For a growth stock investor like myself, a major challenge is buying companies that really will grow as fast as Wall Street expects—and sell names that run out of gas before it’s obvious to the market. A major risk is that companies get so big they can no longer grow rapidly because they:
- Are battling the law of large numbers.
- Already dominate their domestic market, so go overseas where margins are lower (think Wal-Mart in China).
- Are too big to manage (JPM’s London Whale).
- Make dumb acquisitions that are only profitable for the investment bankers (Pfizer since 1999).
- Diversify into a temporarily lucrative but risky ancillary business (GE Capital).
- Over-diversify, lose focus, and become a grab bag of mediocre businesses (P&G, J&J for a while).
I decided to quantify this risk by comparing the “Biggest” company in various industries with smaller but important competitors (“the Merely Big”). My methodology is not airtight and would not pass muster at The Journal of Finance, but it gets the job done.
Focus on 20 “Biggest” and Compare with 2-6 “Merely Big“ In Same Industry
To identify the “Biggest” I used 19 of the 30 Dow Industrials (plus Schlumberger) that each had a group of 2-6 smaller competitors in the same industry. For example, I compared CAT with Cummins, Deere, ITW, Joy Global, and Paccar. On average, in the 20 industries studied the market cap of the “Biggest” was four times the average market cap of the “Merely Big” in that industry. I calculated the 2004-2014E EPS CAGR (compound annual growth rate) of each company, to which I added the current dividend yield to calculate “Growth+Yield.” (Notice I am looking only at “fundamentals”—not the valuation or price performance of the stock.) So, for example, CAT’s EPS grew from $2.88 in 2004 to $6.23 in 2014, a CAGR of 8%; CAT’s current yield is 2.3%, so its Growth+Yield is 10.3%. That compares with an average Growth+Yield for the five aforementioned “Merely Bigs” of 13.8%. So, in this industry, the “Biggest” (CAT) had a Growth+Yield that was only 75% of the “Merely Bigs” (10.3 / 13.8 = 0.75 or 75%).
Again, I performed this analysis for 20 “Biggest” companies in a variety of industries. In all the study involves 103 companies with an aggregate market cap of $7.4 trillion, or nearly half the market cap of the entire S&P 500.
The Biggest Lag, but Not By Too Much
So, what did I learn? The “Biggest” usually lag the “Merely Big” but in many cases not by a huge amount. I was impressed that many—though by no means all—giant, dominant, comparatively safe companies were able to keep up with, or nearly keep up with, smaller competitors. Specifically:
- In 5 of the 20 industries, the “Biggest” had a higher Growth+Yield than the “Merely Big” companies it was compared to. In 15 industries it was lower, but often not much lower.
- Comparing Growth+Yield of the “Biggest” with the average Growth+Yield of the “Merely Big” in its industry (a la the 75% figure in the CAT example), the median value for the 20 industries was 87%. (13 of the 20 were above 80%.) This 87% figure means, for example, that if the Growth+Yield return of the “Biggest” was 10%, the average Growth+Yield of the “Merely Bigs” in that industry would be 11.5%.
- This result is better than it looks because in most cases the Biggest is considerably less risky than some of the “Merely Bigs” it is compared to.
- Shifting from relative to absolute figures, the median Growth+Yield of the 20 “Biggest” was 10.3%–not bad.
- As we would expect, the Biggest delivered a higher proportion of Growth+Yield via dividend yield as opposed to earnings growth. For the typical (median) company, the dividend yield was 37% higher for the Biggest than for the Merely Bigs in the same industry.
From Fundamentals to Stock Price: Beware the Street’s Love Affair with the Biggest
Though there were a few disasters like PFE and GE (see below), overall the Biggest did better than I expected. But keep in mind that we are talking here about “fundamentals” (EPS growth and dividend yield) NOT valuation and stock price performance. If you pay too much for the “Biggest” company it can be a bad stock even though the earnings growth remains fairly strong. This is true, for example, of MSFT, KO and INTC, which are still trading below their peaks of 1998-2000.
Obviously if you pay for 15% secular growth in a stock and it turns out to be only 10%, price performance will be poor. Psychologically and analytically, it is extremely difficult to figure out if and when the growth of an industry leader such as Coke or Microsoft will decelerate. And, frankly, Wall Street tends to do a poor job here, for a few reasons:
- By definition, these have been great stocks that have trampled the bears for years. (I remember an analyst who was bearish on MSFT in the mid-1980s, until the stock gave him a nervous breakdown and he left Wall Street.)
- Analysts may not be eager to downgrade a popular stock that all their clients own in size.
- Every analyst needs some stocks rated “Buy,” partly because they have clients that must have an investment in the industry and want to know, “What’s your top pick in the space?”—even if the space is not attractive. A good example is Big Pharma over the past 10 years.
- When EPS growth slows, analysts are prone to maintain a “Buy” and tell clients, “The stock is cheap. The PE ratio relative to the S&P 500 is well below historical norms.” This is a dumb observation if the multiple is declining because growth is slowing.
- Finally, and oddly, the Street does not do a great job of spotting secular trends that hurt growth—such as Coca-Cola being hurt by the aging and increasing health consciousness of consumers; big pharma failing to replace revenue lost to patent expirations; big banks being hurt by harsh regulations since 2009; or paper, newspaper, office products retailers, and PC printing companies being hurt by the shift to the mobile web.
A Look at the Twenty Stocks, from Best to Worst
Methodological note: When reading about individual stocks, one should not put excessive weight on the 2004-2014 EPS CAGR and “Growth+Yield” because CAGR’s are sensitive to end points. If a company had a bad year in 2004 and/or a particularly good year in 2014, this would flatter the growth rate. The converse is also true. Also, investing is always about the future; past growth may not be sustainable. On this score, it is reassuring that the average 2014 EPS growth rate of the 20 “Biggest” is 7.6%; their current average dividend yield is 2.7%
JP Morgan: At 9.8%, its Growth+Yield was not particularly high on an absolute basis, but it was 242% of the average of the “Merely Big” (USB, PNC, STI, BK, FITB, STT) some of which were clobbered by the financial crisis.
Travelers: A high Growth+Yield of 16.5%, which was 228% of the Merely Bigs (CB, ALL, MMC, PFG).
Exxon-Mobil had a decent Growth+Yield of 9.8%, which was actually 160% of the average of the Merely Big (APA, APC, OXY, DVN).
Boeing: A duopoly is a wonderful thing, and BA benefits from Asia’s travel explosion. BA had a very high Growth+Yield of 19%, or 122% of the average of the Merely Bigs (GD, LMT, NOC, RTN).
Coca-Cola: Its 10.3% Growth+Yield was 108% of the average of the Merely Bigs (PEP, GIS, K and HSY). In this industry the Growth+Yield was remarkably uniform across the five companies, ranging from 9.2% to 10.3%.
Wal-Mart’s Growth+Yield was 10.6%, 97% of the average of the Merely Bigs (COST, TGT, KSS, M, KR). Saturation and Amazon are big challenges in the future. Also, retailing is rather difficult to take abroad successfully.
IBM: Its Growth+Yield was high at 15.8%, which was 96% of the peers (Accenture, HPQ, ORCL).
Schlumberger’s Growth +Yield was very high at 20.1%, 96% of the average of HAL and BHI. This is an underappreciated “high tech industry” that oil producers around the world—whether private or state-owned companies—need. Admittedly it is more risky than oil producers because it is leveraged to capital spending, not oil and gas output and price.
Microsoft: Growth+Yield of 12.8%, 92% of the average of ADBE, GOOG, INTU, ADSK.
United Health had a decent Growth+Yield of 12.4%, 88% of the average of WLP, AET, CI and HUM.
McDonald’s has a solid Growth+Yield of 14.7%, 86% of the average of fast-growing SBUX and YUM. Whether MCD can keep growing rapidly is far from clear, given saturation, tough competition, and being locked into a “not very good for you” menu by its kitchen configuration. Plus, Obamanomics continues to hurt MCD’s low-income customer base.
AT&T has a Growth+Yield of 11.5%, 85% of the average of CMCSA, DISH, DTV, AND TWC.
JNJ has a decent Growth+Yield of 9.4%, 81% of the average of BAX, MDT, and BDX. After a period of severe mismanagement of its consumer business, JNJ’s organic growth is picking up thanks to a new CEO and a rollout of successful new drugs (which, to be fair, were initially developed under the prior CEO).
P&G has a decent Growth+Yield of 9.2%, but it is only 76% of the average of CL, CHD, EL, CLX, and KMB.
Caterpillar, as mentioned, had a Growth+Yield of 10.3%, 75% of its peer group.
American Express has a Growth+Yield of 8.2%, which is 67% of the Mergely Bigs (COF, DFS, AMP, and TROW). However, AXP is a fundamentally safer stock than some of its peers.
Intel has a Growth+Yield of 8.4%, which is only 61% of the merely big (QCOM, SNDK, ADI, TXN). INTC missed the boat on the shift from PC’s to smart phones and tablets and now has a smaller market cap than QCOM. However, as the world’s best designer and builder of chips it remains very competitive long term.
DuPont’s Growth+Yield was 8.8%, which is not too bad in absolute terms but just 61% of the merely big (DOW, PPG, PX, APD, EMN, MON). DD is streamlining to improve its growth rate.
Pfizer: a low Growth+Yield of just 4.0%, 50% of the average of MRK, LLY, BMY, and AMGN. Amgen has grown EPS at a 14% clip, versus just 1.8% for the four Big Pharma names. PFE’s sudden shift from restructuring mode to another giant deal (buying AstraZeneca) suggests its organic growth prospects are poor.
GE had a dreadful Growth+Yield of just 3.8%, 31% of the average Merely Big (UTX, HON, ETN, DHR, EMR, ITW). Mr. Immelt has done his best, but the company was clobbered by the financial crisis and has a too big to manage problem. A smart analyst once told me it would be impossible to find a CEO who could effectively manage GE’s disparate parts.
Selected Mega-caps Are a Decent Investment
The average PE ratio of these 20 stocks on 2014 EPS is 15.1x—very reasonable in a low-rate environment. Investors get a 2.7% current yield plus growth of 5-10% per year, in most cases. Yes, the quoted price of the shares will fluctuate. But you own some of the biggest and best companies in the world. It is strange that, at a time when pundits are complaining about how capitalism creates inequality as the rich get richer, investors are lukewarm on owning shares of big, successful companies. The 20 stocks discussed here are a sample, not a portfolio, and there are names on the list I definitely would not own. Consult your investment advisor or do your own work.
Copyright Thomas Doerflinger 2014. All Rights Reserved.