Why Do the Biggest Companies Outperform?

Apple's one trillion dollar valuation is a milestone for the largest US companies, which have significantly outperformed their smaller rivals since 2013

John Rekenthaler 7 August, 2018 | 2:16PM
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Apple (AAPL) became the world's first trillion dollar company last week. But this milestone was not an anomaly: the top 1% of US companies have outgunned their rivals since the 2008 financial crisis, with most of these gains made in the last five years.

An investor in August 2013 who sorted all publicly traded firms in the US stock market 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 until 2018 would have gained an annualised 13% over the next five years. In contrast, someone who employed the same tactic for the remaining 99% wouldn't have made a penny. Since 1926, half of all listed US stocks have posted negative returns.

What is unexpected is that the largest companies fared so well. Only four among the 67 lost money for the half-decade.

The conventional argument is investor demand, particularly for tech stocks like Apple, Amazon (AMZN) and Facebook (FB), has driven valuations higher and forced index funds to allocate more of their money to the biggest firms.

The influence of index funds on stock-market prices is overstated, because they are the visible portion of the investment iceberg. As registered funds, their inflows are monitored far more closely than are those of the other major sources of assets, such as pensions and sovereign wealth funds. 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. Top firms do not receive any special favours.

Earnings Growth the Main Driver

Have the market's biggest companies benefited from sentiment? Perhaps the business results of the more-expensive companies were pleasant surprises. Pricier companies were expected to grow faster than the cheaper firms. That is why they commanded steeper valuations ratios. However, if their superiority was even greater than expected, then their stocks might have outperformed.

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 and Amazon. 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.

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. 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.

John Rekenthaler has been researching the fund industry since 1988. He is a columnist for Morningstar.com. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Alphabet Inc A2,178.16 USD-1.34Rating
Amazon.com Inc2,151.82 USD0.25Rating
Apple Inc137.59 USD0.17Rating
Facebook Inc A193.54 USD1.18Rating

About Author

John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.