Top Dogs? Downward Dogs

Many of the best performing companies rarely stay on top.

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“Uneasy lies the head that wears a crown.”
(William Shakespeare, Henry IV, Part 2 [Act III, Scene I])

As the shares of Canada’s largest company (by market capitalization), Valeant Pharmaceuticals, crumbled in early 2016, investors were left dazed, confused, and considerably less wealthy. Across the land came a collective sigh, “not again.” Like many champions before it, Valeant was on the ropes soon after laying claim to the title, a victim of the so-called “winner’s curse.” A widely recognized phenomenon, the curse strikes frequently in Canada. And when it does happen here it matters more.

Top dogs in Canada posted the worst average relative performance: -10 per cent per year for the following decade.

The winner’s curse

In 2012 Rob Arnott and Lillian Wu published “The Winner’s Curse: Too Big To Succeed?”, a paper that looked at the track record of the world’s biggest stocks from 1952 to 2011. They found a persistent pattern in each of the nine countries they studied of companies, once achieving “top dog” status, underperforming their respective country’s equal-weighted index by an average of 4.3 per cent per year for the following decade (1 year -3.5 per cent, 3 years -4.0 per cent, 5 years -4.9 per cent.) Top dogs in Canada posted the worst average relative performance: -10.0 per cent per year for the following decade. And Arnott and Wu found the fall from the throne was typically as quick and dramatic as was the rise to it (Figure 1).

The Economist found similar results when it compared average returns, before and after claiming leadership status, of companies that led the S&P 500 by market cap between 1993 and 2005 (“The Curse of the top dog”, March 7, 2015.) In the ten years preceding their ascendency, the firms’ average total return was 1282 per cent versus 302 per cent for the S&P 500 over corresponding periods. For the 10 years after they averaged 125 per cent versus 199 per cent for the index (Figure 2).

What is happening?

The Economist points to dis-economies of scale and the ‘law of large numbers,’ but suggests that most likely, as valuations rose due to rapid growth, the top dogs’ stocks simply became more vulnerable to disappointment.

Arnott saw it differently: “When you are #1, you have a bright bull’s-eye painted on your back.”

Targeted by new competition

Challenges from nimbler competitors may raise the “innovator’s dilemma,” where attention to current customers leads to a failure to adopt new technologies or practices required to serve new customers. Higher fixed costs and established infrastructure hampers flexibility. Management may fall prey to internal rivalries or external distractions further restricting the ability to react to challenges.

Scrutiny of regulators

Rapid growth can put a company in the sights of regulators (who are often egged on by resentful competitors). Microsoft became such a target in the 1990s, and AT&T in the 1980s, resulting in seven new ‘Baby Bells.’ Alphabet (Google) is now facing scrutiny in Europe. As Arnott explains, “the very business practices that propel an organization to #1 in market cap – aggressiveness, focus, canny outmanoeuvering of the competition – become unacceptable if you’re wearing the yellow jersey.”

The curse of the cover

Media coverage as a jinx was first associated with athletes on the cover of Sports Illustrated. The idea then migrated to business and the covers of Fortune, Forbes, and Business Week. In both realms the generally accepted explanation is that some incidence of outlier performance propels athletes or businesses to the cover, and that simple regression to the mean subsequently looks disappointing.

In business there is more to it than that. Vaulting to the top and attracting attention brings more analyst coverage. Wider coverage means a broader scope of opinions, some of them contrarian. More eyes increases the chances that problems or fraudulent activities, if present, are uncovered. Perhaps the companies become targets for environmental or social activists.

A changing breed. Who are the top dogs?

Until the 1990s technology boom, the U.S. market cap leader was typically an industrial giant (e.g. General Motors, Exxon) with high capital spending requirements. High capital needs created protective barriers to entry and made shifting relative sizes and rankings a slow process. Top dogs often held the title for more than a decade.

The tech boom accelerated the pace of change as new technology quickly disrupted incumbents. Five companies have held the S&P 500 top spot in just the last 15 years (Figure 3).

In Canada, however, the top ranks were long dominated by the major banks (especially Royal Bank) and BCE. Then the commodity super cycle elevated energy and resource companies alongside our technology champions.

The ugly canadians

Even to a casual observer, something distinguishes the Canadian top dog list since 2000 from the U.S. list apart from the presence of financials and resources. Exxon, IBM, GE, Microsoft and Apple all remain successful global giants. The Canadian champs? Not so much. Nortel and Valeant collapsed amid allegations of questionable bookkeeping and business practices. Blackberry was crushed by competition. EnCana, Potash and Barrick all succumbed to the down leg of the commodity cycle. Excluding Royal Bank, Canada’s former champions have a less than impressive stock market record:

  • Nortel Networks (NT) rode the dot.com frenzy to a peak in July, 2000. Twelve months later the stock had fallen more than 90 per cent. It filed for bankruptcy in 2009.
  • Manulife Financial (MFC) grabbed top spot in April 2004 by merging with John Hancock Financial Services. The stock climbed to a 2007 peak, then fifteen months later was off 79 per cent as the financial crisis dragged down world markets.
  • EnCana (ECA) reached its high June 2008. By February 2016 it had declined over 90 per cent.
  • Blackberry (BB, RIM) (Research in Motion) surpassed Royal Bank in late 2007 and continued upward until reversing course in June 2008. Five years later the stock was 95 percent off its peak.
  • Potash Corporation of Saskatchewan (POT) rode a wave of enthusiasm for agricultural commodities. It now trades at roughly one quarter its split-adjusted June 2008 high.
  • Barrick Gold (ABX) took the lead in 2009 and continued its climb until December 2010. Five years later it was down more than 80 percent. After a partial recovery in recent months it still trades almost two thirds off its peak value.
  • Valeant Pharmaceuticals (VRX) passed Royal Bank to become the biggest company on the S&P/TSX in July 2015. It reached its high less than two weeks later and in the following eight months fell spectacularly, losing 90 per cent of its value.

Why us?

Canada displays a home country bias for many reasons including f/x and geopolitical risk aversion, market rules, taxation and legal considerations, and government and employer incentive programs. Unfortunately, many investors put their financial security at risk in a display of blind patriotism, much like sports fans dogmatically cheering the home team, regardless of the team’s merit. With a relatively small stock market, Canada has so few true global champions that investors and analysts tend to enthusiastically jump on the patriotic bandwagon whenever one appears, turning a blind eye to what should be red flags.

A hot stock will have a big footprint on a small market’s index, as institutional funds pile in for fear of missing out on gains being experienced by competitors. As Nortel streaked to its high it dominated the Toronto index so completely (over 36 per cent of the index by weight at one point) that most mutual and pension funds came under severe pressure from unit holders questioning why they were so badly underperforming the benchmark.

Everybody hurts

When a Canadian top dog tumbles, there is often no escaping the pain. The size and concentration of the market not only makes stock implosions more frequent, but makes them matter more. Domestic bias happens in all markets, but in a broader market investors have a greater natural level of protection by diversification.

If all institutional investors jump into a market darling that dominates the benchmark index, all investors will be wounded when the dream dies. Diversification across many funds offers little protection if all the funds own the same names.

Passive vehicles such as ETFs may be especially dangerous in concentrated markets because they often just track an index, even into dangerously concentrated territory. Active managers may have more flexibility to mitigate over-concentration risk.

The fallout can extend to all Canadians, whether they consider themselves investors or not. According to the National Post, in 2015, as Valeant approached top dog status, it was the third largest equity holding of the Canada Pension Plan Investment Board, the fund charged with providing retirement, disability and death benefits to almost all Canadians.

What can you do?

If the CPP can be caught up in the hype, what hope is there for the rest of us?

The first step is to have a well-defined investment strategy as part of your financial plan. A long-term plan with reasonable return targets and a defined sell discipline goes a long way to helping you avoid getting swept up in fads. Keep watch for hype and be extra vigilant when it comes to jumping on bandwagons. Deviations from a well-constructed strategy warrant more due diligence than typical investment decisions.

Secondly, recognize the risk of index concentration, particularly in a small market like Canada. If a single stock (or sector) rises to a dangerous weight in the benchmark, seek diversification elsewhere.

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