- Some of the world's largest
companies have dominated stock market returns in recent history. For the five years ending July, 2020 an equal weighted portfolio
of Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla more than quadrupled in value, leaving a total market index fund investor in the dust. Who knew beating the
market could be so easy. I'm Ben Felix, Portfolio
Manager at PWL Capital. In this episode of Common Sense Investing, I'm going to tell you what we can learn from the recent returns
of the world's biggest and most exciting companies. (upbeat music) The stock market can be sorted into nine broad categories based on size and relative price. Company size is measured
by market capitalization, the total value of a
company's outstanding shares. Relative price is measured
by the company's price relative to some fundamental
measure like its book value or earnings. Value stocks have low prices
relative to their fundamentals while growth stocks have high prices. The five biggest companies
in the US market, Facebook, Apple, Amazon,
Alphabet and Microsoft currently make up nearly 20% of the US stock markets' value and Apple alone makes up around 6%. These are huge companies with high prices, also known as a large cap growth stocks. Between their unbelievable recent returns and their world changing
products and services, it is easy to believe that
this time is different and that these are the only
stocks that you need to own. Well, it may seem like
uncharted territory, it's actually nothing new. From 1927 through 1979, it was not unusual to have
the largest company makeup around 6% of the US stock markets value. General Motors, AT&T and IBM took turns over that time period
as the largest company in the US market, routinely surpassing
Apple's current 6% weight. The story is similar for
the historical contribution of the largest five and
largest 10 companies to the US markets total value. All right, so these companies
aren't unusually huge relative to market history, but the network effects infinite scale and ever increasing data
advantage that today's biggest companies have,
does seem unprecedented. But consider this, in the 1930s AT&T was the largest US company. Alexander Graham Bell had
invented the telephone in 1876 and by 1885 his
company began to build out the telephone network. Think about that for a moment. Telephones did not exist until this company started
creating them and they built and owned the telephone network. AT&T quickly became and
remained the most valuable US company for decades. Other innovative companies
have similarly grown to and maintained tremendous
size and dominance for decades. Massive companies like General Motors which created the electric
car starter, airbags and the automatic transmission
and General Electric which made electric lighting mainstream, have played crucial roles
in shaping the world that we live in today, but
that has not necessarily made them good long-term investments. For each decade, starting 1930, 1940, 1950 and so on through 2010,
the 10 largest companies at the start of the decade have made up on average 23.6% of
the US stock market. The average annual returns
of those 10 largest companies for the following decade
has trailed the market by an annualized 1.51% on average. To understand why massive successful world changing companies can
trail the stock market, let's consider where
stock returns come from. There are two primary components, the expected return and
the unexpected return. A stock's value is theoretically
the discounted price that the market is willing to pay for the company's expected future profits. The expected stock return
is the discount rate applied to those expected future profits. If you expect a company to
deliver some level of profits and you buy those expected
profits at a 7% discount, you expect to earn a 7%
return on your investment. The unexpected stock return comes from new previously unknown
information that gets included in the price when it becomes known. For example, a company releasing earnings that are much better than
expected may result in its price increasing to reflect
now higher expectations for future profits. An unexpected pandemic might
have the opposite effect. When it comes to long-term
investing it is not possible to predict the unexpected
portion of returns. So I think it's pretty sensible to focus on the expected return. Companies like Facebook, Apple,
Amazon, Alphabet, Microsoft and Tesla are not only huge,
they also have high prices relative to their fundamental
financial measures. When I say high, I mean high,
the relative price of US large cap growth stocks
is always going to be high compared to the overall
market based on growth stocks being by definition, the most expensive stocks in the market. But the current level of expensiveness for these companies is
looking a lot like it did at the beginning of 2000,
which was followed by a decade of negative returns for US
large cap growth stocks. That anecdote makes sense when we again consider where expected
stock returns come from. High relative prices
reflect some combination of low discount rates
and high expectations for future profits. If these companies deliver on the markets exceptionally
high expectations, that is they don't exceed
them or fail to meet them all else equal, they should
deliver on the expected return of the large cap growth asset class. For these companies to continue delivering unexpectedly good stock returns, they will need to deliver
financial results that are better than the already high
expectations that the market has set for them. Betting that this will happen is a bet against what the aggregate market expects. A bet that can pay off
sometimes, but usually doesn't. If we can agree that betting
on unexpected returns doesn't make a whole lot of sense, and I know that's a big if. We need to turn our focus
to the expected returns of the large cap growth asset class. Large cap growth stocks have historically delivered lower average
returns than smaller and cheaper stocks over most time periods in the US and around the world. That statement is supported
by the Academic Literature, in their landmark 1992 paper
in the Journal of Finance, Eugene Fama and Kenneth
French documented the evidence that larger companies
have lower average returns than smaller companies and more expensive companies
have lower average returns than less expensive companies. From a theoretical perspective,
there are two ways to think about the historical under-performance of large cap growth stocks. If we take the view that
markets are rational, that is investors rationally assign a reasonable expectations
for future profits then differences in
expected returns are based on differences in risk. Given a level of expected
profits, a company that is viewed as less risky will have
a lower discount rate and therefore a higher price. If we take the view that
markets are not always rational, the lower average returns
of the most expensive stocks could be explained by investors
irrationally extrapolating the high growth of successful
firms too far into the future, leading to their prices rising
higher than what the business fundamentals could ever
reasonably justify. When the prices eventually correct back to something more reasonable, they drag investor returns down with them. In a 2012 paper titled
"Identifying Expectation Errors in Value/Glamor Strategies of
Fundamental Analysis Approach" Joseph Piotrowski and Eric So, take the irrational pricing view, documenting evidence
that the glamor effect of high priced stocks underperforming is related to a reversal
of erroneous expectations, where expectations in
the price are incongruent with current trends in
firms' fundamentals. They also find that
this effect is strongest during periods of high investor sentiment. Cliff Asness the founder
of AQR Capital Management wrote in May, 2020, about
how wide the valuation spread between expensive and
cheap stocks had gotten. At that time the price to book spread, that is the ratio of how
expensive growth stocks are relative to value stocks was as wide as it has been
for the past 50 years. Now it's important to consider here that this might be reasonable
if today's expensive companies are truly
increasingly better businesses than their less expensive counterparts. In the language of Piotrowski and So, if the expectations in
the price are congruent with the current trends
in firm's fundamentals. Cliff showed that this
is simply not the case. The difference in business quality between expensive and cheap stocks measured by gross
profitability, return on assets and debt to equity does not explain the unusually large
spread in relative price. Differences in gross
profitability are currently in line with historical averages. The return on assets for cheap stocks is better than it has been historically, and cheap stocks are less leverage than they've been historically. Okay, gross stocks are
currently extremely expensive relative to history, which means their
expected returns are low, but none of this means that you can't make money by
investing in the next Amazon. The trick is investing in it
before it is one of the world's largest companies, that's
easier said than done. In a 2019 paper titled "Do Global Stocks Outperform
US Treasury Bills" The authors demonstrate that
there is an extreme positive skew in individual stock returns. That is most stocks trail the market while an exceptional
few deliver massive returns. More specifically, they
studied nearly 62,000 global common stocks
from 1990 through 2018 and found that 56% of US
stocks and 61% of non US stocks underperformed one month US treasury bills over the full period. Even more striking was the finding, that the top performing
1.3% of firms in the sample was responsible for
the net wealth creation of the entire sample. While the remaining 98.7% of firms collectively matched
the returns of one month US treasury bills. There is a good chance that
today's largest companies made significant contributions
to global net wealth creation on their way to becoming
massive companies. But now that they are there, their expected future
returns are relatively low. Large cap growth stocks have
been on a phenomenal run. Delivering huge unexpected returns and the biggest most well-known companies have been front and center. As hard as it may be to ignore that hype, betting on future unexpected
returns is a gamble, and based on the huge
positive skew in stock returns it's a gamble with a
negative expected outcome. The theory and evidence strongly suggests that the expected returns of
large cap growth companies as an asset class including the companies that are shaping the
world trail the market. With no way to predict what
will do well in the short run, either at the individual stock level or the asset class level. The best thing that we
can do is consistently own the entire market.. Value and growth, large and
small and everything in between, which we can do very easily using low cost total market index funds. If you need more excitement than that starting with the market and then adding some extra
weight to value stocks or better yet small cap value stocks, is a much more statistically reliable bet than following the crowd
into large cap growth stocks. Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video,
please share it with someone who you think could benefit
from the information, don't forget. If you've run out of Common
Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder Podcast wherever you get your podcasts. (upbeat music)
TL;DW:
Thanks for posting. Ben Felix is the greatest resource for seasoned and novice investors alike - no other person on YouTube distills academic / empirical evidence in an accessible manner like my mans.
Now if only M1 would add AVUV and AVDV (AVUV recently received Ben’s recommendation on some website and will likely make it into his recommended asset allocation this year).