Fundamentals 201006
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The document discusses how companies that achieve the top position ("top dog") in their sector tend to underperform relative to other companies in that sector over time. It finds that on average, the top dog in each sector lags the sector average by 3.5% in the following year, 3.9% over 3 years, and 3.3% per year for the next decade. This "too big to succeed" phenomenon may be partly due to increased scrutiny from competitors, politicians, and the public when a company becomes the sector leader. The document also finds some evidence that top dog underperformance is worse during periods of larger government spending and regulation.
Fundamentals 201006
- 1. Fundamental Index Newsletter · June 2010 ® TOO BIG TO SUCCEED1 Much ink has been spilled on the people think that their business perils of allowing some companies to practices are monopolistic, their become “too big to fail.” This assumes profit margins obscene, and their that governments, hence taxpayers, product is polluting and distasteful must foot the bill when these whales (never mind that we all buy it)? Or become seriously ill, while reinforcing is it because their relentless business a view that the top dogs, whose failure success makes them a popular target? Rob Arnott might do systemic damage, should be Of course, none of this is new. regulated or constrained to mitigate Initially, Bank of America the damage that they might cause.2 management thought they’d be RAFI® Managed Assets* The flip side of this view— lauded by the political elite for USD in Millions indeed, perhaps supported by the buying (and saving!) Merrill Lynch $35,000 “too big to fail” ethos—receives during the disastrous weekend when $30,000 scant attention: companies can Lehman imploded. Instead, they $25,000 become “too big to succeed.” found themselves on the proverbial $20,000 When you’re #1, you have a bright horns of a dilemma when Merrill $15,000 target painted on your back. Indeed, disclosed an extra $20 billion of $10,000 $5,000 in a world of fierce competition and losses before the deal closed. Bank 0 serial witch hunts in Washington, of America could have cancelled the that bull’s-eye is probably painted on deal by invoking the material adverse 4Q05 4Q06 4Q07 4Q08 4Q09 1Q10E *Includes RAFI assets managed or sub-advised by Research Affiliates or RAFI licensees. ® your front and sides, too. Competitors conditions clause or they could have are gunning for you. Governments proceeded and sought additional and pundits are gunning for you. sources of capital. Ultimately, Bank ® In a world that generally roots of America chose to proceed and, for the underdog, hardly anyone instead of being lauded for stepping 620 newport center drive, suite 900 outside of your own enterprise is up, they were pilloried for needing an newport beach, ca 92660 usa cheering for you to rise from world- infusion of capital (which they repaid) phone +1 (949) 325-8700 fax +1 (949) 554-0192 beating success to still-loftier success! and sued for not cancelling the deal. info@rallc.com Was Goldman Sachs targeted with How much of this controversy was www.rallc.com civil and criminal fraud charges because linked to the fact that Bank of America they have criminal intent to defraud was the largest bank in the United Media ContaCtS their clients, while their competition is States by most measures? How much of tucker Hewes Hewes Communications pure as the driven snow? Or have they Citi’s “moments in the spotlight” have +1 (212) 207-9451 become a symbol of success-to-excess, been due to the fact that it was Bank of tucker@hewescomm.com 4Q05 1Q06to an2Q06 that3Q06 populists extent prompts 4Q06 1Q07 predecessor in the #1 spot? America’s 2Q07 Joel Chernoff and pundits to want them to suffer? Microsoft’s opportunity in Research affiliates Is Exxon Mobil regularly the spotlight came a decade ago, +1 (949) 325-8729 pilloried in Washington because when they were attacked on the chernoff@rallc.com continued on page two
- 2. Fundamental Index ® Newsletter · June 2010 grounds of “monopolistic” business practices, as Our research also shows that top dog status was IBM in the prior decade. The decade before that, changes frequently. In most sectors, the top dog is AT&T was successfully dismantled on the same basis. replaced several times over the 58-year time span. The The very business practices that propel an average sector has seen six top dogs over that span, organization to #1—aggressiveness, focus, canny while “Other” has had 17 different #1 companies. No outmaneuvering of the competition—become wonder that the 1-, 3-, 5-, and 10-year shortfalls for these unacceptable if you’re wearing the yellow jersey. “Other” top dogs is nearly always worst on the list. Being #1 means always having to say you’re sorry! 3 The only sector where the top dog was able to hold its position for the entire period occurred in Energy: Exxon Too Big to Succeed? Mobil (and its predecessors, Exxon and Standard Oil Does our tendency to punish our winners hurt their of New Jersey) never lost its top dog status. How did it investors? Yes. In fact, we find the leader in any sector stay on top when the top dogs in other sectors failed in underperforms the average stock in its own sector by 3.5% their quest to be top dog? Perhaps it remained a winner in the next year ... and the next year … and the next year. As because it has always stuck to its core competencies, Table 1 shows, the damage doesn’t really slow down for at avoided the combative business practices that got other least a decade, as the top dog in each sector lags its own sector top dogs in trouble, was content with solid mainstream by 3.3% per year for the next decade! With compounding, growth and profit margins, has not risen to the bait the top stock in the 12 market sectors declined 28% in when under attack, and kept as low a profile as any top value relative to the average stock in its respective sector. dog possibly could. The firm’s persistence at the top On a 10-year basis, the majority beat their peers in only also was aided by the 1999 merger of Exxon and Mobil, 6 of the 49 starting years and in just two sectors over the full which combined the #1 and #2 companies in that sector. span. The “big winner”? Energy, with the top dog scoring an average of just 0.8% outperformance per annum relative Is There a Political Connection? to the average energy stock, over the subsequent decade. The 15 “successful” five-year spans—in which For investors, top dog status is dismayingly un- more than half of the 12 sector top dogs were able attractive! to turn their sector dominance into superior stock Table 1. Relative Performance for the Top Dogs4 The Magnitude of Top Dog Relative Performance (1952-2009) Panel A. Relative Return By Sector Panel B. Frequency of Win by Sector How Many Top Dogs? 1 Year 3 Years 5 Years 10 Years 1 Year 3 Years 5 Years 10 Years Average, all sectors 5.8 -3.5% -3.9% -3.9% -3.3% 42.2% 40.4% 37.2% 33.2% Standard deviation 3.7% 4.1% 3.4% 2.5% 8.0% 10.5% 14.0% 15.3% Adjusted t-Statistic -3.22 -3.25 -4.03 -4.55 -4.19 -2.93 -3.00 -2.73 Sector 1 Nondurables 6 0.4% -1.2% -1.6% -2.8% 43% 46% 46% 33% Sector 2 Durables 5 -3.5% -5.4% -5.2% -4.5% 45% 38% 30% 20% Sector 3 Manufacturing 5 1.3% 0.8% 0.5% 0.1% 48% 54% 63% 55% Sector 4 Energy 1 -1.1% 0.3% 0.5% 0.8% 52% 57% 56% 53% Sector 5 Chemicals 3 -3.1% -1.7% -1.8% -2.0% 52% 46% 46% 43% Sector 6 Business equipment 5 -4.4% -3.8% -4.0% -4.2% 47% 45% 43% 33% Sector 7 Telecommunication 3 -7.4% -6.6% -5.7% -6.1% 34% 32% 26% 12% Sector 8 Utilities (1953-2009) 7 -3.3% -4.3% -4.9% -2.7% 32% 36% 21% 27% Sector 9 Shops 3 -0.8% -0.5% -2.0% -1.8% 43% 43% 39% 47% Sector 10 HealthCare 8 -4.9% -5.0% -4.3% -2.4% 45% 34% 31% 45% Sector 11 Finance 7 -2.3% -4.5% -6.7% -6.6% 40% 36% 30% 14% Sector 12 Other 17 -12.5% -14.4% -11.6% -7.0% 26% 18% 17% 16% Capo dei capi, Largest Big Dog 6 -6.6% -5.4% -6.1% -4.9% 38% 33% 22% 23% Note: We use SIC codes to define the 12 sectors. These definitions may vary from the GIC definitions. Source: Research Affiliates. 2
- 3. Fundamental Index ® Newsletter · June 2010 performance—began in 1952, 1968–72, 1982, 1986, news for top dogs (see Figure 1). Looking at government 1988, 1990, 1993–97, and 2004. These five-year spans outlays and relative performance in concurrent one-year were largely dominated by Eisenhower (first term), spans, the correlation is –31% based on 58 sample years. Nixon, Reagan, Bush I, Clinton, and, in one isolated Where the change in government outlays is correlated case (beginning 2004), Bush II. For the most part, these with the following year’s average relative performance might be seen as political environments characterized of the top dogs, the correlation is –27%. Combining the by rolling back regulation and not demonizing success. two results, the average top dog performance correlation The 14 “seriously unsuccessful” five-year spans,5 with the two-year growth in government outlays is –38%. in which few top dogs (no more than 3 out of 12) were able to turn their sector dominance into superior stock Summary performance, began in 1963–64, 1973–79, 2000–2003, and From these results, one might conclude that an investor 2005. These spans were dominated by the administrations could do rather well by investing in the Russell 1000, minus of Johnson, Ford, Carter, Bush II (but for one starting year), and Obama (one year only, but it’s a doozie). its 12 sector leaders. Better still, perhaps we should exclude Each of these administrations is characterized by sharp all of the companies that have been sector leaders any time increases in government spending and regulation. in the past decade because the performance drag for the Out of curiosity, we conducted a really simple top dogs tends to persist for a decade or more. These stocks statistical test: We compared the correlation between the typically comprise about one-fourth of the Russell 1000! If magnitude of government outlays as a percentage of the these stocks suffer a 300–400 bps shortfall in most years, economy and the relative performance of these top dogs. one could outperform the index by nearly 100 bps per We found a statistically significant negative correlation annum merely by leaving the top dogs out, cancelling the —suggesting that larger government outlays is bad corrosive influence of competitors, populists, and pundits. Figure 1. Performance of Top Dogs vs. Change in Government Outlays (1952–2009) 30% Average Value Added by Top Dogs vs. Average for Sector 20% 10% 0% -10% -20% -30% -40% -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0 Change in Government Outlays as % of GDP Source: Research Affiliates. Endnotes 1. 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 2. 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. 3. 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. 4. I’m indebted to Vitali Kalesnik and Lillian Wu for the yeoman’s task of assembling and analyzing these data. 5. The unsuccessful periods are defined as those in which two or less top dogs beat their sectors. 3
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Fundamental Index ® Newsletter · June 2010 Performance Update ANNUALIZED BLOOMBERG ANNUALIZED ANNUALIZED ANNUALIZED TOTAL RETURN AS OF 5/31/10 YTD 12 MONTH 10 YEAR TICKER 3 YEAR 5 YEAR 10 YEAR VOLATILITY FTSE RAFI 1000 IndexA ® FR10XTR 2.68% 31.50% -6.31% 2.79% 4.82% 17.78% S&P 500B SPTR -1.50% 20.99% -8.69% 0.31% -0.82% 16.09% Russell 1000C RU10INTR -0.88% 22.33% -8.38% 0.67% -0.41% 16.40% FTSE RAFI US 1500 IndexD ® FR15USTR 9.08% 48.65% -1.75% 6.91% 11.65% 22.62% Russell 2000E RU20INTR 6.29% 33.62% -6.57% 2.77% 4.71% 21.05% FTSE RAFI Developed ex US 1000 IndexF ® FRX1XTR -12.45% 7.67% -10.29% 4.21% 5.05% 19.43% MSCI EAFEG GDDUEAFE -12.08% 6.84% -12.61% 1.83% 1.05% 18.13% FTSE All World Series Developed ex USH FTS5DXUS -10.96% 8.23% -11.30% 2.99% 2.08% 18.37% FTSE RAFI Developed ex US Mid SmallI ® FRSDXUS -6.99% 16.64% -8.28% 4.13% 8.69% 18.38% MSCI EAFE SmallJ MCUDEAFE -7.70% 12.61% -15.03% -0.37% 3.79% 20.11% FTSE RAFI Emerging MarketsK ® TFREMU -4.62% 24.03% 3.64% 19.27% 20.25% 25.32% MSCI Emerging MarketsL GDUEEGF -5.36% 22.72% -0.46% 14.00% 10.78% 24.99% FTSE RAFI CanadaM ® FRCANTR 2.70% 23.18% -0.13% 8.99% 9.84% 14.26% S&P/TSX 60N TX60AR 0.77% 12.29% -2.33% 7.71% 4.38% 16.78% FTSE RAFI AustraliaO ® FRAUSTR -9.24% 21.55% -5.59% 6.52% 9.60% 13.02% S&P/ASX 200 IndexP ASA51 -7.54% 20.80% -7.09% 6.06% 8.06% 13.63% FTSE RAFI JapanQ ® FRJPNTR -1.06% 0.38% -16.89% -1.18% 0.08% 18.58% MSCI JapanR GDDLJN -2.85% -0.09% -19.58% -2.98% -4.07% 18.41% FTSE RAFI UKS ® FRGBRTR -2.08% 19.31% -5.22% 4.04% 3.95% 16.98% MSCI UKT GDDUUK -2.64% 21.71% -4.34% 4.50% 1.67% 14.90% RAFI Investment GradeU 4.25% 16.34% 7.69% 5.71% 7.05% 5.61% Merrill Lynch US Corporate MasterV C0A0 3.96% 17.44% 6.22% 4.91% 7.01% 6.21% RAFI High YieldW 4.16% 22.60% 9.68% 9.46% 10.14% 9.49% Merrill Lynch US High Yield BB-B RatedX H0A4 3.11% 23.23% 4.24% 6.21% 6.52% 10.18% Definition of Indices: (A) The FTSE RAFI® 1000 comprises the 1000 largest companies selected and weighted using our Fundamental Index methodology; (B) The S&P 500 Index is an unmanaged market index that focuses on the large-cap segment of the U.S. equities market; (C) The Russell 1000 Index is a market-capitalization-weighted benchmark index made up of the 1,000 highest-ranking U.S. stocks in the Russell 3000; (D) The FTSE RAFI® 1500 comprises the 1001st to 1500th largest companies selected and weighted using our Fundamental Index methodology; (E) The Russell 2000 is a market-capitalization weighted benchmark index made up of the 2,000 smallest U.S. companies in the Russell 3000; (F) The FTSE RAFI® Developed ex US 1000 Index comprises the largest 1000 non US-listed companies by fundamental value, selected from the constituents of the FTSE Developed ex US Index; (G) MSCI EAFE (Morgan Stanley Capital International Europe, Australasia, Far East) is an unmanaged index of issuers in countries of Europe, Australia, and the Far East represented in U.S. dollars; and (H) The FTSE All World ex-US Index comprises Large and Mid-Cap stocks providing coverage of Developed and Emerging Markets excluding the United States. It is not possible to invest directly in any of the indexes above; (I) The FTSE RAFI® Developed ex US Mid Small Index tracks the performance of small- and mid-cap equities of companies domiciled in developed international markets (excluding the United States), selected based on the following four fundamental measures of firm size: book value, cash flow, sales, and dividends. The equities with the highest fundamental strength are weighted according to their funda- mental scores. The Fundamentals Weighted® portfolio is rebalanced and reconstituted annually. Performance represents price return only; (J) The MSCI EAFE Small Cap Index targets 40% of the eligible small-cap universe (companies with market capitalization ranging from US$200 to US$1,500 million) in each industry group of each country in the MSCI EAFI Index; (K) The FTSE RAFI® Emerging Markets Index comprises the largest 350 companies selected and weighted using the Fundamental Index® methodology; (L) The MSCI Emerging Markets Index is an unmanaged, free-float-adjusted cap-weighted index designed to measure equity market performance of emerging markets; (M) The FTSE RAFI® Canada Index comprises the Canadian stocks represented among the constituents of the FTSE RAFI® Global ex US 1000 Index, which in turn comprises the 1,000 non-U.S.-listed companies with the largest fundamental value, selected from the constituents of the FTSE Developed ex US Index; (N) The S&P/Toronto Stock Exchange (TSX) 60 is a cap-weighted index consisting of 60 of the largest and most liquid (heavily traded) stocks listed on the TSX, usually domestic or multinational industry leaders; (O) The FTSE RAFI® Australia Index comprises the Australian stocks represented among the constituents of the FTSE RAFI® Global ex US 1000 Index, which in turn comprises the 1,000 non-U.S.-listed companies with the largest fundamental value, selected from the constituents of the FTSE Developed ex US Index; (P) The S&P/ASX 200 Index, representing approximately 78% of the Australian equity market, is a free-float-adjusted, cap-weighted index; (Q) The FTSE RAFI® Japan Index comprises the Japanese stocks represented among the constituents of the FTSE RAFI® Global ex US 1000 Index, which in turn comprises the 1,000 non-U.S.-listed companies with the largest fundamental value, selected from the constituents of the FTSE Developed ex US Index; (R) The MSCI Japan Index is an unmanaged, free-float-adjusted cap-weighted index that aims to capture 85% of the publicly available total market capitalization of the Japanese equity market; (S) The FTSE RAFI® UK Index comprises the U.K. stocks represented among the constituents of the FTSE RAFI® Global ex US 1000 Index, which in turn comprises the 1,000 non-U.S.-listed companies with the largest fundamental value, selected from the constituents of the FTSE Developed ex US Index; (T) The MSCI UK Index is an unmanaged, free-float-adjusted cap-weighted index that aims to capture 85% of the publicly available total market capitalization of the British equity market; (U) The RAFI® Investment Grade Master Index is a U.S. investment-grade corporate bond index comprised of non-zero fixed coupon debt with maturities ranging from 1 to 30 years issued by publicly traded companies. The issuers held in the index are weighted by a combination of four measures of their fundamental size—sales, cash flow, dividends, and book value of assets; (V) The Merrill Lynch U.S. Corporate Master Index is representative of the entire U.S. corporate bond market. The index includes dollar-denominated investment-grade corporate public debt issued in the U.S. bond market; (W) The RAFI®High Yield Master is a U.S. high-yield corporate bond index comprised of non-zero fixed coupon debt with maturities ranging from 1 to 30 years issued by publicly traded companies. The issuers held in the index are weighted by a combination of four measures of their fundamental size—sales, cash flow, dividends, and book value of assets; (X) The Merrill Lynch U.S. High Yield Master II Index is representative of the U.S. high yield bond market. The index includes domestic high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. Source: All index returns are calculated using Total Return data from Bloomberg except for the FTSE RAFI Developed ex US Mid Small (FRSDXUS) and the MSCI EAFE Small (MCUDEAFE) which uses price return data. ©2010 Research Affiliates, LLC. The material contained in this document is for general information purposes only. It relates only to a hypothetical model of past performance of the Fundamental Index® strategy itself, and not to any asset management products based on this index. No allowance has been made for trading costs or management fees which would reduce investment performance. Actual results may differ. This material is not intended as an offer or a solicitation for the purchase and/or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. This material is based on information that is considered to be reliable, but Research Affiliates® and its related entities (collec- tively “RA”) make this information available on an “as is” basis and make no warranties, express or implied regarding the accuracy of the information contained herein, for any particular purpose. RA is not responsible for any errors or omissions or for results obtained from the use of this information. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this material should not be acted upon without obtaining specific legal, tax or investment advice from a licensed professional. Indexes are not managed investment products, and, as such cannot be invested in directly. Returns represent back-tested performance based on rules used in the creation of the index, are not a guarantee of future performance and are not indicative of any specific investment. Research Affiliates, LLC, is an investment adviser registered under the Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC). Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination, or redistribution is strictly prohibited. This is a presentation of RA. Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in RA’s presentation thereof. ® The trade names Fundamental Index®, RAFI®, the RAFI logo, and the Research Affiliates corporate name and logo are registered trademarks and are the exclusive intellectual property of RA. Any use of these trade names and logos without the prior written permission of RA is expressly prohibited. RA reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these terms and logos. Fundamental Index®, the non-capitalization method for creating and weighting of an index of securities, is patented and patent-pending proprietary intellectual property of Research Affiliates, LLC (US Patent No. 7,620,577; Patent Pending Publ. Nos. US-2005-0171884-A1, US-2006-0149645-A1, US-2007- 0055598-A1, US-2008-0288416-A1, US-2010-0063942-A1, WO 2005/076812, WO 2007/078399 A2, WO 2008/118372, EPN 1733352, and HK1099110). The views and opinions expressed are those of Rob Arnott and not necessarily those of Research Affiliates, LLC. The opinions are subject to change without notice. 4