The conventional wisdom developed over the past year seems to be that large-cap stocks will outperform small- and mid-cap, and that growth will outperform value. This view will probably dominate the year-end forecasts due from the sell-side shortly. The logic seems formidable.
A distinct economic slowdown seems underway; most economists put the chance of recession at somewhere between 30% and 50%. Decelerating sales and revenue growth, continued dollar weakness, and a thinning stock market would all seem to help big growth stocks. Plus, so-called value stocks have not done well for a number of months.
Then comes the tougher issue of which companies qualify as growth companies. Some of the best macro work we’ve been acquainted with on the topic comes from Steve Leuthold and the Leuthold Group in Minneapolis. Earlier this fall, they published an update on prior work on growth company longevity they began almost three decades ago.
Their original report was called “Is IBM (NYSE:IBM) Forever?” Their answer then was that “you’d better not bet on it.” The same general theme was repeated in 2002, when Leuthold released a new version entitled, “Is Microsoft (NASDAQ:MSFT) Forever?” These were timely studies because considerable doubt had arisen in the investment community as to whether strong growth was assured in both the case of IBM and Microsoft. The title of the latest version is “Are Google (NASDAQ:GOOG) and Cisco (NASDAQ:CSCO) Forever?” The important subtitle is “. . . No Growth is Permanent.”
None of the three studies included a detailed analysis of these four companies, but rather contained historic market data tracking the shifts in total assets and market capitalizations of America’s largest and most acclaimed companies in the decades preceding. Steve Leuthold was influenced early in his career by the work done by Mansfield Mills who studied the typical life cycle of companies. Some companies might succeed in becoming growth leaders, but then would reach mature growth before slipping into earnings cyclicality and then earnings decline. Most veteran investors have experienced this, but are not always prepared for it. Many are familiar with the old refrain that every business eventually becomes a commodity business, but many just ignore the evidence when they see it first-hand, and often ignore the inevitability of life cycles, as well.
There are still way too many analysts who expect too many companies to generate annual long-term earnings growth of 20% to 25% or more. Analysts pay too little attention to how easily such a rapid rate of growth can fade after just a few years. Research departments aren’t shy about putting out lists of companies they expect to generate annual earnings increases of 15% or more for at least five years. One value of Leuthold’s work is the reminder it provides that such high sustained earnings growth is truly rare.Who Was Big in 1960?
If we were to examine a list of the 100 largest companies by market capitalization in August of this year, how many of the 100 would have been included among the 100 biggest back in 1960? Actually, only 11. Even going back just to 1990, only 36 of today’s 100 largest-cap companies were on that 1990 list. The 11 who were also among the largest in 1960 were: Chevron (NYSE:CVX), Coca Cola (COK), Dow Chemical (NYSE:DOW), DuPont (NYSE:DFT), Exxon Mobil (NYSE:XOM), General Electric (NYSE:GE), International Business Machines, Merck (NYSE:MRK), Procter & Gamble (NYSE:PG), 3M (NYSE:MMM), and Wyeth (WYE).
By 1990, those 11 had been joined by the following, who now comprise the remainder of the 36 which comprised the biggest in 1990: Abbott Labs (NYSE:ABT), Altria (NYSE:MO), American Express (NYSE:AXP), American International Group (NYSE:AIG), Anheuser Busch BUD), Bank of America (NYSE:BAC), Baxter International (NYSE:BAX), Boeing (NYSE:BA), Bristol Myers Squibb (NYSE:BMS), Walt Disney (NYSE:DIS), Eli Lilly (NYSE:LLY), Emerson Electric (NYSE:EMR), Hewlett Packard (NYSE:HPQ), Home Depot (NYSE:HD), Intel (NASDAQ:INTC), JPMorgan Chase (NYSE:JPM), McDonald’s (NYSE:MCD), Microsoft, Motorola (MOT), Pepsico (NYSE:PEP), Pfizer (NYSE:PFE), and Schering Plough (SGP).
The expanded representation came primarily from the growth in the drug and health care industry and technology, as well as the mergers that took place in the banking business.
So who among today’s largest 100 didn’t qualify by size in 2001? You can probably name most of them, but it’s good to be reminded, just to maintain perspective regarding change. Today’s relative newcomers are Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) , BHP Billiton(NYSE:BHP), CVS Caremark (NYSE:CVS), Carnival (NYSE:CCL), Caterpillar (NYSE:CAT), Corning (NYSE:GLW), Devon Energy (NYSE:DVN), eBay (NASDAQ:EBAY), Exelon Corp (NYSE:EXC), FedEx (NYSE:FDX), Franklin Resources (NYSE:BEN), Gilead Sciences (NYSEARCA:GLD), Google, Kraft Foods (KFT), Las Vegas Sands (NYSE:LVS), Liberty Global (NASDAQ:LBTYA), Marathon Oil (NYSE:MRO), Met Life (NYSE:MET), Monsanto (NYSE:MON), News Corp (NASDAQ:NWS), Nextel (NYSE:S), Occidental Petroleum (NYSE:OXY), Prudential Financial (NYSE:PRU), Publix Super Markets (OTCPK:PUSH), Schlumberger (NYSE:SLB), Sprint (S), Time Warner Cable (NYSE:TWC), Travelers Corp (NYSE:TRV), Valero Energy (NYSE:VLO), and WellPoint (WLP).
Looking at the additions to the list, you’re reminded of the growth in the media and leisure/entertainment industries, and also of the role of investment bankers taking companies public for the first time. You’re probably also a little startled to see some of the companies identified as among today’s giants.Has There Been Safety in Size?
There really hasn’t been. If you look back to 1917’s list of largest-cap companies, you likely won’t recognize the overwhelming majority of the names. Oh, you would spot General Electric and Exxon Mobil and recognize some others that have merged with companies to remain relative giants. But GE and Exxon have been the real exceptions. One study shows that if you had invested in the 100 largest stocks by capitalization at the beginning of each decade, you would not have outperformed the market average most of the time. The exception was in the decade of the 1990s. In the 1960s, 1970s, and 1980s you would have underperformed the S&P 500 if you only owned the 50 largest companies, and you would have also lagged since the end of 2001 through this past August.
On the whole, underperformance was not by a lot, but still a measurable amount. The only double-digit gains over a decade since 1960 was the decade of the 1990s, when the 50 largest provided a 16% annualized return. But in three of the decades, the average returns were less than 5%. The Leuthold study shows that, on average, only 35% of the largest stocks were able to beat the S&P 500 over the 10-year period.Which Have Been the Dropouts?
Anyone looking back to the list of 100 largest-cap companies in 1917 would be hard put to recognize more than a handful of the names on the list. Thirty percent of the largest 50 industrial companies in 1917 were in the metal and mining industry. Today, only two of the top 50 are metal and mining companies. Obviously, the complexion of the American economy continues to undergo great (and probably accelerating) change. Commodity type companies that were among the largest 100 companies in 1917 included American Cotton Oil, American Sugar Refining, American Woolen, Cambria Steel, Central Leather, Chile Copper, Cuba Cane Sugar, Lackawanna Steel, Midvale Steel and Ordnance, Magnolia Petroleum, Pittsburgh Coal, Prairie Oil and Gas, and United Verde Extension Mining. Familiar to you? Meatpackers who were also among biggest-cap companies are probably more readily remembered. Change on the list accelerated after World War II and is still gathering pace given the rapid changes in the world of technology and globalization.
It’s hard for young people today to recognize the importance of the roles played by Polaroid and Eastman Kodak (EK) in photography, those of the blue-chip phone companies, and the attention that had been accorded Burroughs and Sperry Rand in the computer business. A study by McKinsey and Co. referred to in the book Creative Destruction by Richard Foster and Sarah Kaplan illustrates the shortening life expectancy of the components of the S&P 500.
In the 1930s, a company joining the S&P 500 list might expect to remain there for 65 years or more. But only 50 names that were on the list in 1957 remain. McKinsey estimates that, by 2020, the average tenure of a component of the S&P 500 will have shrunk to 10 years from what has been running recently at about 15 years.
Not all the companies that drop off the list stay off. Most never return, but some, such as Boeing, Honeywell (NYSE:HON), Lockheed (NYSE:LMT), Pfizer, and Texas Instruments (NASDAQ:TXN) do return. Others, such as Macy’s (NYSE:M) and Philip Morris, come back in different forms.Simple Lessons
This study doesn’t imply that you should forget about Cisco or Google now. They’ve recently joined the 100-biggest list and seem to have a lot going for them. But we’ve been reminded of corporate life cycles and that no growth is permanent. We’ve also been reminded that the rapidity of change has accelerated because of technology and the flattening of the world. And we have one other factor that is larger than ever before, which is the activist role played by investment bankers, hedge funds, and private equity in forcing or inviting change. The only thing we can count on is that future market leadership will be different and that we have to be increasingly alert in spotting it before everyone else does.