Why the largest companies are too big to succeed


The allure of the largest U.S. technology companies is understandable given significant returns last year, but their sheer size is the reason for their eventual downfall and long-term stock underperformance, according to Rob Arnott, founder of Research Affiliates.

Investing in equal proportions only in the largest five tech companies in 2017Amazon.comInc.
AMZN, +1.71%
Apple Inc.
AAPL, -2.41%
Google-parentAlphabet Inc.
GOOG, +0.93%
GOOGL, +1.06%
Microsoft Corp
MSFT, -0.65%
and Facebook Inc.
FB, +0.68%
would have returned nearly 44%, more than double of the S&P 500 total return of about 20%.


The S&P 500
SPX, -0.78%
is up 0.6% since the start of the year, but a portfolio of the same top five companies is up about 9%.

Given such outsize returns, investors might question the wisdom of diversification, however, history suggests that the shares of the biggest companies tend to underperform their respective sectors over the following 10 years.


In other words, holding just those aforementioned large-cap names, or a even a heavy concentration of those stocks in a portfolio, will eventually lead to underperformance, compared against a broader and more diversified investment basket, research has found.

On average, about seven of the 10 largest companies by market value in the S&P 500 underperformed their industry over the following decade by about 7 percentage points, based on research going back to 1997, according WSJ Market Data Group.

Arnott produced similar results by analyzing stock returns globally over six decades in a 2012 study, titled Too big to succeed.


We found that two-thirds of the largest companies in the world underperformed their own sector over the ensuing 10 yearsby an average 4.70% a year, Arnott said in a recent interview with MarketWatch.


The persistent outperformance of todays largest tech companies isnt sustainable in the long run, according to Arnott.

Future success of these companies seems assured in the same way future success of tech companies in 2000 seemed assured. Back then, each had a compelling story. But of the 10 largest tech companies two failed and none outperformed the S&P 500 over the following 18 years, Arnott explained.

nasdaqlostyears


The two companies that Arnott referenced are Dell and Sun Microsystems. Dell was taken private in 2013 after losing 76% of its value from its peak in March of 2000. Sun Microsystems was bought by Oracle in 2010 after losing more than 90% of its value from peaking in early 2000.

Indeed, the Nasdaq Composite Index
COMP, -0.88%
took about 17 years to put in a fresh all-time high after peaking in early 2000 during the dot-com bubble.


Could investors make the case that somehow it is different this time and that the largest companies, most of which happen to be technology corporations have learned to keep profit margins high?

The S&P 500 Technology sectors net profit margins have been rising since 2008. Net margin for the S&P 500s tech sector in 2017 was at 17.5 according to FactSet, much higher than the 9.5 ratio for the broader S&P 500 index.

Arnott, however, doubts that such profitability can be sustained.

Once companies grow to be the biggest their ability to keep growing and innovating declines. Moreover, they attract attention of regulators and competitors who want to disrupt their business, Arnott said.


Arnott brings up Facebook scandal centered on social networks management of user information, which punished the companys shares and ultimately led to its CEO Mark Zuckerberg testifying on Capitol Hill for two days, as one such example.

Check out: Opinion: This one number proves Facebooks data scandal is already history

The possibility of Facebook facing regulatory pressure did not register on anyones radar until Cambridge Analytica news. Facebooks business model of harnessing private information for advertising purposes is now viewed as a bug, but it was a feature to begin with, Arnott said.


More: What Facebook and other tech leaders must do now to win back our trust

Arnott said high valuations present another problem for the largest companies, leading them to underperform.

Most of these companies also tend to be priced at lofty valuations, reflecting a consensus view that they will remain on top and continue to grow handily. Any disappointments can be severely punished, he said.

Since most index funds are weighted based on a companys market cap, it is hard to avoid being exposed to the largest companies.

Arnott, who is considered the most prominent authority in so-called factor-based or smart-beta investing suggests using index funds that are weighted according to fundamentals. Smart-beta investing refers to funds that use rules, or factors, like those targeting volatility, market cap, as well as value and growthto name a fewto deliver certain investment targets.


Any indexing that can break the link with the prices of the stocks would outperform in the longer run, Arnott said.

Equal-weighted indexes, where the allocations of components within the fund arent based on size, could be one such strategy for investors, with an abundance of evidence supporting this notion.

Below a chart from Arnotts paper shows that an equal-weighted portfolio of the largest 1,000 U.S. companies trumps the cap-weighted one by a hefty margin.


Read: How a more balanced S&P 500 can lead to richer returns

Investors who are enamored with short-term returns of popular stocks would be better off staying disciplined and having a diversified portfolio in the long run.

The very business practices that drive an enterprise to the top might not necessarily make the company a good investment [over the long term]. Bigger isnt always better, Arnott said.

Related Topics U.S. Stocks Markets NY Stock Exchange NASDAQ


Quote References AMZN +26.05 +1.71% AAPL -4.28 -2.41% GOOG +9.92 +0.93% GOOGL +11.41 +1.06% MSFT -0.63 -0.65% FB +1.13 +0.68% SPX -21.13 -0.78% COMP -64.20 -0.88% Show all references
MarketWatch Partner Center
Most Popular Watch for violent selloff to thwart Saudis wish for $100 oil Stock market loses ground, with tech and consumer staples leading the skid Jeff Bezos: Amazon employees should start meetings by reading memos with the clarity of angels singing The Trump risk in the markets is still hard to quantify What every cannabis investor should be paranoid about Anora M. Gaudiano


Anora M. Gaudiano is a MarketWatch markets reporter based in New York.

$(function () { if (typeof dianomiUnitCallback !== ‘undefined’) { var dianomiCallback = new dianomiUnitCallback(‘articlerightrail’, 2583, ‘dianomiRightRail’, ”,

Leave a Reply

Your email address will not be published. Required fields are marked *