Beware the bite of the ‘top dogs’

The top ranking companies in every sector go on to suffer years of underperformance, a US expert claims

All over the world, the "top dogs" in stock sectors go on to suffer years of underperformance, according to prominent money manager Rob Arnott.

Just as Microsoft shares suffered years of underperformance after becoming the biggest US company in history in December 1999, Apple shareholders suffered a torrid time shortly after the company smashed the market capitalisation record in August 2012, descending from a high of $705 (€520) to a low of $385 (€284) just seven months later.

The winner’s curse, as it is known, is not a rare phenomenon – it can be seen in every sector in every developed market.

So says US fund manager Arnott, who argues investors need to be wary of the “top dogs”, irrespective of their sector or location. His statistics are eye-popping, and of relevance both to individual stock-pickers and to ordinary fund investors, the latter potentially suffering due to the heavy weight accorded to the top names in conventional indices.


Decade of damage

In a 2010 US-only study, Arnott found that, over the previous 59 years, the most valuable company in the various sectors typically underperformed the average stock by nearly 4 per cent over the next 12 months. Worse, “the damage doesn’t really slow down for at least a decade”, with the sector top dogs lagging their own sectors by 3.2 per cent annually over that time.

“Put another way, with compounding, the top stock in the 12 US market sectors declined 28 per cent in value in 10 years, relative to the average stock in its respective sector, over the past 59 years.”

The national top dog – today, that title still belongs to Apple – tends to do even worse, underperforming by an average of 5 per cent annually over the next decade.

The stats are not distorted by a handful of disasters; underperformance is the norm, with two-thirds lagging their sector over the following decade.

The Winner's Curse: Too Big to Succeed?, Arnott's follow-up paper in 2012, found the top dogs' performance is "dismayingly unattractive" – even worse than in the US – in each of the major G8 markets (Australia, Canada, France, Germany, Italy, Japan, the UK and the US) and New Zealand.

On average, the top companies lag their sectors by an average of 4.3 per cent per year over the next decade. This lag was seen in all nine countries, ranging from more than 1 per cent per year in Germany to an “astonishing” 10 per cent in Canada.

Again, the results are even worse for the biggest company in each country, annual underperformance ranging from 7 to 10 per cent in Germany, Japan, Canada and New Zealand. The worst performance of all was seen in companies that managed to become the biggest in the developed world.


In most developed markets, indices are extremely reliant on the top dogs, with the largest stock typically accounting for about 9 per cent of the index, compared to 3 per cent in the US. The sector top dogs comprise an average of 36 per cent of their own sector. (Irish investors know all about such outsized influence, of course, with CRH’s €15 billion market capitalisation accounting for one-quarter of the Iseq).

The extent of their underperformance, coupled with this large index weighting, means they pull down investment performance by about 2 per cent a year, globally. A global index that simply excluded the largest stock in each sector would gain an additional two percentage points per year – a performance most active managers can only dream about.

“Based on chance alone, we would expect to find many sector or national top dogs that can reliably outperform over long spans,” says Arnott. “We do not; they are barely more common than unicorns.”

Priced for perfection

Why? Unsurprisingly, the biggest companies outperformed in the five years prior to becoming sector leaders – superior performance is, after all, a given for any company to become the most valuable firm in its sector or country. The subsequent underperformance, Arnott found, is a “mirror image” of the previous outperformance.

In other words, good times don’t last forever; even the best companies don’t grow to the sky. A company can easily double its market share if it holds 1 or 2 per cent of the market, says Arnott, but doing so is impossible if the company has a 51 per cent market share.

Investors tend not to anticipate this, with the top dogs “usually priced to reflect a consensus view that they will remain on top”. The market “becomes aware of such pricing errors only gradually, as the company fails to meet the unrealistic growth expectations imposed upon it”.

Arnott’s research echoes that of Ned Davis Research, which last year looked at the performance of US companies that have topped the “most valuable” list since 1972 – AT&T, Altria, Apple, Cisco, Exxon Mobil, General Electric, IBM, Microsoft, and Wal-Mart. A portfolio owning the most-valued stocks would have risen by about 400 per cent, compared to almost 5,000 per cent for the S&P 500.

“By the time a stock is No 1 in the market, nearly everyone owns it, and the story is well-known”, said Ned Davis Research. “And, generally, what everyone knows in the market is not worth knowing, because the positives are already discounted in the price.”

Or to put it another way, "popularity kills". Taking stock: US money manager says top dogs drag down global indices and argues for 'equal weighted' indices Rob Arnott says the top dogs drag down global indices by about two percentage points annually. He argues traditional indices like the S&P 500 or the FTSE 100 are inherently flawed, in that they are weighted by a company's market value. Essentially, the more overvalued a company becomes, the greater its weighting in the index, with the opposite being true for undervalued stocks.

Critics point to companies like Microsoft, which was obviously overvalued in late 1999 – despite this, funds tracking the S&P 500 were more exposed to it than any other stock.

One alternative is equal-weighted indices, which give the same weighting to each component stock. For example, Apple, currently valued at €535 billion, accounts for 3.23 per cent of the S&P 500. An equal-weighted index would see its weighting fall to 0.2 per cent, the same as every other stock on the index, irrespective of its market value.

Arnott’s firm, Research Affiliates, prefers so-called fundamental funds, with indices weighted by a fundamental factor such as dividend yields or cash flows.

Such funds have taken off in recent years, being pitched as an alternative to active investing while retaining the essence of the passive approach, but not everyone is a fan. John Bogle, who pioneered the world's first index fund in the 1970s, sees it as "witchcraft", while efficient market gurus such as Nobel economist Eugene Fama and Burton Malkiel are also sceptical. They point to the increased cost of such funds and argue there is no free lunch in finance, with more volatility and risk intrinsic to market-beating performance.

However, the performance of alternative indices has been strong. A 2008 study found an equal-weighted S&P 500 would have outperformed the conventional market-capitalisation index by 1.5 per cent since 1990. According to Research Affiliates’ website, its’ All World 3000 Index, which weights 3,000 global companies according to fundamental factors, has given annualised returns of 9.7 per cent over the last decade, compared to 7.53 per cent for the market-cap weighted MSCI World Index.