Bigger doesn’t mean better

Mega-capitalization companies are immensely appealing to many clients. The comforting familiarity of household names such as Apple Inc., Coca-Cola Co., Johnson & Johnson and Procter & Gamble Co. seems to reduce client trepidation and create inherently attractive investments. Unfortunately, what is emotively pleasing is not always financially optimal.

The Russell top 50 mega-cap index (RT50) measures the performance of the largest companies in the Russell 3000 index and comprises almost 40% of the total market cap of publicly traded stocks in the U.S. With an average market cap of almost US$250 billion, these 50 companies are the behemoths of U.S. business.

Yet, from January 2002 to November 2014, the RT50 posted an annualized return of 5.2%, badly lagging the 7.3% of the overall market as measured by the Russell 3000.

There are periods in which extremely large companies outperform the broader U.S. market. For example, in the 1990s, the S&P 100 index, which measures the performance of 100 major, blue-chip companies, had an annualized return of 19.9%, outpacing the 17.7% return of the broader market.

Nonetheless, the long-term data are quite clear. On average, the larger the company, the lower the realized return. Research by Morningstar Inc. found that from 1926 to 2013 the largest decile of companies on the NYSE, AMEX and NASDAQ exchanges had a combined annual return of 9.3%, trailing well below the 10.7% of the second decile; the 11.6% return of the fifth decile; and far behind the 13.4% return of the tenth decile. Bigger is definitely not better.

A comparable pattern emerges at the global level. The Dow Jones global titans 50 index (constituents include international giants such as Nestle SA, HSBC Holdings PLC and Toyota Motor Corp.) had an annualized return of 6.3% from January 1992 through November 2014, lagging the 7.7% return of the broader global equities market as measured by the MSCI world index.

In Canada, a similar pattern occurs – with one notable exception. Based on Russell Canada indices, the 8.6% annualized return of large-cap stocks from August 1996 to November 2014 lagged the 10.2% return of mid-cap stocks. However, small-cap stocks were the poorest performers with an 8% return. Sector variances, with the small company index having a lower weighting in financials and a much higher exposure to cyclical materials, is a probable cause.

Financial advisors who invest in mega-cap companies to reduce risk significantly are likely to be disappointed. The RT50 had an annualized standard deviation of 15.1%, only modestly below the 16.5% of the overall market. During the global financial crisis, the drawdown of the RT50 was minus 48.6%, not materially different from the minus 51.2% of the overall market. In Canada, mid-cap stocks actually enjoyed reduced volatility and a lower maximum drawdown than large-cap stocks did.

Advisors who build stock portfolios for their clients solely out of mega-cap companies are trading “client comfort” for long-term performance. With the availability of low-cost, broadly diversified exchange-traded funds, there are better ways to construct a portfolio.IE

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.