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Rekenthaler Report

The Biggest Companies Have Deserved to Be Best

Their business results have driven their stock-market gains.

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Two Tiers
Tuesday's column detailed how, in recent years, blue chips have dominated. An investor in August 2013 who sorted all publicly traded firms by their market caps from largest to smallest, selected the top 1%, invested equally in each of those 67 stocks, and then held that portfolio would have gained an annualized 13% over the next five years. In contrast, someone who employed the same tactic for the remaining 99% wouldn't have made a penny.

The latter finding isn't completely surprising. As I once wrote, most stocks stink--not just for five years, but forever. Half of all issues contained in the Center for Research in Security Prices' U.S. stock-market database, which dates to 1926, have posted negative returns for their lifetimes. Thus, the tactic of investing equally across the market's smaller 99% only succeeds if the winners are so huge as to overcome the majority's drag. Sometimes, that occurs--but not in this case, for the hypothetical buy-and-hold August 2013 investor.

What is unexpected is that the largest companies fared so well. Only four among the 67 lost money for the half-decade. Granted, big companies are more reliable than small fries--the nature of a blue chip being to grind out a moderate gain rather than go boom or bust--but even so, that is a very high success rate. The investor in the top 1% did not even need to purchase a basket of securities; a handful of darts would have been enough.

Are Indexes to Blame?
My initial thought was that this outcome was determined by fashion. Almost every blue chip notched positive returns because that is what investors sought. Stocks, after all, are valued not by God's measuring scale, but by investor demand. Hundreds of billions of dollars have flowed into index mutual funds. Those monies were placed into large-company U.S. stocks, thereby propping up those securities' prices.

Then I reconsidered the part about the index funds.

For one, most (all?) previous index-fund conspiracy theories have failed. The influence of index funds on stock-market prices is overstated, because they are the visible portion of the investment iceberg. As publicly registered funds, their inflows are monitored far more closely than are those of the other major sources of assets: unregistered funds, endowment funds, sovereign funds, pensions, and individual accounts. Frequently, the consequences of index-fund flows are counteracted by parties whose effects are not measured.  

For another, there's no index-fund argument that can explain why the largest 1% of companies--fewer than 70 businesses--would outgain the rest of the firms that make up the S&P 500. Essentially all U.S. stock-market inflows are into either an S&P 500 portfolio or a total-market portfolio, each of which invests in the S&P 500's members according to their market caps. The top 1% don't receive any special favors.

Testing the Fundamentals
Nevertheless, setting aside the cause, there might indeed be evidence suggesting that the market's biggest companies have benefited from sentiment. But how to test that? After some thought, I decided to examine how much of each group's results owed to fundamental factors, such as growth in earnings or revenues, and how much to something else. Presumably, the former is a more trustworthy source of stock-market returns than the latter.

I did find a difference between the two groups, although not in the direction I expected.

For the top 1%, the correlation between stock-market performance and earnings growth, with each item being measured over the trailing five years, was 0.41. That is, companies that grew their earnings most rapidly tended to post the highest stock-market gains. (For example,  Facebook (FB) and (AMZN).) The relationship between stock returns and earnings growth was not overwhelmingly strong, but it was significant--and higher than the 0.26 correlation that was registered by the remaining 99%. The stock prices of the market's biggest companies were more linked with their earnings growth than with the rest of the marketplace, not less so.

The pattern was even more pronounced with top-line growth. While the broad market showed a similar, 0.27 correlation between stock-market performance and five-year revenue growth, the top 1% of companies measured at 0.61. As shown by this chart of two items that have a 0.60 correlation, a relationship of that level is quite strong. For many of the largest companies, knowing only their future revenue growth would have sufficed to predict their relative stock-market performance.

Relatively Speaking
Note that I wrote “relative.” After reviewing the evidence, I am satisfied with the internal logic of the blue-chip group. Broadly speaking, stock-market performance was proportional to the companies' economic achievements. Firms that grew their businesses the most rapidly had the highest stock-market gains; those that placed in the middle typically finished in the middle; and those that recorded flat to negative fundamentals were mostly duds. (Examples are  Merck & Co (MRK),  International Business Machines (IBM),  American Express (AXP),  Chevron (CVX), and  Coca-Cola (KO).)

Such analysis, however, does not address those stocks' absolute valuations. Blue chips seem reasonably priced when compared with each other, but perhaps not when compared against other assets. It may be that smaller-company shares are currently the better choice, or bonds, or cash. This article does not address that issue. Nor does it advocate for or against large-company U.S. stocks. It merely defends their relative pricing. The stock-market gods have not been indiscriminate with their favors.

In summary, over the past several years the stock market has become tiered: The largest companies have been better investments than have the rest of the marketplace. Within that large-company group, there has been a significant gap between the relative haves and have-nots. Before working on this topic, I had wondered those results owed to fashion. I wonder no longer.  


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.