Articles

The Winner's Curse
By Rob Arnott, Lillian Wu

Page 3 of 16

Moreover, given that their top dog status is partly due to share price, a high price is often needed to get to the vaunted No. 1 rank by market cap. The largest market-cap companies are empirically likely to trade at higher multiples and higher prices. Existing literature documents various stock characteristics that empirically presage underperformance. For example, Basu (1977) studies the returns on the common stock of NYSE-listed firms, and suggests that high earnings-to-price (E/P) firms—or low price-to-earnings (P/E) firms—have earned, on average, higher risk-adjusted returns than low E/P firms—or high P/E firms. Banz (1981) shows that stocks of small firms (measured by market cap) earned higher average returns than large-cap stocks. Further research, Basu (1983), concludes that small firms tend to have higher returns even after controlling for E/P. Fama and French (1992) argue that the superior returns of value strategies compensate for the higher fundamental risks these strategies are bearing.

An alternative behavioral explanation for the price-to-earnings ratio (P/E) anomaly, documented in Dreman (1977) and supported more recently in the "clairvoyant value" work by Arnott, Li and Sherrerd (2009a and 2009b), is that the mispricing of securities can be caused by a mismatch between market expectations and realized company performance. Specifically, market participants systematically overestimate the future earnings or growth of the low E/P firms, and systematically underestimate the future performance of the high E/P firms. This hypothesis is further supported by Lakonishok, Shleifer, and Vishny (1994), who show that naïve investors extrapolate firms’ past performance into the future; these investors are often surprised when some out-of-favor (value) firms recover, and the stocks of these firms experience high returns.

Companies with high market cap are often "glamour" stocks, carrying high prices and valuation multiples, reflecting consensus expectations for lofty growth, low risk or both. As a company grows in size, its products become more visible and, therefore, subject to a larger pool of investors’ judgments. Investors often tend to project their likes or dislikes about a company’s products onto its stock. Apple successfully creates a near-cult following for its products; Apple fans are willing to stand in long lines overnight to get the newest product on the release date. Speculators seem to approach Apple’s stock with the same zeal—they are eager to buy Apple stock regardless of how expensive the stock is relative to its underlying fundamentals.

Furthermore, many investors seem to ignore the fact that the forces that drove these companies to dominate their competitive landscape do not guarantee sustained growth in the future, or a sustained position at the top. Said another way, these investors do not appear to expect mean reversion in their growth forecasts; they form biased expectations based on extrapolating past successes that are often not predictive of the future. While it is easy (in theory, at least!) to double market share when a company holds 1 percent or 2 percent of the market, it is impossible to double market share once the company has a 51 percent market share.³

Investors tend to ignore these simple facts and mistakenly price glamour stocks as if they were nimble enterprises whose past growth need never slow. The market becomes aware of such pricing errors only gradually, as the company fails to meet the unrealistic growth expectations imposed upon it. In short, size itself is becoming less of an advantage and more of a curse.

The organization with the No. 1 rank in market cap will often be a truly great company, but empirically is not necessarily a good investment. Therefore, investors should anticipate the underperformance of large companies relative to the overall market.