August 18, 2014

The Case Against Mega Caps: Too Big to Succeed

I'm largely of the opinion that various investing styles are meaningless and have little chance of beating the market long-term. Despite there being countless growth and value ETFs available to investors, I haven't found much evidence that one is better than the other. Then there's the explosion of "smart beta" strategies that attempt to outperform based on some rule-based approach other than market cap weighting. Smart beta strategies are somewhere in between passive and active management. They're not quite as subjective as a purely actively managed fund since they tend to stick to a clear set of criteria or rules, but the mere existence of defining a set of rules other than cap weighting means the fund manager believes they can outperform based on some inefficiency in the market.

CNNMoney sums the idea up nicely:
The goal of smart beta is to boost returns by using a "rules based" approach that puts more weight on other factors, such as valuations, dividends, momentum or volatility to determine which companies to own and how much of their stock to buy.

Dropping another big one into the portfolioBut weighting by other metrics seems just as arbitrary as weighting by market cap. There are reasons different companies have difference valuation metrics and there's no guarantee that dividend growth or high dividend-paying companies will always beat the market. Momentum and volatility seem even more arbitrary. Low volatility stocks have their benefits, but in the long stretches, higher volatility small cap equities will do better. Many of these strategies might look pretty based on some convenient back-tested data and are used to justify higher expense ratios than pure passive index ETFs. But I suspect smart beta will end up succeeding about as much as most other active strategies before them: not very well over time.

But I digress. From what I can tell, there is one metric that consistently predicts over and under-performance relative to the market: size. And by that I mean the outliers in the market. Yes, the biggest public companies is the U.S. make up most of the market's value, but ultimately they're the biggest of the big. It's a legitimate question to ask if it makes sense to have most of your investment tied up in the extreme end of one spectrum of the market. And when you hold the market portfolio or something similar, like the S&P 500, most of your eggs are in mega (or giant) cap stocks.

On the other end, we have another extreme: micro caps. These little guys have a whole different set of problems of their own. They're so tiny, they're often difficult to invest in (low liquidity, huge bid/ask spreads) and it's a challenge finding an ETF that accurately mimics existing micro cap indexes. In theory they may have great long-term returns, but it's just a theory because there are many challenges to owning them.

Big, slow, and probably not growing much more
Returning back to the large end of the spectrum, the mega caps, there's an intuitive sense that many of these companies are just so huge that the upside potential is limited. Exxon is worth $422 billion. Where in the world is Exxon going to find growth opportunities to double their stock price? Apple is worth over $586 billion! But its developed markets are saturated and its products are too expensive for many emerging market customers. The company has done a phenomenal job increasing profitability, but it's hard to see many avenues for AAPL to get to a $1 trillion valuation. In comparison, a typical mid cap company might be valued more in the $5 billion range. Many mid caps are established companies with low growth prospects, but it's a lot easier to envision a $5 billion company getting to $10 billion than a $100+ billion company doubling in size.

To test this hypothesis, let's look at the Kenneth French data on portfolios formed on size (including dividends). I can't emphasize enough how useful and valuable this data is (from CRSP - The Center for Research in Security Prices). The data is broken split out three ways: 30/40/30, quintiles, and deciles. We'll just look at deciles since the top 10% of companies by market cap is the best representation of mega caps (currently consisting of about 161 stocks, so a bit more than the S&P 100).

There are endless ways to slice-and-dice this data, but I thought it would be useful to look at average annual returns for each decile by decade. I highlighted the deciles that performed above and below average during each time period (including to partial decades at the end of the 1920s and the current decade):

A few things jump out at me. First, in general, the largest three deciles have consistently been among the worst performers decade-after-decade, with the largest decile most often being the worst.
Second, the smallest deciles exhibit some consistency with performing above average, indicating the small cap premium is consistent and real. Lastly, the smallest decile, while it's had bad stretched of performance, has often outperformed everything else by a wide margin. But we know investing in these stocks difficult (if not impossible) in practice.

What market caps generally correspond with each decile? In the first box below, you can see the top decile consists of companies averaging about $83 billion in size - mega cap territory. As we mentioned above, mid caps (specifically the S&P 400) fall roughly closer to the $5 billionish range, so probably map closer to deciles 6-8. Some of the biggest holdings in the Russell 2000 cross into mid cap territory, but the weighted average is closer to $1.7 billion. Deciles 3-5 are probably most indicative of that index. The smallest decile would firmly fall into a micro cap categorization, and I suspect we could classify some of the 2nd decile stocks the same way (and many likely have liquidity issues).

Next, if we look at cumulative returns over different time periods, the largest U.S. public companies have turned in the weakest performance. Interestingly, the smallest decile looks incredible over the past 87 years (if it were possible to easily invest in these companies), but the second decile turned in a weaker performance the next 5 larger deciles.

Over shorter 30, 20, and 10-year time spans, the small and mid cap range of the market has also been the place to be. While most agree small caps have overheated during recent years, a major correction would be required and/or a large run-up in large and mega caps to narrow the gap.

Let's have one more look a recent mega cap performance. I've plotted the iShares S&P 100 ETF (OEF) in blue below against the SPDR S&P 500 ETF (SPY) in orange. Keep in mind SPY includes the constituents of OEF. In fact, over half of SPY's value is from S&P 100 companies. Even so, the total returns of SPY have exceeded those of OEF by about 26% during the past 14 years, meaning the bottom 400 companies in the S&P 500 likely outperformed the top 100 in excess of 50% during that time.

Draw your own conclusions from this data, but from my perspective there is ample evidence to suggest:
  1. The size premium is real (or at least more convincing than the value premium) and appears to hold true for stocks in the more liquid small and mid cap range.
  2. Mega caps might be too big - they may weigh down long-term returns.
Probably should have thrown some small and mid caps into the mix

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