Monday Morning – Top stocks: Here today, gone tomorrow

If at the end of 1990 you had invested $1,000 in each of the 50 largest companies as measured by market capitalization, and sold the stock 10 years later, you would have earned a 16% compound annual return, excluding dividends.

The Standard & Poor’s 500 stock index (excluding dividends) grew by 14.9% a year during the same period. That’s one finding of a study by Andrew Engel, a senior analyst at The Leuthold Group in Minneapolis.

That seems to suggest buying and holding the largest 50 stocks may be a terrific investment strategy, but the 1990-2000 results from buying and holding the 50 largest companies is an aberration.

In the three previous decades, buying the 50 largest stocks and holding them produced poor results relative to the S&P 500. Even in the 1990-2000 period, only 18 of the 50 companies outperformed the S&P 500, and the primary factor contributing to the portfolio’s outperformance was a huge gain in Microsoft Corp., which compounded at 35.4% a year.

In fact, Mr. Engel’s study shows the power of the forces of “creative destruction” (in economist Joseph Schumpeter’s words) in the capitalist system. Companies with better products or ideas replace and drive out of business older, less creative companies.

few have survived

Mr. Engel identified today’s biggest companies ranked first by assets and then by market capitalization. He then tracked the ranking of each stock at various periods in the past. For the ranking by assets, he looked at each company’s rank in 2001, 1995, 1985, 1977, 1966, 1945, 1929 and 1917.

He found that only 13 of the top 100 at the end of 2001 were in the top 100 in 1917, only 15 in 1929 and only 24 in 1945. The 13 in the top 100 in 1917 included ExxonMobil, General Electric, DuPont, AT&T, Ford and General Motors.

In 1945, ExxonMobil, GM, Ford, DuPont and GE were all near the top of the rankings, and IBM and Honeywell had slipped into the list, suggesting the computer revolution to come. But many of today’s blue-chip companies had yet to appear: GTE, PepsiCo, Boeing, Johnson & Johnson and Merck among them.

And some major industrial names had disappeared from the 1917 top 100, among them Armour Meat Packing, W.R. Grace, Great Northern Iron Ore, American Locomotive, Baldwin Locomotive, United Shoe Machinery, United Motors, Heinz and Consolidated Coal.

By 1995, tech firms had climbed onto the list. Microsoft ranked 90th. Hewlett-Packard ranked 21st, Motorola 29th and Intel 41st. By 2001, Microsoft ranked 16th, Intel 22nd, Cisco Systems 33rd, and Hewlett-Packard 36th.

Mr. Engel also examined the top 100 companies in terms of market capitalization beginning in 1966. Even since then, there have been major changes. AT&T, which ranked as the largest company in terms of market capitalization in 1966 and was second as late as 1995, was 39th in 2001. IBM was second in 1966 and 10th in 2001.

not in the picture

Eastman Kodak, which ranked as the nation’s fifth-largest company in terms of market capitalization in 1966, no longer was big enough to qualify for the top 100 in 2001. Likewise, Xerox, Polaroid, Avon Products, Caterpillar and Corning. All were top companies and household names in 1966 but had disappeared from the list by 2001.

“Of the largest 100 companies at the end of 1966 [based on market capitalization], only 22 remained on the list at the end of 2001,” Mr. Engel writes in the August issue of Perception, The Leuthold Group’s monthly research publication. In fact, between 1966 and 1977, 35% of the initial companies dropped off the list.

The key message of Mr. Engel’s study is that no investor can buy the biggest, or what they regard as the best, companies and simply hold them. Investing must be dynamic. Investors constantly must monitor all the stocks in a portfolio and re-evaluate their prospects.

And investors must not fall in love with stocks (or even mutual funds) that have performed well for them in the past.

One of the key jobs for a financial adviser is to make sure that that does not happen.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.