- Some of the world's largest companies have dominated
stock market returns in recent history.
For the five years ending July, 2020
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.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you what we can learn
from the recent returns of the world's biggest
and most exciting companies.
(upbeat music)
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.
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 markets' value
and Apple alone makes up around 6%.
These are huge companies with high prices,
also known as a 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,
it's actually nothing new.
From 1927 through 1979,
it was not unusual to have the largest company makeup
around 6% of the US stock markets value.
General Motors, AT&T and IBM took turns
over that time period as the largest company
in the US market,
routinely surpassing Apple's current 6% weight.
The story is similar for the historical contribution
of the largest five and largest 10 companies
to the US markets 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, does 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 has 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, they also have high prices
relative to their fundamental financial measures.
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.
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 markets 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
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 under-performance
of large cap growth stocks.
If we take the view that markets are rational,
that is investors rationally assign
a 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 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.
The return on assets for cheap stocks
is better than it has been historically,
and cheap stocks are less leverage
than they've been historically.
Okay, gross stocks are currently extremely expensive
relative to history,
which means their expected returns are low,
but none of this means
that you can't make money by investing in the next Amazon.
The trick is investing in it before it is 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
was 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 suggests
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 watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
If you enjoyed this video, please share it with someone
who you think could benefit from the information,
don't forget.
If you've run out of Common Sense Investing videos to watch,
you can tune in to weekly episodes
of the Rational Reminder Podcast
wherever you get your podcasts.
(upbeat music)