Think outside the blue chips

By Andrew Feinberg
Sunday, March 6, 2011

Since 2009, I've been hearing stock-market pundits say, "Buy quality, buy quality, buy quality." Voices whisper in my ear: "Buy J&J, buy Microsoft, buy Pfizer, buy Wal-Mart. Please buy J&J. Please, for heaven's sake, won't someone buy J&J?" Some of the sharpest investors on the planet, including Warren Buffett and Jeremy Grantham, of GMO, say that blue-chip stocks are dirt-cheap compared with the rest of the market.

Nonetheless, small caps, mid caps, cyclicals, gold stocks and companies that barely survived near-death experiences have all thrashed blue chips since the market bottomed in March 2009. The trend was evident in 2010. For the year, Standard & Poor's 500-stock index, which is dominated by large companies, returned 15.1 percent. But the S&P MidCap 400 index and the small-company Russell 2000 each gained 27 percent. Such prominent blue chips as Abbott Labs, Cisco Systems, Hewlett-Packard, Microsoft, Pfizer and, yes, Johnson & Johnson all fell in 2010.

Grantham has said that it is "almost a certain bet" that blue chips will outperform lower-quality stocks over the longer term. I'm not making that bet on a big scale just yet. Over the intermediate term - the next three to six months - I'm finding much more value in small caps and mid caps.

Now mind you, I have owned Cisco, Intel, J&J and some other true blues over the past 18 months. But I sold all of them, either because something seemed to be going wrong at the company or because I believed better opportunities beckoned elsewhere.

One of the big problems with owning blue chips now is that we're in the wrong part of the economic cycle for them. "In a recovering economy," says a well-known large-cap fund manager, "people want to invest in companies more geared to expansion." With growth likely to accelerate in 2011, many investors see little reason to abandon this view.

Cleve Rueckert, a research associate at Birinyi Associates, offers an interesting perspective. His firm looks at which stocks money is flowing into and out of to determine what to own. Birinyi's top holdings include such novas as Apple, Chipotle Mexican Grill and Netflix. Such stocks "are good until they're not," Rueckert says. He notes, too, that the stock market has changed considerably over the past 10 years: "Now people want instant gratification."

I have only 20 percent of my fund in those lagging blue chips. As I was writing this column, I decided to repurchase Microsoft and Pfizer, but that may be it for a while. I believe in the long-term case for blue chips, but I'm taking Saint Augustine's approach: "Give me chastity and continence, but not yet."

On the other hand, Don Yacktman, the star manager of the Yacktman Fund, makes investment "chastity" look positively sexy. Even with Yacktman's focus on quality stocks, his fund has clobbered the S&P 500 by an average of 11 percentage points a year over the past decade. His top five holdings are PepsiCo, News Corp., Coca-Cola, Microsoft and Pfizer. His fund's 12.6 percent return in 2010 trailed the market slightly, but he is unperturbed.

For the truly long-term investor, this is a great time to load up on high-quality stocks. As for the hedge-fund manager in me, well, I promise to load up soon - just not quite yet.

Feinberg writes about the choices and challenges facing individual investors.

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