlated with the performance of large cap stocks

Source: Strategic Insight Simfund MF, Lipper and Bernstein analysis Source: Strategic Insight Simfund MF, Lipper and Bernstein analysis

(8%)

(6%)

(4%)

(2%)

0%

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4%

6%

1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

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urn

s

Largest 1500 StocksAnnualized Total Returns by Market Cap Cohort

Cap-Weighted, 1936 - March 2011

10-Year Rolling Returns: Mega Cap vs Rest of Stocks

"Mega" is defined as the largest 50 stocks by market capitalization, "Rest" as stocks 51-1500.

0

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Exchange Traded FundsAssets Under Management

1994 through 2011 YTD

Annualized Return Differential Between Largest 50 & Smallest 500 Stocks

By Change in Shares Outstanding in iShares Russell 2000 Index Fund (IWM)

Largest 1500 Stock Universe, 5/24/2000 Through 5/20/2011

Concurrent Return Spreads Positive Zero Negative

Rolling 3-Month Correlation

Daily (12%) 35% 43% (0.09)

Weekly (2%) 46% 27% (0.14)

Change in Shares Outstanding

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In our view the risk environment also has had an impact on size cohort performance. In recent years the financial crisis placed much higher emphasis on risk management and as a result the risk characteristics of asset classes and specific securities have become critical determinants of pricing and performance (Exhibit 8). In risk seeking environments higher beta small capitalization companies have gained as risk-driven trading exploded (Exhibit 9).

Exhibit 8Growing emphasis on risk attributes affected asset pricing

Source: Compustat, Bloomberg, Bernstein analysis

Exhibit 9Small caps tend to have higher betas and outperform when investors are long risk

Source: Compustat, Bernstein analysis

0%

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Explanatory Power of Risk CharacteristicsLargest 1500 Stocks,

1993 through February 2011

Other vol factors

Due to change in VIX

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1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Largest 1500 StocksBeta by Market Cap Cohort

1968 - April 2011

Mega Cap. vs. Small Cap. Stocks Large Cap. vs. Small Cap. Stocks

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High frequency trading and hedging also played a role. In the last decade we've seen a steady rise in short interest (Exhibit 10). Increases in short interest tend to penalize large capitalization stocks because they're more liquid and therefore likely to be sold short when hedging against market declines. To test this we looked at the changes in short interest following periods of sharp market declines vs. all other time periods since 1997. Sharp declines are defined as two week trailing returns in the lowest quintile vs. history. We found that the short interest changes in large capitalization stocks nearly quadruple following sharp market declines, while the short interest changes for the small cap universe increase by only 40% (Exhibit 11).

Exhibit 10Short interest in highly liquid large capitalization stocks has been on the rise

Source: Factset, Bernstein analysis

Exhibit 11Changes in short interest nearly quadruple for large cap. stocks following large market declines, while the increase is much less dramatic for small cap. names

Source: Factset, Bernstein analysis

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Largest 1500 Stocks12 Month Change in Short Interest by Market Cap Cohort

Cap-Weighted, 1997 - April 2011

Mega Cap. vs Small Cap. Stocks Large Cap. vs Small Cap. Stocks

12-Month Change in Short Interest by S&P 500 Performance1997 - May 2011

Large Cap Small CapS&P 500 Sharp Decline (Q5) 4.7% 12.1%All other time periods 1.2% 8.7%

Sharp Declines vs. Other 3.8 x 1.4 x

12-Month Change in Short Interest

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Looking forward we do see some of the structural headwinds on the decline for large stocks as a more benign environment leads to less risk driven rebalancing. Attractive relative valuations alone won't move the needle, but attractive multiples with additional support from upward earnings revisions and earnings growth should act as a catalyst. The likelihood of decelerating earnings growth for the market and a lower profitability differential vs. smaller names should heavily favor large and mega capitalization stocks in the near term. A comparison of first quarter pricing power and year-over-year EBIT growth shows that large cap growth companies are well represented among the top growers with superior pricing (Exhibit 13-Exhibit 14). There are currently large cap opportunities in energy, technology and healthcare (Exhibit 15).

Exhibit 12Earnings revisions have improved for large and especially mega capitalization stocks

Source: First Call, IBES, Bernstein analysis

-0.2%

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

Largest 1500 StocksEarnings Revisions

1978 - April 2011

Mega vs. Small Large vs. Small

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Exhibit 13Large capitalization growth stocks exhibited strong EBIT growth and pricing power in the first quarter

Source: Factset, Compustat, Bernstein analysis

Exhibit 14Small capitalization companies have weaker first quarter growth rates and pricing

Source: Factset, Compustat, Bernstein analysis

Q1: 2011 Pricing: Large Cap Companies Reported by May 24, 2011Pricing Relative Performance

Contribution to EBIT Growth vs Top 1500 Stocks # CompaniesSector EBIT Growth (YoY) Past 1 Month Past 3 Months Reported Q1Materials 18.5% 51.9% (2.4%) (3.7%) 32Health Care Equipment & Services 8.1% 12.6% 4.9% 7.2% 24Technology Hardware & Equipment 5.6% 29.0% (0.8%) (5.8%) 22Retailing 3.7% 6.2% 4.5% 7.1% 18Capital Goods 3.6% 12.1% (0.7%) (2.6%) 29Media 3.5% 10.6% 3.5% 1.8% 17Consumer Services 1.6% 15.2% 4.9% 2.9% 13Utilities 1.5% (0.2%) 5.0% 6.5% 21Consumer Durables & Apparel 0.5% 2.1% 1.1% 1.6% 12Pharmaceuticals, Biotechnology & Life Sciences (0.3%) (0.2%) 4.3% 9.5% 22Semiconductors & Semiconductor Equipment (1.6%) 18.3% 1.0% 1.6% 10Automobiles & Components (2.7%) 25.8% (3.0%) (2.5%) 8Software & Services (3.1%) 14.9% 0.8% (1.1%) 17Transportation (3.4%) 13.7% 4.5% 4.7% 8Commercial & Professional Services (6.5%) 0.1% 3.9% 4.4% 7Food, Beverage & Tobacco (7.3%) 8.6% 5.0% 6.9% 15Household & Personal Products (7.9%) (3.2%) 6.1% 5.3% 5Energy (9.0%) 18.8% (4.6%) (7.7%) 48Food & Staples Retailing (15.8%) 2.0% 5.7% 10.9% 7Telecommunication Services (18.1%) 1.7% 6.1% 6.3% 11Large Cap (3.2%) 13.3% 1.4% 1.0% 346

Q1: 2011 Pricing: Small Cap Companies Reported by May 24, 2011Pricing Relative Performance

Contribution to EBIT Growth vs Top 1500 Stocks # CompaniesSector EBIT Growth (YoY) Past 1 Month Past 3 Months Reported Q1Utilities 12.0% 11.5% 2.6% 3.8% 17Food, Beverage & Tobacco 10.3% 38.6% 2.1% 5.4% 9Health Care Equipment & Services 8.9% 11.3% 1.7% 6.2% 17Pharmaceuticals, Biotechnology & Life Sciences 7.5% (34.2%) 1.4% 15.8% 11Capital Goods 0.2% 22.3% (3.1%) (2.5%) 24Commercial & Professional Services (2.5%) 9.1% 1.4% 2.2% 12Materials (2.6%) 27.4% (5.1%) (4.6%) 17Telecommunication Services (4.2%) 4.4% (0.2%) (2.2%) 1Food & Staples Retailing (5.3%) (23.8%) 5.2% 20.8% 3Consumer Services (5.7%) 0.9% 2.7% (0.9%) 19Media (6.3%) (20.3%) (1.4%) (14.4%) 7Semiconductors & Semiconductor Equipment (10.8%) (1.9%) (2.0%) (4.1%) 18Software & Services (14.2%) (2.6%) 0.4% (1.0%) 32Automobiles & Components (20.2%) 10.1% (9.3%) (9.2%) 2Retailing (21.0%) (1.0%) (1.2%) (3.8%) 11Transportation (32.5%) (8.0%) (1.4%) 2.2% 10Technology Hardware & Equipment (35.2%) (17.6%) (1.1%) (8.2%) 17Energy (39.0%) (27.5%) (8.2%) (12.5%) 17Consumer Durables & Apparel (76.1%) (91.7%) (1.9%) (3.2%) 9Small Cap (14.4%) (6.2%) (0.9%) (1.2%) 253

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Exhibit 15Attractive large cap opportunities include energy, technology, and healthcare

Source: Compustat, Bernstein analysis

Large Cap Stocks with Attractive Model Rankings and Upward Earnings RevisionsAs of June 7, 2011

Symbol Company Name Price ($)Market

Cap.($m)Year-to-Date Return (%)

XOM EXXON MOBIL CORP 80.00 394,087 10.6%AAPL APPLE INC 332.04 307,029 2.9%CVX CHEVRON CORP 99.47 199,962 10.7%IBM INTL BUSINESS MACHINES CORP 163.69 198,262 12.5%GE GENERAL ELECTRIC CO 18.48 195,989 1.7%JNJ JOHNSON & JOHNSON 65.50 179,369 7.8%PFE PFIZER INC 20.74 163,869 20.9%BP BP PLC 44.00 138,355 1.5%PM PHILIP MORRIS INTERNATIONAL 67.81 120,920 17.0%INTC INTEL CORP 22.06 117,712 6.6%GSK GLAXOSMITHKLINE PLC 42.83 111,278 12.3%COP CONOCOPHILLIPS 70.87 100,175 5.9%OXY OCCIDENTAL PETROLEUM CORP 101.46 82,474 3.9%UTX UNITED TECHNOLOGIES CORP 83.25 76,196 6.9%AZN ASTRAZENECA PLC 52.12 72,134 17.2%UBS UBS AG 18.56 70,587 12.7%CMCSA COMCAST CORP 24.02 66,444 10.3%SU SUNCOR ENERGY INC 39.78 62,574 4.4%V VISA INC 79.82 56,240 13.9%AMGN AMGEN INC 58.83 54,888 7.2%DB DEUTSCHE BANK AG 58.56 54,186 14.6%UNH UNITEDHEALTH GROUP INC 47.97 51,664 33.7%AIG AMERICAN INTERNATIONAL GROUP 27.42 49,266 (43.2)%BMY BRISTOL-MYERS SQUIBB CO 27.99 47,751 8.4%HON HONEYWELL INTERNATIONAL INC 56.85 44,741 8.2%DOW DOW CHEMICAL 35.18 41,357 3.5%LLY LILLY (ELI) & CO 37.26 41,071 9.2%DTV DIRECTV 47.62 37,063 19.3%APC ANADARKO PETROLEUM CORP 73.74 36,686 (3.0)%MRO MARATHON OIL CORP 51.20 36,454 39.7%CNI CANADIAN NATIONAL RAILWAY CO 76.41 34,782 16.0%DVN DEVON ENERGY CORP 80.73 34,302 3.0%DELL DELL INC 15.90 30,194 17.3%NOV NATIONAL OILWELL VARCO INC 71.22 30,123 6.1%

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Disclosure Appendix

Disclosure Appendix

SRO REQUIRED DISCLOSURES

References to "Bernstein" relate to Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited, and Sanford C. Bernstein, a unit of AllianceBernstein Hong Kong Limited, collectively.

Bernstein analysts are compensated based on aggregate contributions to the research franchise as measured by account penetration, productivity and proactivity of investment ideas. No analysts are compensated based on performance in, or contributions to, generating investment banking revenues.

In addition to his role at Bernstein, Vadim Zlotnikov is also an employee of AllianceBernstein L.P., an asset management firm and Bernstein affiliate. Mr. Zlotnikov serves as Chief Market Strategist of AllianceBernstein, as one of the portfolio managers of the AllianceBernstein Market Neutral Strategy Fund (the “Fund”), and as an advisor to the portfolio managers of other AllianceBernstein investment products. Accordingly, he owes fiduciary duties to the Fund and other clients of AllianceBernstein and is subject to information barriers that may prevent him from disclosing certain information to Bernstein’s clients. Mr. Zlotnikov is compensated for his duties at AllianceBernstein along with the compensation he receives from Bernstein. While Mr. Zlotnikov is normally not involved in specific security selection for AllianceBernstein investment products, insights and analysis that Mr. Zlotnikov shares with Bernstein’s clients may differ from or be contrary to positions taken by the Fund and other AllianceBernstein investment products, and vice versa.

OTHER DISCLOSURES

A price movement of a security which may be temporary will not necessarily trigger a recommendation change. Bernstein will advise as and when coverage of securities commences and ceases. Bernstein has no policy or standard as to the frequency of any updates or changes to its coverage policies. Although the definition and application of these methods are based on generally accepted industry practices and models, please note that there is a range of reasonable variations within these models. The application of models typically depends on forecasts of a range of economic variables, which may include, but not limited to, interest rates, exchange rates, earnings, cash flows and risk factors that are subject to uncertainty and also may change over time. Any valuation is dependent upon the subjective opinion of the analysts carrying out this valuation.

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CERTIFICATIONS

I/(we), Ann Marie Larson, Vadim Zlotnikov, Senior Analyst(s)/Analyst(s), certify that all of the views expressed in this publication accurately reflect my/(our) personal views about any and all of the subject securities or issuers and that no part of my/(our) compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views in this publication.

Approved By: CDK

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