digest
Short Summary
Main recommendation: Do not bet on mega-cap growth stocks such as Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla as a sure thing; instead, consistently own the entire market through low-cost total market index funds. Ben Felix argues that the recent outperformance of these companies is an unexpected return, while their high prices imply low expected future returns.
Key Points
- Large cap growth stocks' current expensiveness looks similar to the level seen at the beginning of 2000, which was followed by a decade of negative returns for US large cap growth stocks.
- Stock returns have an expected component (the discount rate applied to expected profits) and an unexpected component (new information), and only the expected component can be reasonably planned for.
- Academic work by Fama and French (1992) found larger and more expensive companies have historically had lower average returns than smaller and cheaper ones.
- From 1927 to 1979 the largest US company routinely held about 6% of market value (General Motors, AT&T, IBM); looking at each decade from 1930 through 2010, the 10 largest companies at the start averaged 23.6% of the market and trailed the market by an average of 1.51% annualized over the following decade.
- Returns are highly skewed: in a study of nearly 62,000 global stocks from 1990 to 2018, the top 1.3% of firms created the net wealth of the entire sample, while the remaining 98.7% collectively matched one-month US Treasury bills.
Details Worth Noting
- Concrete instructions:
- Own the entire market using low-cost total market index funds, covering value and growth, large and small, and everything in between.
- If seeking more return, start with the total market and add extra weight to value stocks, or better yet small cap value stocks, rather than concentrating in large cap growth stocks.
- Avoid betting on unexpected returns by chasing the largest or most well-known companies, since beating expectations consistently is unlikely.
- The five largest US companies (Facebook, Apple, Amazon, Alphabet, Microsoft) made up nearly 20% of the US market, with Apple alone around 6%.
- Piotroski and So (2012) found the glamour effect of high-priced stocks underperforming is related to a reversal of erroneous expectations, and is strongest during periods of high investor sentiment. Cliff Asness noted in May 2020 that the price-to-book spread between growth and value was as wide as in the past 50 years.
- Cliff Asness's analysis showed business quality (gross profitability, return on assets, debt to equity) does not explain the unusually large valuation spread, since cheap stocks currently have better return on assets and lower leverage than historically.
Bottom Line
Mega-cap growth stocks may have delivered exceptional recent returns, but their high valuations suggest lower expected returns ahead, so the more reliable approach is broad, low-cost diversification with a tilt toward value and small companies.
