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Rekenthaler Report

The Top 1%, Corporate Version

In recent years, bigger companies have decidedly been better.

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Atop the Food Chain
That the richest Americans have extended their advantage on the other 99% is well known. This spring, the Congressional Budget Office reported that, during the 35-year period from 1979 through 2014, the top 1% of wage earners had increased their real incomes by a cumulative 221%, as opposed to 69% improvement for the next wealthiest 19%, and 27% for the four remaining quintiles. If this were a fight, it would be stopped.

Less recognized is that the stock market has followed suit, with the largest 1% of companies outgaining their rivals. To be sure, this has not been a 35-year trend. The behemoths are ahead only since the 2008 financial crisis, with most of their bulge occurring over the past five years. Nonetheless, it has been a noteworthy achievement; the bluest of chips do not typically lead a bull market.

Morningstar’s U.S. stock database contained 6,706 companies in August 2013. The largest, at $443 billion of stock-market capitalization, was  Apple (AAPL). The smallest was a firm called Digital Asset Monetary Network, which was valued at $10 million. I split the database into two parts, a) the biggest 67 companies (top 1%); and b) the remaining 6,639 firms (bottom 99%). Then I examined how their stocks have since performed over the ensuing five years.

The median return for the largest 1% of companies was 9.2% annualized. (The best was  Amazon.com (AMZN), at 42.5% per year, with  Facebook (FB) placing second.) Of the 67 entrants, only four lost money, with the worst being  General Electric (GE), which dropped 6.6% per year. A fifth,  Schlumberger (SLB), eked out a narrow gain, but trailed inflation. The other 62 stocks that made up August 2013’s top 1% list all posted positive real returns--a success rate of more than 90%. When it came to selecting blue chips, darts would have sufficed.

Not so for the small fry. Of the 6,442 companies that posted five-year returns (some dropped out due to mergers), nearly half posted negative returns. The median result was a paltry 1.2%--less than the rate of inflation. Naturally, the group’s top winners outpaced the blue-chip leaders (including Digital Asset Monetary Network, which turned its $10 million market capitalization into $430 million), but the occasional explosions were overwhelmed by all those duds.

FAAMG in Disguise?
This may sound like another version of the FAAMG argument. Modified from the original version of FANG, the FAAMG group of stocks--the aforementioned Facebook, Amazon, and Apple, plus  Microsoft (MSFT) and  Google (GOOG)--is said to have driven the market’s recent growth. Remove those firms, runs the contention, and the stock market would be treading water.

True enough, if overstated. However, this column is different. FAAMG addresses the behavior of market-capitalization-weighted indexes, for example the S&P 500. Such indexes are heavily influenced by the behavior of their largest, most-volatile members. That is not so with this study, which is equally weighted. If the FAAMG companies did not exist, the biggest firms would still have notched a substantially better median return than the broad market, along with a higher percentage of stocks that enjoyed double-digit gains.

Thus, the success of the large companies is broader than has been portrayed. The FAAMG discussion implies that a handful of firms have diverged; but the list is longer than that.

Two Tiers
What FAAMG does get correct, however, is the notion of a two-tier marketplace.

As we have seen, the top 1% contained no true “have-nots.” None of the group’s companies went bankrupt, or even suffered the threat of such a fate. Its laggard, General Electric, steadily grew its revenue while remaining profitable. Its stock performance disappointed, to be sure, but with more than $10 billion in operating cash flow over the trailing 12 months, General Electric is far from destitute.

However, in relative terms there certainly were two camps: growth and value. To generalize, the costlier stocks among the top 1% became costlier yet, while the cheaper stocks languished. That is, within the top 1% of companies, the stocks that were more popular entering the period maintained their popularity, while the relative outcasts remained that way.

Specifically, of the 12 firms that had the highest price/book ratios in August 2013, nine enjoyed double-digit gains. (Once again, this was not a FAAMG effect, as there were but two FAAMG stocks among those 12 companies.) In contrast, only four of the cheapest 12 entrants accomplished the feat. It was a difficult time indeed for large-value managers. While history shows that the mean usually reverts, such that the underappreciated companies regain favor, that has not been the case over this recent stretch.

Root Causes
The obvious question is, why? One potential answer is economic. Perhaps the business results of the more-expensive companies were pleasant surprises. When the study began, the pricier companies were expected to grow faster than were the cheaper firms. That is why they commanded steeper price/book ratios. However, if their superiority was even greater than expected, then their stocks might have outperformed.

The other possibility concerns sentiment. It may be that the business results of the costlier firms have so far met expectations, but that their stock prices have risen because investors have become more optimistic yet about their futures. That is, rather than rewarding the popular companies for what they have done (the economic explanation), investors have instead bid up their stocks based on what they believe will happen.

Friday’s column will discuss which of the two possibilities seems more likely, and what that answer might mean for the performance of the biggest companies going forward. Looking backward, as this column showed, the answer is clear: Just as with individuals, the top 1% of corporations has never been better.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.