What if you purchased the largest companies by market cap over each decade?

On the surface investing looks seductively easy, with legendary investors like Warren Buffett telling us to just buy good companies; it is no surprise that many investors are lured into believing they can do the same.

However in trying to emulate them, the average investor typically buys the winning stocks of the last decade (performance chasing), and these are usually the companies with the largest market capitalization. This approach has produced decidedly mediocre results, underperforming the market averages.

Researchers at Dimensional Fund Advisors have examined the performance of stocks following the year they became one of the 10 largest companies, the period covers 1927 to 2019.

To summarize their findings:

-Over the five to 10-year periods before becoming one of the 10 largest companies, they outperformed the market by 19.3% per annum and 10.0% per annum respectively.

-Over the five to 10-year periods after becoming one of the 10 largest, they underperformed the market by 1.1% per annum and 1.5% per annum respectively.

See below:

The average annualised outperformance of stocks before and after becoming one of the 10 largest in the US.

This is compared to Fama/French Total US Market Research Index, 1927–2019.

Source: Dimensional Fund Advisor

The conclusion is that the winning stocks of the last decade often become the losing stocks over the next. A general law of investing is that when investors collectively expect outsized returns, they more or less guarantee the opposite.

FAANG

Today FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) are the largest stocks by market capitalization, having delivered an annual return of more than 34% over the last 10 years, twice that of the 15% for the S&P 500 index.

With high expectations and profits already incorporated into the share price, these stocks are vulnerable to the slightest pinprick of negative news, triggering an outsized price reaction to the downside. And vice versa, being priced to perfection leaves little room for positive surprises which can push the shares prices to new heights.

Visual Capitalist looked at the history of the largest companies by market cap from 1999 to 2019. They found that in 2009 banks and energy giants dominated the indices, only to see their positions undermined by the collapse in oil prices and the financial crisis.

While it is hard to believe now, Exxon Mobil was the second largest company in the world in 2014; today they have been displaced by the likes of Amazon, Google and Apple. Companies which once looked unstoppable have fallen victim to unforeseen events (Great recession) and creative destruction (Fracking) — these only become obvious in hindsight.

Takeaway

The only constant over time is change, the businesses which have succeeded yesterday (capital intensive and energy) are much different to the types of business which are succeeding today (software).

‘The intelligent Investor’ by Benjamin Graham is regarded as one of the greatest investing books of all time, except it has one major problem, that most of the formulas in it don’t work anymore. This is because economies and markets are continually evolving, what worked in the past no longer works today.

In his book ‘Investing, The Last Liberal Art’, Robert Hagstrom wrote about the techniques that worked in the past, but eventually became redundant:

“In the 1930s and 1940s, the discount-to-hard-book-value strategy was dominant. After World War II and into the 1950s, the second major strategy that dominated finance was the dividend model. By the 1960s investors exchanged stocks paying high dividends for companies expected to grow earnings. By the 1980s a fourth strategy took over. Investors began to favour cash-flow models over earnings models. Today it appears that a fifth strategy is emerging: cash return on invested capital.”

Applying these strategies today guarantees below average performance, nothing works indefinitely.

To make matters more difficult, we know that the Pareto principle applies to the stock market, where a tiny number of stocks generate the majority of market returns. Finding them is hard enough, but identifying when and how they become disrupted, which metrics will work in the future and then searching for the next batch of winnings stocks is extremely challenging.

In my view, this underscores the importance of holding a broadly diversified equity portfolio across a wide array of companies, sectors and geographies.