A year when big will be beautiful again?

Will big be beautiful in 2014? After two years during which small companies have been the place to be for the best returns on equity investments, some market analysts believe the next stage of the market cycle will see large companies forge ahead.

That has been a characteristic of bull markets in the past, with anxious investors often embracing larger companies' earnings stability during the latter stages of outperformance from equities. It also helps that large companies are likely to be internationally diversified, so they stand to benefit as the global outlook improves.

"Larger companies tend to have a global business bias," agrees Brian Dennehy, managing director of FundExpert. co.uk.

"So if you believe that the global economy is going on a tear in 2014, perhaps you should buy larger companies, though that's a big call to make."

Stronger UK recovery

Against that, the UK economic recovery appears to be stronger than the bounce-back in, say, Europe, or even the US, which might give more domestically focused companies an advantage this year. There is also the risk posed by the US Federal Reserve's tapering of quantitative easing (QE).

"The impact of this will be a gradual rise in interest rates in the US, and that may help push rates up around the world, including in the UK," says Alan Solomons of Alpha Investments and Financial Planning.

"Government securities and corporate bonds will decline in value as their price responds inversely to the yield, and as UK blue chips have in many cases been used as quasi corporate bonds, they may be affected in a similar way."

Nevertheless, almost all investors building diversified portfolios will want some exposure to larger UK companies this year.

Ben Yearsley, head of investment research at stockbroker Charles Stanley Direct, says: "A pick-up in the global economy and especially China will have a major impact on the resource sector, which could boost the FTSE 100 (UKX), [but even without that] I would still buy larger companies on dividend yield and growth prospects."

So what is a large company? While there's no strict definition of large, most investors would certainly include the FTSE 100 index's constituents. At the end of last year, two new companies joined the FTSE 100 of blue-chip stocks, replacing two businesses they have now overtaken in terms of market capitalisation.

The first, Royal Mail, went straight into the index following its privatisation. The second, equipment hire firm Ashtead, joined after its market capitalisation reached £3.9 billion.

On the reserve list

A number of companies are so close in size to this entry level for the FTSE 100 that FTSE Group, which compiles the index, has them on the reserve list. 3i Group, Berkeley Group, Direct Line, Merlin Entertainment and Taylor Wimpey all have market caps in excess of £3.5 billion.

Healthcare continues to look cheap and has strong and very stable earnings growth over the long term."Adrian Lowcock

In addition, many companies that aren't quite so big would still be thought of as large-cap by many investors.

A business would need a market capitalisation in excess of £250-300 million to make it into the FTSE 250 index of the next largest companies after the blue chips, but many are worth between £2 billion and £3.5 billion.

In contrast, at the other end of the FTSE All-Share, the smallest businesses are worth around £100 million. These smaller companies, starting from a lower base, can produce larger gains more quickly at certain times, which is what we've seen over the past two years. But that's not to say larger companies won't outperform at other times - and returns have been improving.

Indeed, analysts at Citigroup have tipped the FTSE 100 to rise above 8000 by the end of 2014. With the FTSE 100 currently close to its all-time high of 6930 at the time of writing, investors may be feeling cautious about large-cap valuations. But the difference between the market today and late 1999, when that high was achieved, is that companies' earnings appear to justify their ratings.

Large caps currently trade on around 14 times forward earnings, which is below the long-term average of 15.2 times. Even the price of growth stocks, at around 20 times earnings, isn't overly forbidding in a historical context, while high-yield large-cap stocks are trading on price/earnings ratios of below 12, compared to a long-term average of above 13.

UK large caps still offer value

In other words, says Adrian Lowcock, senior investment manager at broke Hargreaves Lansdown, "UK large caps still offer value". However, he believes that in this area some sectors of the market offer better prospects than others.

Some of the more contrarian managers I speak to have been upping their weighting to the FTSE 100 in the last month or so."Darius McDermott

"Healthcare continues to look cheap and this sector has strong and very stable earnings growth over the long term," he says.

"Other popular sectors in 2013, such as consumer goods and financials, look more expensive at the moment, but an economic recovery could drive earnings improvements, so there is potential for these areas of the markets to continue to perform."

Another interesting area is basic materials, where last year saw sentiment turn against many companies. "The sector is beginning to look cheap, though momentum is still against it, so I would suggest drip-feeding money in," Lowcock says.

A recovery from the natural resources sector would certainly help large-cap stocks' performance relative to smaller companies, since last year's difficulties for the sector were a significant contributory factor in large-cap underperformance.

Overall, large-cap stocks made about 19% in 2013, but the 30 percentage point underperformance of mining stocks meant the FTSE 100 lagged small and medium-cap indices, which returned 44% and 32% respectively.

Hedge bets

In practice, suggests Darius McDermott, managing director of broker Chelsea Financial Services, it may be wise to hedge your bets, since the UK economic outlook suggests smaller businesses may continue to do better for a while yet.

"Some of the more contrarian managers I speak to have been upping their weighting to the FTSE 100 in the last month or so - Alex Wright at Fidelity Special Situations and the JOHCM UK Equity Income guys, for example," says McDermott.

"But longer-term, I think mid and small caps will continue to outperform - that's why I tend to prefer multi-cap funds, which are able to adjust their weightings accordingly.'