Rob Arnott: When stocks become too big to succeed

The following is an excerpt from a monthly newsletter written by Rob Arnott, chairman of investment management firm Research Affiliates LLC. To read the full newsletter, please visit the Research Affiliates site. 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 the table below 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. 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 shortfalls 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.