In the US, the biggest companies have outperformed. Why?

John Rekenthaler, VP of research for Morningstar, notes that the largest U.S. companies have significantly outperformed their smaller rivals since 2013..
By Morningstar Analysts |  08-08-18 | 
 

Apple became the world's first trillion dollar company last week. But this milestone was not an anomaly: the top 1% of U.S. companies have outgunned their rivals since the 2008 financial crisis, with most of these gains made in the last five years.

An investor in August 2013 who sorted all publicly traded firms in the U.S. stock market by their market caps from largest to smallest, selected the top 1%, invested equally in each of those 67 stocks, and then held that portfolio until 2018 would have gained an annualised 13% over the next five years. In contrast, someone who employed the same tactic for the remaining 99% wouldn't have made a penny. Since 1926, half of all listed U.S. stocks have posted negative returns.

The latter finding isn't completely surprising. As I once wrote, most stocks stink--not just for five years, but forever. Half of all issues contained in the Center for Research in Security Prices' U.S. stock-market database, which dates to 1926, have posted negative returns for their lifetimes. Thus, the tactic of investing equally across the market's smaller 99% only succeeds if the winners are so huge as to overcome the majority's drag. Sometimes, that occurs--but not in this case, for the hypothetical buy-and-hold August 2013 investor.

What is unexpected is that the largest companies fared so well. Only four among the 67 lost money for the half-decade.

Why?

  • More reliable?

Granted, big companies are more reliable than small fries--the nature of a blue chip being to grind out a moderate gain rather than go boom or bust--but even so, that is a very high success rate. The investor in the top 1% did not even need to purchase a basket of securities; a handful of darts would have been enough.

  • Are indexes to blame?

The conventional argument is investor demand, particularly for tech stocks like Apple, Amazon and Facebook, has driven valuations higher and forced index funds to allocate more of their money to the biggest firms.

The influence of index funds on stock-market prices is overstated, because they are the visible portion of the investment iceberg. As registered funds, their inflows are monitored far more closely than are those of the other major sources of assets, such as pensions and sovereign wealth funds. There's no index fund argument that can explain why the largest 1% of companies – fewer than 70 businesses – would outgain the rest of the firms that make up the S&P 500. Top firms do not receive any special favours.

  • Sentiment? 

Could there be evidence suggesting that the market's biggest companies have benefited from sentiment?

I examined how much of each group's results owed to fundamental factors, such as growth in earnings or revenues, and how much to something else. Presumably, the former is a more trustworthy source of stock-market returns than the latter.

I did find a difference between the two groups, although not in the direction I expected.

For the top 1%, the correlation between stock-market performance and earnings growth, with each item being measured over the trailing 5 years, was 0.41. That is, companies that grew their earnings most rapidly tended to post the highest stock-market gains. (For example,  Facebook and Amazon.) The relationship between stock returns and earnings growth was not overwhelmingly strong, but it was significant--and higher than the 0.26 correlation that was registered by the remaining 99%.

The stock prices of the market's biggest companies were more linked with their earnings growth than with the rest of the marketplace, not less so.

The pattern was even more pronounced with top-line growth. While the broad market showed a similar, 0.27 correlation between stock-market performance and 5-year revenue growth, the top 1% of companies measured at 0.61. For many of the largest companies, knowing only their future revenue growth would have sufficed to predict their relative stock-market performance.

After reviewing the evidence, I am satisfied with the internal logic of the blue-chip group.

Broadly speaking, stock-market performance was proportional to the companies' economic achievements. Firms that grew their businesses the most rapidly had the highest stock-market gains; those that placed in the middle typically finished in the middle; and those that recorded flat to negative fundamentals were mostly duds. Examples are Merck & Co, IBM, American Express, Chevron and Coca-Cola.

Over the past several years, the stock market has become tiered.

The largest companies have been better investments than have the rest of the marketplace. Within that large-company group, there has been a significant gap between the relative haves and have-nots. Broadly speaking, stock market performance was proportional to the companies' economic achievements.

Firms that grew their businesses the most rapidly had the highest stock-market gains; those that placed in the middle typically finished in the middle; and those that recorded flat to negative fundamentals were mostly duds.

Do note....

The above analysis does not address those stocks' absolute valuations. Blue chips seem reasonably priced when compared with each other, but perhaps not when compared against other assets. It may be that smaller-company shares are currently the better choice, or bonds, or cash. This article does not address that issue. Nor does it advocate for or against large-company U.S. stocks. It merely defends their relative pricing.

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