John Scherer and Bridget Sullivan Mermel discuss why it's difficult for companies to stay at the top and what investors can do about it. They analyze the historical performance of top stocks and the factors that contribute to their decline. They highlight government intervention, competition, and the diminishing returns of large companies. They emphasize the importance of diversification to mitigate risk and capture future high-performing stocks.
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TRANSCRIPT:
John: Once a company is successful, it's really hard to stay at the top. On today's episode of Friends Talk Financial Planning, we're going to discuss why that's the case and what you can do about it in your investment policy. Hi, I'm John Scherer and I own a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. Before we start talking about why it's hard to stay at the top, please hit subscribe. It helps us reach more viewers. So, John, this is inspired by some information that Dimensional Funds put out about what happens to companies after they're one of the top stocks. Inspired by our episode about FANG, which is Facebook, Apple, Amazon, Netflix and Google, what happens when companies are at the top? And so, they put together a prediction, or not prediction, but an experience about what happens after one company reaches the top? So why don't we talk that through?
John: Yeah, that sounds good. And so let me just bring up the graphic from our previous episode. We'll put a link to it in the show notes, too. If you didn't see that FANG episode, this graph was really useful to talk about concentration in stocks and in the stock market and why you shouldn't worry about it as much as the media might tell you to. But look at this graphic here, going left to right. And the one thing that we talked about last time is on the bottom, that concentration of the top ten stocks.
But let's look for a minute at that, going across, following the lines on here. And what Dimensional did with this is they connected the dots in the same colors. And you can see from left to right when companies come in and out of the top ten in the market as far as size goes. And I'll point out that the ones that don't have any lines or arrows, just the empty circles, that's when they only made a one-decade appearance in the top ten.
And so, one of the things that catches my eye is that back in the olden days, thirties, forties and fifties of the last century, there was a fair amount of consistency. And this century, the last 20 or so years, there are a lot of new faces. It'll be interesting to see how those things change and move over time. And we started to point out a little bit that things like AT&T, General Motors, and General Electric. If you look at where they started almost 100 years ago, not too many of them, maybe none of them are in the top ten today. And that's the basis of this conversation. We started looking at this and thinking, “Hey, let's dig into this and talk about this.”
Bridget: Yeah. Let's talk about what happens to these top stocks. And it's easier to think about the stocks that are happening now versus the olden days of my youth. So back then AT&T and General Electric were two big stocks. Now maybe AT&T isn't known as a tech stock, but I would argue that they were the tech stock at the time and actually General Electric was getting the light bulbs going, electricity, et cetera. They were actually a lot more like tech stocks back in the day, I think, than we associate them with today.
John: Right.
Bridget: The other thing is that I think foreign competition really kicked in at one point. And so, I think that's one of the things that has stirred up the pot, because I think after World War II, so many countries were just rebuilding that it took a while for them to be even kind of functional enough, like to be able to compete with the U.S.
John: And talk about how companies stay at the top. And maybe as we think about those FANG type stocks, we might ask, “Should we just ride that train?” And the answer is maybe, but I think AT&T is a great example. Look across the left there, they're on the top for decades in a row. And we're talking 30, 40, 50 years. It was one of the top two companies. What happened in the 80s? We had deregulation or the government got involved and broke AT&T up. One of the risk factors is government intervention—political winds change—and we can discuss that another time. Is that a good thing? A bad thing? I don't know. It’s probably a good thing. But the reality is that can be an influence on staying at the top for a company, especially in the tech area.
Bridget: And how they handle the regulators. When the market share gets too concentrated, there's a move to take a closer look and say, “What are these companies really doing? Are they trying to get this market share by ways that are either against the law or we don't agree with? And people might say, “A big company is doing this. Let’s do it too. We can do it more efficiently.” So just being at the top invites competitors.
John: Maybe there is some technology or something that you didn't have with competition when you were first starting out, maybe even for a decade or two. You've got that advantage. How does that change over time? And that's a risk that comes in. One of the other things that I think about with this sort of gets into a little bit of weeds on some economic theory and things, but the reality is if I expect to get this kind of return on a stock and the stock is worth $50 and this is the profits in the future, well, if it goes up to $100 and the profits are at the same level, that means that my returns are going to be lower based on that change.
As the stock price goes up, it's sort of this perverse relationship. So I'm getting this growth, but then my expected returns down the road, just by definition, aren't going to be as high. And so, you get that huge growth in the early years with things. As I describe it to clients, I go back to Walmart, who's on that chart that we were looking at is back in the 50s or 60s when there were two Walmart stores. For them to double their growth, that's not too hard to do. They can skyrocket.
But then what happens if there's road construction in front of one of their two stores when they're first starting out? They could also go out of business in a hurry. But now, there's a gazillion stores on every corner in every town. Walmart's not going to double their sales next year. At a certain scale you can't do that. And if the stock goes up, their sales just can't keep up with it. So the expected return doesn't mean it's a bad investment or anything. It's just that the expected returns have to go down, and it's sort of this yin and yang relationship.
Bridget: Yeah. And then we don't even get into the fact of how bureaucracies and size of companies can kind of slow them down. It's hard to even just add employees. It makes it more difficult to make changes in my company, the few employees, much less the number of employees a large company hires. They deal with that, too. There's a lot of factors that basically drag companies back to the mean, drag them back to average.
John: There’s one thing that just struck me, Bridget, as we're talking. And I tend to focus on the known factors. These are things that we can identify. Think about the other side of this, too, is the unknown factors. And I think of Kodak. They were the leader in film technology and a rock-solid option, one of the companies that you couldn't go wrong with. And then as the digital age came in, they didn't adjust quite fast enough and have basically gone away.
Bridget: Xerox is on the list too. You kind of feel for the company because nobody makes copies anymore.
John: Right. All these things that we're discussing are real and accurate. Those are the known risk factors. There are certainly some things in 20 years I will look and say, “Who would have guessed that X or Y or Z came in and took some of those companies that were in the top and made them obsolete if they don't stay up. There’re all those unknown things and with all that future innovation that we just don't know what it even looks like. And I sort of morphed a little bit into asking, “What are these large companies? How do they stay there?” And sort of talking a little bit about returns And I do think it is interesting. Maybe we'll pull up another graphic here that Dimensional had provided and you can take a look at the returns after a company gets into the top decade here and it goes back to 1927, so this goes back a long time.
Bridget: Do you mean the top ten?
John: Yes, thank you. It goes back a long time. And you go,” Listen, once they get in the top ten, they're doing pretty well.” But then over five and ten years, look at those returns, or the excess return they're talking about. But they're outperformers in the early stages. They're on the upswing, but they're actually on average underperformers longer term. And so, what does that mean for the FANG stocks? I don't know. History says that maybe we should expect some underperformance. It'll be interesting to see. But it's not like those things keep on rolling as we talk about large company stocks and where they are. That's all nice and interesting, but at the end of the day, we want to know, hey, what are we getting from these things? And this return, I think, talks a little bit about that.
Bridget: I think the overall message is about diversification. Having a broad basket of everything helps lower your risk and capture the highflyers that we don't even know because they haven't even formed yet.
John: I love that idea. We don't even know the future, so diversification captures them all. It's a great place to wrap things up. I'm John Scherer. I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. John and I are both taking clients. We see clients all over the country. But if you're interested in an advisor in your local area, we're both proud members of the Alliance of Comprehensive Planners, which is a not-for-profit group. We're all tax focused, comprehensive financial planners. And the other thing I urge you to is please subscribe.
John: That's right.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.