Fundamentals |June 2010

6/1/2010
Rob Arnott
Monthly

Too Big To Succeed

Much ink has been spilled on the perils of allowing some companies to become “too big to fail.” This assumes that governments, hence taxpayers, must foot the bill when these whales become seriously ill, while reinforcing a view that the top dogs, whose failure might do systemic damage, should be regulated or constrained to mitigate the damage that they might cause.[ii]
The flip side of this view—indeed, perhaps supported by the “too big to fail” ethos—receives scant attention: companies can become “too big to succeed.”
When you’re #1, you have a bright target painted on your back. Indeed, in a world of fierce competition and serial witch hunts in Washington, that bull’s-eye is probably painted on your front and sides, too. Competitors are gunning for you. Governments and pundits are gunning for you. In a world that generally roots for the underdog, hardly anyone outside of your own enterprise is cheering for you to rise from world-beating success to still-loftier success!
Was Goldman Sachs targeted with civil and criminal fraud charges because they have criminal intent to defraud their clients, while their competition is pure as the driven snow? Or have they become a symbol of success-to-excess, to an extent that prompts populists and pundits to want them to suffer?
Is Exxon Mobil regularly pilloried in Washington because their business practices are monopolistic, their profit margins obscene, and their product is viewed as polluting and distasteful (never mind that we all buy it)? Or is it because their relentless business success makes them a popular target?
Of course, none of this is new.
Initially, Bank of America management thought they’d be lauded by the political elite for buying (and saving!) Merrill Lynch during the disastrous weekend when Lehman imploded. Instead, they found themselves on the proverbial horns of a dilemma when Merrill disclosed an extra $20 billion of losses before the deal closed. Bank of America could have cancelled the deal by invoking the material adverse conditions clause or they could have proceeded and sought additional sources of capital. Ultimately, Bank of America chose to proceed and, instead of being lauded for stepping up, they were pilloried for needing an infusion of capital (which they repaid) and sued for not cancelling the deal.
How much of this controversy was linked to the fact that Bank of America was the largest bank in the United States, by most measures? How much of Citi’s “moments in the spotlight” have been due to the fact that it was Bank of America’s predecessor in the #1 spot?
Microsoft’s opportunity in the spotlight came a decade ago, when they were attacked on the grounds of “monopolistic” business practices, as was IBM in the prior decade. The decade before that, AT&T was successfully dismantled on the same basis.
The very business practices that propel an organization to #1—aggressiveness, focus, canny outmaneuvering of the competition—become unacceptable if you’re wearing the yellow jersey. Being #1 means always having to say you’re sorry![iii]
 
Too Big to Succeed?
Does our tendency to punish our winners hurt their investors? Yes. In fact, we find the leader in any sector underperforms the average stock in its own sector by 3.5% in the next year ... and the next year … and the next year. As Table 1 shows, the damage doesn’t really slow down for at least a decade, as the top dog in each sector lags its own sector by 3.3% per year for the next decade! With compounding, the top stock in the 12 market sectors declined 28% in value relative to the average stock in its respective sector.

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How did these top dogs do relative to their own sectors? The average performance shortfall for the 12-sector top dogs is over 3% per year for one year, three years, five years, and even ten years. On a 10-year basis, the majority beat their peers in only 6 of the 49 starting years and in just two sectors over the full span. The “big winner”? Energy, with the top dog scoring an average of just 0.8% outperformance per annum relative to the average energy stock, over the subsequent decade.
For investors, top dog status is dismayingly unattractive!
Our research also shows that top dog status changes frequently. In most sectors, the top dog is replaced several times over the 58-year time span. The average sector has seen six top dogs over that span, while “Other” has had 17 different #1 companies. No wonder that the 1-, 3-, 5-, and 10-year shortfall for these “Other” top dogs is nearly always worst on the list.
The only sector where the top dog was able to hold its position for the entire period occurred in Energy: Exxon Mobil (and its predecessors, Exxon and Standard Oil of New Jersey) never lost its top dog status. How did it stay on top when the top dogs in other sectors failed in their quest to be top dog? Perhaps it remained a winner because it has always stuck to its core competencies, avoided the combative business practices that got other top dogs in trouble, was content with solid mainstream growth and profit margins, has not risen to the bait when under attack, and kept as low a profile as any top dog possibly could. The firm’s persistence at the top also was aided by the 1999 merger of Exxon and Mobil, which combined the #1 and #2 companies in that sector.
 
Is There a Political Connection?
The 15 “successful” five-year spans—in which more than half of the 12 sector top dogs were able to turn their sector dominance into superior stock performance—began in 1952, 1968–72, 1982, 1986, 1988, 1990, 1993–97, and 2004. These five-year spans were largely dominated by Eisenhower (first term), Nixon, Reagan, Bush I, Clinton, and, in one isolated case (beginning 2004), Bush II. For the most part, these might be seen as political environments characterized by rolling back regulation and not demonizing success.
The 14 “seriously unsuccessful” five-year spans,[iv] in which few top dogs (no more than 3 out of 12) were able to turn their sector dominance into superior stock performance, began in 1963–64, 1973–79, 2000–2003, and 2005. These spans were dominated by the administrations of Johnson, Ford, Carter, Bush II (but for one starting year), and Obama (one year only, but it’s a doozie). Each of these administrations is characterized by sharp increases in government spending and regulation.
Out of curiosity, we conducted a really simple statistical test: We compared the correlation between the magnitude of government outlays as a percentage of the economy and the relative performance of these top dogs. We found a statistically significant negative correlation (see Figure 1). Looking at government outlays and relative performance in concurrent one-year spans, the correlation is –31% based on 58 sample years. Where the change in government outlays is correlated with the following year’s average relative performance of the top dogs, the correlation is –27%. Combining the two results, the average top dog performance correlation with the two-year growth in government outlays is –38%.

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Summary
From these results, one might conclude that an investor could do rather well by investing in the Russell 1000, minus its 12 sector leaders. Better still, perhaps we should exclude all of the companies that have been sector leaders any time in the past decade because the performance drag for the top dogs tends to persist for a decade or more. These stocks typically comprise about one-fourth of the Russell 1000! If these stocks suffer a 300–400 bps shortfall in most years, one could outperform the index by nearly 100 bps per annum merely by leaving the top dogs out, cancelling the corrosive influence of competitors, populists, and pundits.

Endnotes
 
[i] A shorter version of this paper was published in the U.S. edition of FT.com on June 6, 2010. http://www.ft.com/cms/s/0/a1783e04-7002-11df-8698-00144feabdc0.html
[ii] There’s a wonderful film, “Phar Lap,” based on a true story about an Australian horse that beat all comers. Brought to the United States to compete, the horse continued to win. The horse was saddled with more and more weight, until its heart gave out. It finally lost.
[iii] Of course, there are other factors why some big firm’s don’t remain top dogs year after year, such as misguided diversification of business lines into non-core areas, deterioration of their culture, or emergence of new game-changing technologies. But that doesn’t change the fact that populist tendencies seek to bloody the biggest players.
[iv] The unsuccessful periods are defined as those in which two or less top dogs beat their sectors.