With stocks, bigger isn’t better: Andrew Hallam

Market cap leaders are poor performers

(Photo by Ramin Talaie/Getty Images)

(Photo by Ramin Talaie/Getty Images)

Google’s stock has made some impressive headway in the past year, gaining 19% over the 12 months ending in September 2013. With former tech darling Apple slumping more than 30% from its $700 high over the same period, many investors are thinking about dumping the losing stock for the winning one. They probably shouldn’t. In fact, they should steer clear of both.

I have nothing against Google as a business. But it’s now one of the 10 largest stocks on the S&P 500 index, with a market capitalization just shy of $300 billion. And for this reason alone, you may want to steer clear. Sound like a crazy rationale? It isn’t. While some market-cap leaders have done well, historically they have failed to impress.

Between 1926 and 2006, the S&P 500’s 10 largest stocks by market cap underperformed the market by 2.9% the subsequent year. After three years, they lagged by 11.1%; after five years, by 17.7%; and after 10 years they were 29.4% behind. During the 81-year period looked at by the study, the Top 10 companies have never, as a group, outperformed the S&P 500 in subsequent years. Having some of the biggest market caps in the world turns out to be no advantage for these companies; in fact, it puts the odds squarely against them.

The study in question ended in 2006. On average, it found that seven out of 10 market-cap leaders tended to underperform the S&P 500. I wanted to check the performance of the market-cap leaders more recently, and compare their aggregate performance with the S&P 500 using the same method. I found that during the 12 months ending on Oct. 1, seven of the leaders underperformed the S&P 500 index: Apple, Exxon Mobil, Google, Microsoft, General Electric, Wal-Mart and Chevron. Only Berkshire Hathaway, Johnson & Johnson and Wells Fargo beat the index (and not by a very large margin even then). If you’re a stock picker faced with such long odds, you may want to sidestep the whole lot.

Is this just a statistical anomaly? Perhaps not. Benjamin Graham, Warren Buffett’s former mentor, once suggested that the stock market is a popularity contest over the short term, but over the long term, it’s a weighing machine. Although the largest 10 stocks at any given time are usually heavyweights in the business earnings department, they’re rarely the 10 most profitable companies. The market, therefore, pushes some stocks into lofty positions beyond their respective economic footprints. And because, as Graham notes, the stock market is a long-term weighing machine, popular stocks undeserving of their market-cap status eventually realign with their intrinsic values. Markets, according to Graham, are only efficient over the long term.

This could explain the poor results of market cap leaders: most of them don’t deserve their place at the top. Their economic footprint doesn’t justify their lofty price. For example, of the 10 current market-cap leaders, only half—Wal-Mart, Exxon Mobil, Chevron, Berkshire Hathaway and Apple—have revenues that would place them in the Top 10 for S&P 500 companies.

The middling-to-poor performance of market-cap leaders didn’t escape researchers Robert D. Arnott, Jason C. Hsu and John M. West. Authors of The Fundamental Index: A Better Way to Invest, they found that building indexes based purely on market cap produced worse returns than indexes based on other measures. They suggested weighting companies in an index by metrics that tell you more about how good the business is rather than just how big it is. That means weighting stocks in an index by qualities such as earnings, cash flow, dividends and book values rather than the sheer size of their market caps.

With only three of the 10 market-cap leaders on average proving to historically beat the S&P 500, Google might be one of the lucky trio. But investing, remember, is all about statistical probabilities. If you do buy a market-cap leader, be aware of the odds against it. Swimming in groups might be safer than swimming solo, but not when you’re investing.

Andrew Hallam is the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School.