When good stocks turn bad

Good morning. Friday’s jobs report was middling-to-solid: 227,500 jobs were added in November, and the October number was revised up to 36,000 from 12,000. The unemployment rate ticked up a little, to 4.2 per cent from 4.1. The market took this all as a sign that the Fed will, indeed, cut the policy rate by 25 basis points later this month. The jury is still out for 2025. Sticky inflation and somewhat cautious comments by Fed members in recent weeks has the market guessing that the FOMC will hold in January, a week after Trump’s inauguration. After that, the uncertainty only increases. Email us: [email protected] and [email protected]. 

When good stocks turn bad

People spend a lot of time thinking about what makes a good stock. Somewhat less time is devoted to what makes a bad one. Certainly, you can take the generalities about what is desirable (barriers to entry, secular industry growth, sensible management) and invert them. But the interesting bit is the details. How, exactly, does it all go wrong? 

In a wildly unscientific effort to think about this, I looked at US stocks that were already big (at least $35bn in market cap) 10 years ago, and then ranked them by total return in the decade since. I wanted a list of the companies that had been successful enough to become large, but where something had subsequently gone awry.

Big cap US stocks have done amazingly well over the past decade. The unweighted average total return in my sample of 110 companies was 210 per cent. Even some companies in the bottom quartile posted respectable returns. Here are the bottom 25 performers (stocks that had lost value because of big divestitures or spin-offs removed). I have categorised most of them with sweeping (but tentative) explanations for what went wrong (see the colour key at right): 

What can we observe about the underperformers, and what lessons can we draw? Some readers will know these companies much better than me, but here are my preliminary conclusions:

Do not, if possible, buy a legacy airline, car manufacturer, or wireless network. (American Airlines, Delta, Ford, Verizon). These are all capital intensive and highly competitive industries. Even perfect management might not have made much difference. Ford and Verizon’s competitors General Motors and AT&T didn’t shine, either. Note that all of these companies had low valuations a decade ago. Bargain hunting in structurally difficult industries is dangerous. 

Do not buy big legacy companies in industries entering a transformation (Franklin Resources, Intel, Simon Property, Disney). Operating malls, selling actively managed mutual funds, making computer chips optimised for the last generation of computers, and providing content to video stores and cable TVs has been hard in the past ten years. In retrospect, the management teams of each company could have handled the industry transitions differently. And Disney may be making a comeback. But try to think of a big legacy company that has thrived through the first decade of an industry transformation. I can’t. 

Do not buy companies with complacent management (Boeing). I don’t know what went wrong at Boeing’s headquarters, but whatever it is, it proves that it is possible to screw up even the most enviable position in an industry. I’m not sure if it was possible for investors to see this coming, though. 

Beware pharma companies near the peak of their product cycles (Gilead, Bristol-Myers, Biogen Idec, Pfizer). In 2014 Gilead sold over $10bn of its blockbuster Hepatitis C drug Sovaldi; Bristol-Myers was the most expensive of the big pharma because of an exciting oncology portfolio; and Biogen Idec’s portfolio of multiple sclerosis drugs was growing fast. Competition and patent expirations threw all that into reverse. A decade ago Pfizer was still selling billions of dollars of Lyrica, Celebrex, Lipitor and Enbrel; all are now facing competition from generics and new entrants, too. Pharma is a defensive sector, but it has cycles of its own. A warning, perhaps, for investors paying top dollar for Eli Lilly and Novo Nordisk today? 

Make sure the justifications for transformational mergers make sense (Walgreens, CVS Health). Walgreens bought European pharma chain Alliance Boots in 2014; CVS announced it would buy the health insurer Aetna in 2017. Why chain pharmacies should be a global business, or should own insurance companies, remains unclear. 

Lots more to be said about the other weak performers on this list. Please send your insights.

More on small caps

Small companies have had a great run since Trump’s election, and there are good reasons why: greater domestic focus could give them an edge if trade barriers go up, and corporate tax cuts will have a higher proportionate impact on their earnings. Since the day before the election, the Russell 2000 and the S&P 600 small cap indices have outperformed the large cap S&P 500 and the mid cap S&P 400: 

The last time we wrote about small caps, the S&P small cap index price/earnings valuation had risen to match the forward P/E ratio of the mid cap index. It has stayed at par:

This is interesting, because mid caps have a lot of the Trump-era advantages of the small caps, but have a notable edge: quality. Broad small cap indices — particularly the all-encompassing Russell 2000 — have a lot of unprofitable companies. And the Russell 2000 has outperformed the slightly higher-quality S&P 600 since the election, in terms of both valuations and returns. This all might suggest the sort of “dash for trash” that is typical of a cyclical peak. 

This would makes sense. If the new administration’s policies are going to prioritise growth, and they sure look like they will, the weakest companies should have the most to gain. Less stringent antitrust enforcement means unprofitable but promising firms will be more likely to be acquisition targets, too.

But the story is not quite so simple. “Quality” small cap ETFs, which are weighted by earnings rather than market cap and therefore exclude unprofitable companies, have done well, too. Here, for example, is the normalised returns of WisdomTree’s earnings-driven small cap ETF, the S&P 600 small cap index and the Russell 2000 small cap index. Notice that the earnings-generating stocks have outperformed a bit in the past month:

Quality small caps usually outperform in bear markets. That they have not been left behind in the post-election excitement suggests there is still an element of caution present in the market. This is a healthy sign, given that no one really knows what the Trump market will mean for smaller companies. We’ll be watching the trend.

(Reiter)

One good read 

Go for a walk (H/T Torsten Slok).

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