10 big stocks for the large-cap rally

By Harry Domash

Judging by the headlines about the Dow hitting new highs, seemingly almost daily, it sounds like party time for the market. But that's not the case. If fact, only big stocks have been invited to this party.

Over the past three months, the Dow Jones Industrial Average ($INDU) has gained 5.1%, compared with 4.2% for the Standard & Poor's 500 Index ($INX). The Nasdaq Composite Index ($COMPX) was up only 0.4% for the period.

What's different about Dow stocks? They are bigger companies. The Dow's stocks have an average market capitalization of $147 billion, versus $28 billion for the S&P 500.

If you're not familiar with the term, market capitalization (recent share price multiplied by number of shares outstanding) is how much cash you'd have to come up with to buy all of a company's shares.

Intrigued by the Dow's outperformance, I did some research and confirmed that it is about large caps. In fact, I found that by sticking with the largest S&P stocks, those with market caps over its $28 billion average, you would have achieved a 5.6% gain, versus the Dow's 5.1% three-month return.

The reason for the big stocks' relative outperformance is anybody's guess, but, for now, it looks to me like that this is where you have to be if you want to join the party. With that in mind, here's a simple screen for finding big-cap stocks worthy of further research.

Only the biggest need apply

I'll start by defining my large-stock universe. As I mentioned above, stocks with market caps above the S&P's $28 billion average outperformed the overall S&P as well as the Dow. However, there was nothing magic about the $28 billion figure. In fact, I found that allowing stocks with market caps of $20 billion or higher improved the S&P's three-month return to 6.3%.

So I set my minimum market cap at $20 billion. Roughly 700 stocks out of the 5,000 or so U.S.-listed stocks fall into this category.

Screening parameter: Market Capitalization >= 20 billion

Profits and cash

Whether large or small, high tech or simple retail, profitable companies, both in terms of reported earnings and actual cash flow, are always your best bets.

Profitability ratios such as return on assets, return on equity and return on invested capital measure how efficiently a company employs its shareholders' capital to produce profits.

Return on equity (ROE), the most widely used profitability ratio, compares income with shareholders' equity or book value. One reason for its popularity is that ROE tells you how fast a company can fund earnings growth from its profits. For instance, a 20% ROE means that a company can grow earnings 20% annually without needing to raise additional capital, either from borrowing or by selling more shares. That's important because both of those alternatives tend to reduce earnings per share.

• Video: Time for large caps?

Many professional money managers that I've talked to won't touch a stock with lower than 15% ROE, so that what I've used here.

Screening parameter: Return on Equity >= 15

Thanks to flexible accounting rules, many companies manage to report positive earnings when, in fact, they are losing money when you count the cash. Operating cash flow measures how much cash actually moved into, or out of, a company's bank accounts.

Cash burners -- that is, companies with cash flowing out instead of in -- will eventually run out. Then, similar to low-ROE companies, they will have to raise additional cash from outside sources, which is bad for existing shareholders.

For now, we only need to know whether cash is flowing in or out, not necessarily how much. We can't screen for cash flow directly. However, we can accomplish the same thing by requiring a positive cash flow ratio. That ratio will only be positive when cash flow is positive.

Screening parameter: Price/cash flow >= 1

Applying the profitability and cash flow requirements reduced my pool of candidates down to 136 stocks.

Continued: Get sentimental

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