*All short-term data comes from a database maintained by the American Association of Individual
Investors. All long-term data comes from the Center for Research of Securities Prices (CRSP).
A Tale of Two Markets: How 50 Giant Companies have Overshadowed a Mediocre Market
There are currently 9217 companies that trade on the NYSE, NASDAQ and AMEX markets, considered to be the "national"
markets. There are thousands more companies that trade on a regional basis and are generally known as penny stocks.
If you compare the stock market returns of the fifty biggest companies by market capitalization against the other
9167 companies over the past three years, you will see two vastly different stock markets. If you extend the comparison
for a history of longer than three years, say thirty years or more, you will again see a different story.
So which story is right? Which is a more accurate predictor of the future? Has this kind of situation come up before?
Are things different this time? These are the questions that will be addressed in this issue of Sharp Investing.
The chart*, "Short-term Returns", shows the end result of investing one hundred dollars 36 months ago
into the fifty biggest companies versus putting the same amount into the other 9167 companies.
The other chart, "Long-term results", shows the end result of investing one hundred dollars 31 years
ago into either the Big Fifty or the rest of the market.
A $100 investment in the Big Fifty 36 months ago has become $228 today, while a $100 investment in the rest
of the market has turned to $120. A $100 investment in the Big Fifty in 1966 has become $2739 today, while a $100
investment in the rest of the market has become $18,669 today.
|Many investors have been disappointed over the past several years if their portfolio hasn't done what the "market"
has done over the same period. However, unless their portfolio was composed mostly of the Big Fifty, comparing
against the perceived "market" is like comparing apples to oranges.
Why is it widely reported that the "market" has done so well over the past three years even though it
is obvious from the chart that only the very biggest companies have experienced above average returns? It is because
almost all market indexes are weighted by market capitalization, rather than being an average of all the stocks
in the index. This means that a giant company like General Electric influences the S&P 500 index hundreds of
times more than the 500th company in the index. Microsoft, Intel, Dell and Cisco make up more than a third of the
entire NASDAQ index which contains over 4000 stocks.
So four stocks make up 1/3rd of the NASDAQ average and the 2/3rd's
of the NASDAQ contains over 3996 stocks.
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Daniel R. Sharp
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|However, unless investors purchase an index fund, most investors do not buy
$100 worth of GE stock and $1 worth of Smallstock, Inc. They mostly buy equal amounts of each company, and those
that do should compare their results against what the average stock has done, not against what the biggest stocks
have done. The DJIA, the S&P500, the NASDAQ, and even the Russell Indexes are all geared so that the biggest
stocks have the majority of the influence on how much the index goes up or down.
The Good News
The good news is that over almost all periods of time greater than three years, holding stocks in equal amounts
versus holding stocks in proportion to their market capitalization has proven to be beneficial, as can clearly
be seen from the Long-term chart on the bottom right of page one.
It is no coincidence that I chose 31 years as the timeframe to illustrate the long-term investing chart. Thirty-one
years ago was the last time that the biggest stocks, which over long periods of time have always had lower risk
and lower returns than the market in general, outperformed the market for an extended period of time. The "Nifty
Fifty's" outperformance went on for over four years with all the same sorts of rational that we see today;
companies trading at over 50 times earnings with very low growth prospects. It made complete sense to investors
at that time until it finally ended. And it ended badly.
As you can see from the long-term chart, even including the high returns of the past three years (the Big Fifty)
and the high returns on the original Nifty Fifty, the group
still significantly underperformed the market as measured by all stocks other than the Big Fifty.
Why is this? The relationship between risk and return in financial markets keeps big stocks underperforming the
rest of the market over the long-run, even if the relationship occasionally gets out of whack in the short-run.
Consider interest rates. If you are loaning money for a long period of time, you expect to be paid a higher interest
rate because of the higher risk of tying up your money for a longer period of time. If you are loaning for a shorter
amount of time, there is less risk and therefore you are usually paid a slightly lower interest rate. A 15-year
mortgage can be obtained at a lower interest rate than a 30-year mortgage. But sometimes, such as this summer during
the worst of the world financial crisis, this normal relationship can get turned upside down, so that short-term
rates yield higher than long-term rates. This also happened during the inflation scare of the early 80's.
Stocks aren't any different than any other type of investment. Big stocks carry lower risk (they have stronger
market positions, lots of money, are less likely to go out of business, etc.)
and therefore their normal rate of return is less than that of the
market in general. But every 30 or 40 years there will be an extended period of several years where the normal
relationship does not hold.
Are Things Different This Time?
Remember last fall, just before the Asian Crisis hit the fan, when all the "New Era" thinking about investing
was at its peak? Surveys came out that said that investors weren't expecting as much as a single 10% correction
over the next 25 years because of the incoming 401k money and the Baby Boomers endlessly feeding the stock market
with new cash. Then the Asian Crisis cut the stock market in half and stopped all that nonsense thinking.
It was the exception, not the rule, that allowed the market to go from 1992 to 1997 without a single 10% correction.
It wasn't normal.
The exact same thing can be applied to today's disparity between the Big Fifty and the rest of the market. The
Big Fifty has just about run it's course, just as the original Nifty Fifty did thirty years ago.
Just as there is no free lunch, Santa Claus or Easter Bunny, there is no long-term opportunity in investing
in which you can expect less risk with more return.
Over the past 31 years, the Big Fifty has returned 10.9% with 17% risk, and the rest of the market
has returned 17.75% with 24% risk. Less risk, less return, more risk, more return.
Big stocks are less risky, and their long-term returns will always reflect that There is a long line of scientists
who have won Nobel prizes based on that single concept. At some point, this relationship will return to normal,
and investors who have invested in the other 9167 stocks for the long-run should be rewarded for taking on the
higher risk of owning the non-giant companies.
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Beaverton, OR 97005
|Three years can seem like a long time to be waiting to see your higher risk stocks produce higher returns. The
investors of 1966 had to wait for over four years for
this relationship to return to normal. The reward? Their one hundred dollars, which had only grown to $140 in five
years, grew to $18,669 over the next 26 years.
This topic will be continued in the next issue of Sharp Investing. At that time, we will examine the differences
in the valuation levels between the Big Fifty and the rest of the market, both in the short-term and the long-term.
To this point we have limited the discussion to simple price levels and returns, which is only half of the story.
Those of you that are interested in whether the Big Fifty is over-or undervalued in comparison to it's long-term
levels and in comparison to the rest of the market will have that question answered next quarter.