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AJan 21, 2013

Predictable Returns For Market Cap Monsters?

Andrew Hallam

In 1999, I joined an investment club comprised of fellow school teachers. We used the service at Bivio.com to track our returns.  On the company homepage, they list the most popular holdings among America’s investment clubs.  After thirteen years of accessing Bivio’s site, I noticed something interesting.  The most widely held stock by investment clubs is usually the biggest (or nearly the biggest) company in America.  More than one third of investment clubs are drawn to the same monster market cap stock.

Should you follow their lead?  Perhaps not.  According to a study by finance professors Brad Barber and Terrance Odean the average investment club underperformed the market by 3.8 percent from 1991-1997.  Their love for market cap leaders could explain their lackluster performance. 

Our investment club soon discovered that buying popular stocks was a losing proposition.  We shifted towards buying unpopular businesses and have beaten the market since 1999.  

I’m calling our performance luck rather than skill.  But avoiding market cap leaders may have been a good strategy:

Cisco’s market cap was $538 billion in 2000. Now it’s $108 billion.
G.E.’s market cap was $581 billion the same year.  Now it’s $221 billion.
Exxon Mobil hit $465 billion in 2008.  Today it’s $408 billion.
Microsoft ruled with $600 billion in 2000.  Today it’s $221 billion.

Unfortunately, Cisco, GE, Exxon Mobil and Microsoft all underperformed the S&P 500 since basking in the market cap stratosphere. And it might not be a coincidence.  Researchers Robert Arnott and Lillian Wu recently published their findings suggesting that market cap leaders tend to be glamour stocks that underperform after cresting the market capitalization pile.  In The Winners Curse, they describe that the largest company in virtually every industry usually falls painfully from the perch.

In the U.S., 59 percent of market cap leaders underperform their sector in the year ahead. In the decade that follows, two thirds of market cap leaders underperform by an average of 3.7 percent each year.  Market cap leaders in international markets perform even worse.

Arnott and Wu site a few difficulties market cap monsters usually face. They’re targets for top competitors hungering for a piece of the action. Their size limits corporate flexibility. Their internal rivalries can create inefficiencies. And their new innovations don’t move the corporate needles as easily as they would with smaller companies.

In August 2011, Apple surpassed Exxon Mobil as the world’s largest company. According to Bivio, it’s also the most popular investment club stock in America.  Considering how poorly the average investment club performs, this could be a bad sign.  Thirty eight percent of America’s clubs own Apple.  In a possible prologue, the stock has underperformed the S&P 500 by 20 percent in the past three months.

Personally, I would like to see Apple buck the historical trend.  It could prove to be the market cap leader that continues to reward investors.  History, however, suggests otherwise.  And hope is a flimsy weapon for an investor to wield.

Filed Under: Investing