INVESTING

The Market’s Biggest Names Aren’t Always the Smartest Investments

Why market leaders don’t always create the best returns for investors

Photo by micheile henderson on Unsplash

Some of the world’s largest companies have dominated stock market returns in recent history.

For the year ending, an equal-weighted portfolio of Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla more than quadrupled in value, leaving a total market index fund investor in the dust. Who knew beating the market could be so easy?

The stock market can be sorted into nine broad categories based on size and relative price.

Company size is measured by market capitalization, the total value of a company’s outstanding shares.

Source: Edited y Author

Relative price is measured by the company’s price relative to some fundamental measure like its book value or earnings.

Value stocks have low prices relative to their fundamentals, while growth stocks have high prices.

The five biggest companies in the US market, Facebook, Apple, Amazon, Alphabet, and Microsoft, currently make up nearly 20% of the US stock market’s value, and Apple alone makes up around 6%.

These are huge companies with high prices, also known as large-cap growth stocks.

Between their unbelievable recent returns and their world-changing products and services, it is easy to believe that this time is different and that these are the only stocks that you need to own.

Well, it may seem like uncharted territory, but it’s actually nothing new.

From 1927 through 1979, it was not unusual to have the largest company make up around 6% of the US stock market’s value.

General Motors, AT&T, and IBM took turns over that time period as the largest companies in the US market, routinely surpassing Apple’s current 6% weight.

The story is similar for the historical contribution of the largest five and the largest 10 companies to the US market’s total value.

All right, so these companies aren’t unusually huge relative to market history, but the network effects, infinite scale, and ever-increasing data advantage that today’s biggest companies have do seem unprecedented.

But consider this: in the 1930s, AT&T was the largest US company.

Alexander Graham Bell had invented the telephone in 1876, and by 1885, his company began to build out the telephone network.

Think about that for a moment. Telephones did not exist until this company started creating them, and they built and owned the telephone network.

AT&T quickly became and remained the most valuable US company for decades.

Other innovative companies have similarly grown to and maintained tremendous size and dominance for decades.

Massive companies like General Motors, which created the electric car starter, airbags, and the automatic transmission, and General Electric, which made electric lighting mainstream, have played crucial roles in shaping the world that we live in today, but that has not necessarily made them good long-term investments.

For each decade, starting 1930, 1940, 1950, and so on through 2010, the 10 largest companies at the start of the decade have made up, on average, 23.6% of the US stock market.

The average annual returns of those 10 largest companies for the following decade have trailed the market by an annualized 1.51% on average.

To understand why massive, successful, world-changing companies can trail the stock market, let’s consider where stock returns come from.

There are two primary components: the expected return and the unexpected return.

A stock’s value is theoretically the discounted price that the market is willing to pay for the company’s expected future profits.

The expected stock return is the discount rate applied to those expected future profits.

If you expect a company to deliver some level of profits, and you buy those expected profits at a 7% discount, you expect to earn a 7% return on your investment.

The unexpected stock return comes from new, previously unknown information that gets included in the price when it becomes known.

For example, a company releasing earnings that are much better than expected may result in its price increasing to reflect now higher expectations for future profits. An unexpected pandemic might have the opposite effect.

When it comes to long-term investing, it is not possible to predict the unexpected portion of returns. So, I think it’s pretty sensible to focus on the expected return.

Companies like Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla are not only huge, but they also have high prices relative to their fundamental financial measures.

Data Source: Morninhstar direct

When I say high, I mean high. The relative price of US large cap growth stocks is always going to be high compared to the overall market, based on growth stocks being, by definition, the most expensive stocks in the market.

But the current level of expensiveness for these companies is looking a lot like it did at the beginning of 2000, which was followed by a decade of negative returns for US large cap growth stocks.

Data Source: Dimensional returns web

That anecdote makes sense when we again consider where expected stock returns come from.

High relative prices reflect some combination of low discount rates and high expectations for future profits.

If these companies deliver on the market’s exceptionally high expectations, that is, they don’t exceed them or fail to meet them, all else equal, they should deliver on the expected return of the large-cap growth asset class.

For these companies to continue delivering unexpectedly good stock returns, they will need to deliver financial results that are better than the already high expectations that the market has set for them.

Betting that this will happen is a bet against what the aggregate market expects, a bet that can pay off sometimes, but usually doesn’t.

If we can agree that betting on unexpected returns doesn’t make a whole lot of sense, and I know that’s a big if, we need to turn our focus to the expected returns of the large-cap growth asset class.

Large-cap growth stocks have historically delivered lower average returns than smaller and cheaper stocks over most time periods in the US and around the world.

That statement is supported by the Academic Literature.[ In their landmark 1992 paper in the Journal of Finance, Eugene Fama and Kenneth French documented the evidence ](https://www.bauer.uh.edu/rsusmel/phd/Fama-French_JFE93.pdf)that larger companies have lower average returns than smaller companies, and more expensive companies have lower average returns than less expensive companies.

From a theoretical perspective, there are two ways to think about the historical underperformance of large-cap growth stocks.

If we take the view that markets are rational, that is, investors rationally assign reasonable expectations for future profits, then differences in expected returns are based on differences in risk.

Given a level of expected profits, a company that is viewed as less risky will have a lower discount rate, and therefore a higher price.

If we take the view that markets are not always rational, the lower average returns of the most expensive stocks could be explained by investors irrationally extrapolating the high growth of successful firms too far into the future, leading to their prices rising higher than what the business fundamentals could ever reasonably justify.

When the prices eventually correct back to something more reasonable, they drag investor returns down with them.

**In a 2012 paper titled “Identifying Expectation Errors in Value/Glamor Strategies of Fundamental Analysis Approach,”** Joseph Piotrowski and Eric So take the irrational pricing view, documenting evidence that the glamor effect of high-priced stocks underperforming is related to a reversal of erroneous expectations, where expectations in the price are incongruent with current trends in firms’ fundamentals.

They also find that this effect is strongest during periods of high investor sentiment.

Cliff Asness, the founder of AQR Capital Management, wrote in May, 2020 about how wide the valuation spread between expensive and cheap stocks had gotten.

At that time, the price to book spread, that is, the ratio of how expensive growth stocks are relative to value stocks, was as wide as it has been for the past 50 years.

Now, it’s important to consider here that this might be reasonable if today’s expensive companies are truly increasingly better businesses than their less expensive counterparts.

In the language of Piotrowski and So, if the expectations in the price are congruent with the current trends in the firm’s fundamentals.

Cliff showed that this is simply not the case. The difference in business quality between expensive and cheap stocks, measured by gross profitability, return on assets, and debt to equity, does not explain the unusually large spread in relative price.

Differences in gross profitability are currently in line with historical averages.

source: AQR, CRSP, XPressFeed.

The return on assets for cheap stocks is better than it has been historically, and cheap stocks are less leveraged than they’ve been historically.

Okay, growth stocks are currently extremely expensive relative to history, which means their expected returns are low, but this means that you can’t make money by investing in the next Amazon.

The trick is investing in it before it becomes one of the world’s largest companies. That’s easier said than done.

**In a 2019 paper titled “Do Global Stocks Outperform US Treasury Bills,”** the authors demonstrate that there is an extreme positive skew in individual stock returns.

That is, most stocks trail the market, while an exceptional few deliver massive returns.

More specifically, they studied nearly 62,000 global common stocks from 1990 through 2018, and found that 56% of US stocks and 61% of non-US stocks underperformed one-month US treasury bills over the full period.

Even more striking was the finding that the top performing 1.3% of firms in the sample were responsible for the net wealth creation of the entire sample, while the remaining 98.7% of firms collectively matched the returns of one month US treasury bills.

There is a good chance that today’s largest companies made significant contributions to global net wealth creation on their way to becoming massive companies.

But now that they are there, their expected future returns are relatively low.

Large-cap growth stocks have been on a phenomenal run, delivering huge unexpected returns, and the biggest, most well-known companies have been front and center.

As hard as it may be to ignore that hype, betting on future unexpected returns is a gamble, and based on the huge positive skew in stock returns, it’s a gamble with a negative expected outcome.

The theory and evidence strongly suggest that the expected returns of large-cap growth companies, as an asset class, including the companies that are shaping the world, trail the market.

With no way to predict what will do well in the short run, either at the individual stock level or the asset class level, the best thing that we can do is consistently own the entire market, value and growth, large and small, and everything in between, which we can do very easily using low-cost total market index funds.

If you need more excitement than that, starting with the market and then adding some extra weight to value stocks, or better yet, small-cap value stocks, is a much more statistically reliable bet than following the crowd into large-cap growth stocks.

Thanks for reading :) & FOLLOW ON SUBSTACK