The Mega-Cap Portfolio

Can investing really be this easy? I've come up with a ten-stock portfolio that includes some of the best companies in the world -- stable, fast-growing, well managed. Over the past year to June 1, every stock has produced a positive return and, as a whole, the portfolio has handily beaten Standard & Poor's 500-stock index.

What's more, the group's valuation is relatively low. Half of the stocks carry a price-earnings ratio of 13 or lower. The highest P/E is 22, and the average is just 16 (the average for the S&P 500 is 18, based on the past 12 months' earnings). Liquidity is about as high as it gets (there are plenty of buyers and sellers at the ready). Each of the stocks pays a dividend, and the portfolio's overall yield is an attractive 2.8%, a full point higher than that of the S&P.

The biggest companies

Call it the Mega-Cap Portfolio. It's composed of the ten U.S. stocks with the largest market capitalizations (a company's market cap is its stock price multiplied by shares outstanding). In other words, these are the public companies that investors value most. On June 1, ExxonMobil ranked number one, with a cap of $474 billion, followed by General Electric and Microsoft. The market caps of the ten companies total $2.6 trillion. That's greater than the gross domestic product of Britain, France or China.

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The other seven stocks, in order of capitalization, are Citigroup, AT&T, Bank of America, Procter & Gamble, Pfizer, American International Group and Johnson & Johnson (see the table on page 28). It's a remarkably diverse portfolio that's slightly overweighted in financials and health care but includes representatives from most of the key sectors of the global economy: industrials, consumer products, energy and information technology. Retailing is the only big absentee.

Today's mega-caps are very different from those of just six and a half years ago, when the tech bubble was about to burst. In a Wall Street Journal article on March 14, 2000, Jeremy Siegel, a Kiplinger's columnist and a professor at the Wharton School, cited 33 stocks with market caps greater than $85 billion. Eighteen were high-tech companies, "an incredible nine currently have P/Es in excess of 100, and six of those are in the top 20."

I examined the 33 largest-cap stocks in the S&P 500 this year (the cutoff point was also right around $85 billion), and I found that only nine were tech companies -- 11 if you count telecoms AT&T and Verizon. As for P/Es, none was over 100, and just five were over 25. Only drug company Abbott Laboratories had a P/E higher than 50, and the reason was anomalously low earnings over the past year. Abbott's forward P/E, based on expected profits for the year ahead, is just 17.

The only companies that bear even a slight resemblance to the overblown large-caps of 1999 are two that I like a great deal but that don't make the cut for the Mega-Cap Portfolio: Google (symbol GOOG), with a P/E of 45, and Apple (AAPL), at 39. But Google's earnings are growing so fast that its PEG ratio (P/E divided by rate of earnings growth) is just 1.1 -- 1.0 is usually considered a raging bargain -- and its P/E is only 27, based on profit forecasts for 2008. Apple's PEG ratio is a modest 1.5, and its forward P/E is 30.

Compare Google, which has a market cap of $161 billion, with the high-tech mega-cap darlings of March 2000. Back then, Cisco Systems, which was earning less than Google is today, had a market cap of $452 billion and a P/E of 148. Cisco's cap has dropped by nearly two-thirds, and today its P/E is 24. Time Warner has also lost about two-thirds of its capitalization in seven years. The cap of Sun Microsystems has dropped from $149 billion to $18 billion, and Oracle's has fallen by half.

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Runaway trains

The lesson here is that mega-cap stocks can be heavily laden runaway trains about to hit a curve and jump off the tracks. Today's mega-caps, by contrast, are chugging along at a less-dangerous pace. If anything, they are undervalued in a market that, since the tech debacle, has preferred small companies and traditionally undervalued stocks over large, growing companies.

The Mega-Cap Portfolio is diversified not only by industry but by geography. Just as the high-tech mega-caps of the late 1990s reflected their era, the giants of 2007 are representatives of the age of globalization. If you buy these ten, you'll be buying the global marketplace and also getting exposure to the world's currencies beyond just the dollar.

In the first quarter, for example, ExxonMobil earned about $6 billion abroad and $2 billion in the U.S. Last year, about half of GE's sales were international -- up from just 22% in 1986. Citigroup has 200 million customer accounts in more than 100 countries and owns, among other assets, the third-largest stockbroker in Japan. Less than half of Procter & Gamble's sales last year were in North America, and more than one-fourth were in developing nations, mainly in Latin America and Asia. AIG, which operates in 130 countries, is, among other distinctions, the largest life insurer in Southeast Asia.

You are in charge

The real charm of the portfolio is its simplicity and the control it gives you, the investor, over your tax liability and stock preferences. With most mutual funds, it's the manager who gives the okay to buy or sell -- a decision that can sometimes be affected by how much money is flowing into or out of the fund. When you own individual stocks, the power is in your hands.

Yes, you could own an exchange-traded fund that tracks the S&P 500, such as Spiders (SPY), or you could buy Diamonds (DIA), which mimics the Dow Jones industrial average. The ten mega-cap stocks account for about one-fifth of the value of the S&P, but the smaller portfolio is nearly as well diversified, and right now it is better priced. As much as I admire the Dow, it is a quirky index, weighted by price rather than market cap. As a result, the much smaller IBM, for example, has more effect on the index's movement than GE and Microsoft combined. Other components are anachronisms whose inclusion in the Dow in 2007 can hardly be justified (for example, General Motors, with a market cap of $17 billion, or Alcoa, at $35 billion).

It's true that among the 30 stocks of the Dow are nine of the ten mega-caps -- all but Bank of America. But at this point I would rather own the concentrated version of the global economy than the diluted one. Not only are the mega-caps cheaper (the Dow, like the S&P, trades at a P/E of 18), but they are also growing impressively.

Reviewing Value Line Investment Survey's estimates, I calculate that the average annual earnings-growth rates over the next three to five years for the ten mega-caps is an impressive 9.5%. Even better, every stock but one is forecast to grow by at least 7%. For the group, dividend growth is estimated to exceed earnings, at 10%.

The prospective clunker is Pfizer. Its inclusion raises an interesting point: Why tolerate in this mega-cap portfolio a company that isn't firing on all cylinders? In the span of half a dozen years, Pfizer went from being one of the most-admired companies in the world to one nobody wants to talk about. Time and again, I've seen large companies stumble and then right themselves. In the case of this drug maker, investor expectations are very low -- look at that P/E of 11 -- so you're not taking that much of a chance.

Benefits of quality companies

Let's suppose that Value Line is correct about the earnings growth of these companies. Suppose also that the average P/E of the ten stocks rises from 16 to the S&P average of 18. Within five years, an investment of $10,000 would be worth $17,710. You'd be owning some awfully sound companies. Six carry a Value Line financial-strength rating of A++, three are rated A+, and one is an A (AIG). Earnings predictability for seven of the ten (AT&T, AIG and ExxonMobil are the exceptions) is at the top of the scale.

There are no guarantees, of course, but you get steady growers at decent prices -- and you know the companies, to boot.

Mega-caps: They're on a roll

After treading water for several years, stocks of the largest U.S. companies have advanced sharply over the past year. These are the ten biggest stocks by stock-market value.

Data to June 11. Sources: Yahoo, Barron's (P/E for S&P 500)

James K. Glassman is a senior fellow at the American Enterprise Institute and editor of its magazine, The American. Of the stocks recommended here, he owns Apple and General Electric.