Tag Archives: market cap

Looking Beyond Apple and Microsoft

As the 1970s came to a close, six of the world’s ten largest companies were in the oil exploration, drilling, and services business. Just a few years earlier, on April 1, 1976, Steven Jobs and Steven Wozniak, two college dropouts working out of a garage, formed Apple Computers, Inc. In April 1975, Bill Gates and Paul Allen formed a company called Micro-Soft.

Four decades later, these two technology startups are the world’s largest companies, far surpassing the largest oil companies of the 1970s. In fact, the combined market capitalization of Microsoft and Apple is larger than the aggregate market cap of the domestic oil industry. Even more astounding, the combined market cap of Microsoft and Apple just surpassed the total market cap of the entire German stock market.

The table below shows the rotation of the world’s largest publically traded companies over the last fifty years. Of the companies shown below only five have been in the top ten for more than one decade.

Throughout history, most of the world’s largest companies are routinely supplanted by new and different companies from decade to decade. Furthermore, different industries tend to dominate each decade and then fade into the next decade as new industries dominate. For instance, in the 1970’s big oil accounted for six of the top ten largest companies. In the 1980’s, Japanese companies held eight of the top ten spots. In the 1990s it was telecom, the 2000s were controlled by banks and commodities, and this past decade was dominated by technology and social media companies.  

Throughout history, most of the world’s largest companies are routinely supplanted by new and different companies from decade to decade. Furthermore, different industries tend to dominate each decade and then fade into the next decade as new industries dominate. For instance, in the 1970’s big oil accounted for six of the top ten largest companies. In the 1980’s, Japanese companies held eight of the top ten spots. In the 1990s it was telecom, the 2000s were controlled by banks and commodities, and this past decade was dominated by technology and social media companies.  

While table offers several insights, we believe the most important lesson is that our investment strategies must focus on the future and our dependence on past strategies must be carefully considered. Today, two college dropouts in their parent’s basement fooling around with artificial intelligence, block chain, or robotics may prove to be worth more than Apple, Microsoft, or Amazon in just a few decades. The table also emphasizes the importance of selling high and rotating to that which has “value”.

To emphasize that point, we constructed the following graph. Although simple, it effectively illustrates the theme by comparing one stock looking backward and one stock looking forward as an investment strategy. The backward-looking strategy (blue line) buys the largest company at the end of each decade and holds it through the following decade. The forward-looking strategy (orange line), with the gift of 20/20 foresight, buys the company that will be the largest company at the end of the new decade and holds it for that decade.  For example, on January 1, 2010, the forward-looking strategy bought Microsoft and held it until December 31, 2019, while the backward-looking strategy bought Exxon and held it over the same period.

Due to the split-up of AT&T and poor price data, we used GM data which had the second largest market capitalization in 1969. For similar reasons, we also replaced Nippon Telephone and Telegraph (NTT) with The Bank of Tokyo. The graph is based on share price returns and is not inclusive of dividends.

The forward strategy beat the S&P 500 by over 12% a year, while the backward-looking strategy grossly underperformed with a negative cumulative annualized price return over the last 50 years. As startling as the differences are, they fail to provide proper context for the value of 50 years of compounding at the annualized rates of return as shown. If all three portfolios started with $100,000, the backward-looking portfolio would be worth $59,000 today, the S&P 500 worth $3,500,000 today, and the forward-looking portfolio would be worth $791,000,000 today.

Summary

Although no one knows what the top ten list will look like on December 31, 2029, we do know that the next ten years will not be like the last ten. The 2000’s brought two recessions and for the first time in recorded history, the 2010s brought NO recessions. Investors need to be opportunistic, flexible, creative and forward-looking in choosing investments. Investing in today’s winners is not likely to yield us the results of yesterday. It is difficult to fathom as Apple and Microsoft drive the entire market higher, but history warns that their breath-taking returns of the last decade should not be expected in the 2020’s. In fact, history and prudence argue one should sell high.

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

Value Your Wealth – Part Five: Market Cap

The first four articles in this series focused on what might be the most important pair of fundamental factors – growth and value. Those factors have provided investors long-standing, dependable above-market returns.  Now, we take the series in a different direction and focus on other factors that may also give us a leg up on the market. 

The term “a leg up” is important to clarify. In general, factor-based investing is used to gain positive alpha or performance that is relatively better than the market. While “better” than market returns are nice, investing based on factor analysis should not be the only protection you have when you fear that markets may decline sharply. The combination of factor investing and adjustments to your total equity exposure is a time-trusted recipe to avoid large drawdowns that impair your ability to compound wealth.

We continue this series with a discussion of market capitalization.

The four prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Market Cap

Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion. 

Most investors, along with those in the financial media, tend to distinguish companies market caps/size by grouping them into three broad tiers – small-cap, mid-cap, and large-cap. Over most periods, stocks in the three categories are well correlated. However, there are periods when they diverge, and we are currently amidst such a deviation. Since September 1, 2018, the price of the Large Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap S&P 600 Index is down 12.9%.  Deviations in historical relationships, whether short or long-term in nature, can provide investors an opportunity to capitalize on the normalization of the relationship, but timing is everything. 

Historical Relative Performance

The following graphs are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

The data set provides returns based on market cap groupings based on deciles. The first graph compares annualized total return and annualized volatility since 1926 of the top three (High) and bottom three (Low) market cap deciles as well as the average of those six deciles. To be clear, a decile is a discrete range of market caps reflecting the stocks in that group. For example, in a portfolio of 100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap stocks, decile two is the next ten smallest cap stocks, etc.

The next graph below uses monthly ten year rolling returns to compare total returns of the highest and lowest deciles. This graph is a barometer of the premium that small-cap investing typically delivers to long term investors.

The takeaway from both graphs is that small-cap stocks tend to outperform large-cap stocks more often than not. However, the historical premium does not come without a price. As shown in the first graph, volatility for the lowest size stocks is almost twice that of the largest. If you have a long time horizon and are able and willing to stay invested through volatile periods, small caps should fare better than large caps. 

Small-cap stocks, in general, have high expected growth rates because they are not limited by the constraints that hamper growth at larger companies. Unfortunately, small-cap earnings are more vulnerable to changes in industry trends, consumer preferences, economic conditions, market conditions, and other factors that larger companies are better equipped and diversified to manage. 

Periods of Divergence

The second graph above shows there are only three periods where large caps outperformed small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and, the post-financial crisis-era are worth considering in depth.

The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.

The 1990s Tech Boom- With double-digit inflation a distant memory and the swelling technology boom, larger companies that typically benefited most from lower rates, less inflation, and new technologies prospered. While this new technology benefited all companies in one form or another, larger ones had the investment budgets and borrowing capacity to leverage the movement and profit most. 

The 2010’s Post Financial Crisis Era –The current period of large-cap outperformance is unique as economic growth has been prolonged but below average and productivity growth has been negligible. Despite relatively weak economic factors, massive amounts of monetary stimulus has fueled record low corporate borrowing rates, which in turn have fueled stock buybacks. Further, the mass adaptation of passive cap-weighted investment strategies naturally favors companies with large market caps. Circularly, passive investing feeds on itself as indexed ETFs and mutual funds must increasingly allocate more to large caps which grow in size relative to the other holdings.

To reiterate an important point: the current period of outperformance is not based on solid economic fundamentals and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of monetary actions.

The graph below highlights the distinction between the current period and the two prior periods where large caps outperformed.  

Summary

Historically, small-cap stocks tend to provide a return premium over large-cap stocks. However, as we pointed out, there are periods where that is not the case. Currently, large-cap stocks are the beneficiaries of overly generous monetary and fiscal policy. We do believe the relationship will return to normal, but that will likely not occur until a bear market begins.

As we wait for a normalization of valuations and traditional relationships that have become so disfigured in this cycle, we consider the current relative valuations on small-cap stocks similar to those we described in value stocks earlier in this series. The time to weight your stock portfolio allocation more heavily toward small-cap opportunities is coming, but every investor must decide on their own or with good counsel from an advisor when to make that adjustment.  When appropriate, a gradual shift to small-cap stocks from large caps depends on an investor’s risk appetite and defensive preference.

More importantly, have a plan in place because when the market does meaningfully correct, the premium small-cap stocks provide will likely help cushion against a stock market correction.