Some of the most popular companies in the investment market have gotten extra help from long-term low interest rates. Today, Paul and Jim do a deep dive into how low interest rates help these companies more than others and how inflation could hurt growth stocks in a unique way. Later in the episode, Paul answers the question: Are top-heavy markets unusual?
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Paul Winkler: And welcome. This is “The Investor Coaching Show.” Paul Winkler, along with Mr. Jim Wood.
That’s what we talk about. Money, investing, of course, lots to talk about.
I think, a big topic, I guess it bears repeating lots of times. And we’ll talk more about it but hit it from a different angle right now.
The inflation thing. Okay. So it’s been a big topic: inflation hitting this huge high, and what does that mean for markets?
And we’ve been talking about it for weeks. Is it transitory?
Is it going to be something that’s going to be with us for a long time? Is it just something that’s going to be short term?
Okay, so let’s talk, Jim, just asset categories. Let’s talk a little bit about markets, how they’re affected and just what the—
I think you had something you were talking to me in the office this week about. There was something, an article written on the topic that I think was interesting.
Jim Wood: Well, related to interest rates, it was just relating the long-time, low interest rates to the dominance of the darling companies, or the FAANG stocks, which—
PW: Oh, yeah, yeah, yeah. Facebook, Apple, Amazon, yeah.
JW: Yeah. Which we might refer to now as the MAANG stocks.
PW: Oh no, really?
JW: Facebook is now Meta for those you out there who did not get that joke.
PW: Yeah. The MAANG stocks. Okay. “MAANGled” stocks, if interest rates keep doing what they—because of how their growth stocks are affected.
JW: Correct. And just some research: Larry Swedroe actually talking about some other, some research done by Kroen, Liu, Mian, and Sufi in something called “Falling Rates and Rising Superstars.”
And just to summarize, it is just making the point that the long-term low interest rates can be one of the reasons why these companies that have been doing so well for so long, these large U.S. companies.
PW: Okay, so let’s define growth stocks. What is a growth stock versus a value stock, versus a blend stock, or just how would you define that?
JW: Well, I guess in terms of a growth stock, I just simply will explain it as, well, it’s the companies that you read about in the news that have been growing really fast. I always like to make the point that it doesn’t mean that they’re going to grow, it means they have grown.
And people are willing to pay a lot for them, a multiple of the actual assets of the company, because they expect their earnings growth to continue.
PW: And that’s where the term comes from. So when we talk about growth, we’re talking about the earnings growing.
We’re talking about companies that have maybe a really good business plan. Maybe things are really looking good for them from a growth perspective in the growth of their earnings.
Now, from a rate of return standpoint, though, that doesn’t mean that the rate of return, the growth for you as an investor, is something that’s phenomenal in the future.
As a matter of fact, growth stocks have, actually, long-term lower returns than other market segments because of the fact that they have grown so much from a share price appreciation standpoint.
And now they’re growth companies. And now they’re termed that.
They may have been really terribly distressed companies before that turned their lives around. And then they got to this place where they were really doing really well, and they came up with some really great products.
And by then, it’s too late for you to get these phenomenal returns that are supposed to be coming your way by owning them because the price has already grown, and it grew before they were actually called growth stocks.
JW: Yeah, I always—
PW: If you can follow that.
JW: Yeah. I’ll talk to clients sometimes about the idea of growth stocks, because just the fact that they’re called growth stocks: “Oh yeah, that’s what I want. I want growth.”
PW: Right. I want growth.
JW: And there’s mutual funds out there. There’s tons of mutual funds out there with the name “growth” in the name, just because it sounds like, again: “That’s what I want. I want some growth.”
But the point that we’re both making is that that means nothing about what they’re going to do in the future. And, long-term, they actually have a lower expected return than value or distress companies.
But you definitely can have long periods of time where they do outperform, and that’s what’s happened recently. And that’s what this article relates to is that: why is that happening?
And at least in part, in terms of the findings of this particular study, it was because of the long-term, consistent, low interest rates. Just generally a summary of that being “falling interest rates disproportionately benefit industry leaders.”
And then there’s a bunch of reasons that, I won’t go into every technical detail that—
PW: Well, no, I think it is interesting to go into some of why it is. Why is it that low interest rates—because this is really, super important.
One of the biggest mistakes that I see investors making right now, and I’ve been seeing it for the past several years, is—you look at your investments. And you look at an investment portfolio, you look at a manager, and you’re trying to find out, “Where do I put my money?”
“Where do I invest my money?” Well, where do you think, if you’re given a list of 18 different investment managers, what do you think you are going to look at as a layperson in trying to decide where you put your money?
And if you answered, “Well, who had the best return over the past … ?” Typically, five years is what I often say is what people are drawn to, but you’re going to look at a certain track record.
And let’s just face it, if you were an investment manager, and your five-year track record is stellar, you are going to point to that every time.
When I worked for a broker, I was trained to look at funds, and look at what most recently did well, because it was assumed that it was skill that got the good returns.
So you’re looking up a lineup of 18 different investment managers, and you’re going to say, “Well, this one had a 10% return. This one had a 15% return.”
“Whoa, this one had an 18% return. Whoa, this one had a 20% return. Oh, this one only had a 3% return. Oh, this one had—”
And a human today is going to be investing mainly with investment managers that had good performance. And by definition, anything that is investing in growth stocks over the past five to 10 years—which most people think is an eternity.
I’m telling you from an academic standpoint, I want 70 years. Give me as much data as you can possibly give me because—
And you go, “Well, 70 years, that’s ridiculous. Aren’t things different than they were 50 years ago?”
No, companies wanted to use your money 50 years ago, and they had to pay you to use your money.
They want to pay you as little as possible. You want to get paid as much as possible.
Nothing has changed. But here’s basically what happens.
You’ll have a run. Tech stocks had a 10-year run which was superior to everything else.
And you go and stick all your money in tech stocks, and you think, “Wow, this is really great, this got great results.”
And then all of a sudden, when the tech bubble will burst and you’re down 80%, then you’re sitting there saying, “What hit me?”
So from a perspective as an investor: you’re going to be looking at five years you’re going to be in growth stocks. “What caused growth stocks to do so well that is changing?” is really what we’re getting at right here.
What is changing in the marketplace to basically say, “Hey, not only has this dog run, or has this horse run its race?” But there are things that actually have caused it to change since I’ve talked about many times in this show over the past year.
And they are, number one: interest rate changing. So go ahead, how about that?
JW: The effect of those low interest rates: the cost of borrowing falls more for industry leaders. Big companies get to borrow more cheaply than smaller companies, giving them an advantage there.
Industry leaders are able to raise more debt, increase leverage, and buy back more shares. And capital investment and acquisitions increase more for industry leaders.
PW: Slow down. That was way too much for people.
So the very first thing that you said: they are able to borrow more cheaply. Why?
JW: They have more leverage. They have—
PW: Collateral, man.
JW: Yeah.
PW: Yeah, you think about it. If you are somebody that has—think about, companies are no different than you folks.
If you’ve got a bunch of money, and you’ve got a ton of money sitting off in an investment or something like that—you can do this with non-qualified accounts. You can actually borrow against them.
And what happens is you can say, “Well, I got $300,000 in this investment account over here. Hey, would you guys loan me $50,000?”
And the bank’s going to go, “Well, yeah. If we can put up your investments as collateral, absolutely. And we’ll do it cheaply.”
Why? Because they know they’re going to get their money back.
And if they know they’re going to get their money back, they would fall all over wanting to loan you money. There’d be a lot of competition.
Okay. Second point was what?
JW: Well, the industry leaders are able—kind of a corollary to what you were just saying—they’re able to raise more debt. They can increase leverage, and they can buy back more shares.
So again, that’s another way of adding value to the company. They can borrow money really cheap, take shares back out of the market.
PW: So a way of thinking about this to visualize this, folks, is this: I’ve got a pie, and that thing is cut into eight pieces.
And I say, “Okay, so eight pieces.” Let’s make it four pieces. Let’s keep the math really easy.
Let’s say it’s cut up into four pieces and each piece is—so I’m trying to think of a good way of putting it.
This pie weighs 10 pounds. (It’s a really big pie.)
And it’s cut into four pieces. So it’s now, this thing, each piece is going to weigh 2.5 pounds. Okay?
So 2.5 pounds. Now I can somehow weld the pieces back together, and now I only have two pieces, so it’s cut in half.
Well, each piece weighs 5 pounds now. I’ve got two pieces, the pie weighs 10 pounds—
No, this is ridiculous. But this is fun.
JW: I’m hungry about all this pie.
PW: So what just happened to the weight of my pie didn’t change. My whole pie didn’t change.
But each piece, the weight actually went up from 2.5 pounds to 5 pounds because what I do, I welded two of them together, okay?
So what happens? The shareholders are going, “Hey, this is great! There are fewer pieces, and they weigh more now.”
Why? Because the company bought back, or they welded them together. So that is why they would do that.
When would they do that? When they can borrow money cheaper.
Why would they want to borrow money? Because—guess what?—if you’re a company, and you’re borrowing money, then you don’t have to pay earnings to anybody on that money borrowed.
It’s just interest, and if interest rates are low, that’s better.
That is why companies issue stocks, folks! They will especially issue stocks when interest rates are high, because they’re worried about having to repay interest.
If they go and issue stock, they don’t have to pay interest. But they do have to pay profits, and that can be a drag down the line if the company is profitable and was a growth company, a company that’s profitable.
I hope this makes sense to some of you out there. This is really important because if interest rates are low, growth companies would rather borrow, and that’s exactly what Jim is saying.
JW: And with that cheap money, the third point was that capital investment and acquisitions are more readily available. They can go out and buy more companies and more staff and expand the company.
PW: Exactly. So you’ve got a big old company, and they go, “Hey, we want to go into this area, but it’s a pain in the neck to go and set up the infrastructure to do this new product line or this new service.”
“Oh, but there’s a really good company, and they’re struggling. They don’t have a lot of capital.”
“They got a great idea, they got great infrastructure, they got great personnel, they got great everything, but they can’t afford to really do what they really should, and they can’t really meet the potential of this new product that they’ve got. Let’s just buy them.”
JW: And the other part of that too, is not only buy those companies where they think, “Okay, we can help them bring these new products in, but also we can buy out the competition, and then—”
PW: And hence set up a little bit of a monopoly. Maybe not quite a monopoly, but we can lower the amount of our competition which gives us pricing advantages in the future.
JW: There you go.
PW: So hence we can make ourselves grow even more. And this is literally, if you put it in a nutshell, one of the big reasons that we’ve had such good growth in growth companies.
Now another reason is this, which is very related to interest rates. And that is if you have high interest rates or if you have high inflation rates—interest rates and inflation are highly correlated.
If you have very high interest rates, then what happens is the present value of your future earnings that won’t be earned for three, four, five years in the future becomes worth less. And hence, when I’m buying a company, I’m buying the rights to your profits from here to eternity.
If those profits out there aways into the future are worth less because inflation is high, and that money coming in the door later on is not as much, then what happens is my present value of my company—in other words, in English, my stock price—is pressured downward for that reason. So that’s part of what happens.
JW: So what are the takeaways from all this, according, again, to this article? First, and it’s where this whole article is leading, is that we’re likely at the end of this long run of super low interest rates.
They really don’t have anywhere to go but up, particularly with upticks and inflation.
PW: And it could be, we don’t know for sure. But that is the concern that we have.
And this is why we diversify, because we don’t know for sure. But if that does indeed become the case, then yeah.
You look at these, and if you’re an investor that invested based on past performance, which is a lot of companies—I’ve talked about two major companies, major mutual fund companies, in the past couple of weeks that have 90% of their money in large growth stocks.
This isn’t a time that you sit there complacent going, “Hey, the S&P 500 is up, and I’ve really done really well over the past 10 years.”
It isn’t a time you become complacent and go, “Hey, I think this tree’s going to keep growing in heaven.”
It very well could be, if this trend continues, be something that you—so diversification becomes your buddy in a big way, if that’s the case. So that’s number one.
JW: And you actually just touched on the second part of this, is that “investors should always keep in mind that expectations about the future operational performance … are already reflected in its current price.”
PW: Yeah, and that is what you have to be really conscious of, because you don’t know what the future’s going to be, but you know that the future probably at some point will change.
And let’s take a look at the past, because the past informs the future. As an investor, let’s say that it does get something like the 1970s.
That’s what people keep talking about. The 1970s had high interest rates, high inflation rates.
If you look at, let’s say, 1970 through 1985, because interest rates peaked in 1981, so I’m just choosing that particular period of time. S&P 500 over that period of time had about a 10% return, which isn’t terrible.
That’s not terrible. But if you looked at the inflation rate over that period of time, remember inflation reached 12% in 1981.
If you look at large growth stocks at that period of time, from that period of time, the return drops a full three percentage points. If you look at small growth stocks, it literally drops another couple percentage points from what the S&P 500.
But if you go to international small companies over that same period of time, there’s a 25% rate of return per year. International large companies, almost 13% rate of return per year.
Because as you just heard, the rate of return for large growth companies was lower than anything else. You look at various areas of the market and you go, “Wow, that was a real eye opener for some areas.”
And back then, you heard about the Nifty Fifty. The media couldn’t help it; they were falling all over themselves talking about how great these Nifty Fifty companies were.
Basically what they were, were companies that were well-liked, well-run. But by definition, they were growth stocks.
That’s what they were is they were growth companies. So you look at that period of time and go, “Well, that whole thing changed; that whole paradigm changed during that period of time.”
If you look at other areas of the market, for example. Let’s say if we looked at small company stocks or value stocks over that same period of time, there was 13% rate of return for small company stocks during that same period of time.
Value companies were up about 17% per year during that period of time. Small value was up almost 20% per year as measured by the Fama-French US Small Value Index, which is a very specialized index looking at companies that have a very, very low price to book.
When I say value, I always have much trepidation because you might go and buy a value fund and not realize it’s not really only owning value stocks. You may buy a value index fund and not realize it’s not really owning value companies.
So I have to point out that that’s what it was. It’s companies with super, super low price to book value, compared to their peers.
It was during this period of 1966 through literally all the way to 1982 that the S&P 500 had zero return after inflation. If you look at growth stocks, it was a negative return after inflation over that period of time.
And now, well, you might have to listen to this segment a couple times, but now you know why.
This is “The Investor Coaching Show” right here on SuperTalk 99.7 WTN. Paul Winkler along with Jim Wood, be back right after this.
All right. Back here on “The Investor Coaching Show,” Paul Winkler. Along with Jim Wood.
Okay, so I guess Jim wasn’t totally done. He had something else that he wanted to share regarding this.
I thought I was out of the woods on talking about growth stocks. But there’s something else interesting in that study?
JW: Well, to me, this was actually some of the most interesting part of this whole story, and was the third—the third point, or investor takeaway, mentioned in this article was that investors should just “be aware that a top heavy market is not unusual.”
And Dimensional Fund Advisors noted in their June 2020 article, “Large and In Charge,” the “largest 10 stocks accounting for over 20% of market capitalization … is nothing new.”
PW: Yeah, and that’s something I’ve talked about a whole lot over the past year, so this is interesting.
I’ve talked about how, if you take out the FAANG stocks—it was FAANG, now he’s calling it MAANG, because of the change in Facebook’s name—if you take those out of the S&P 500 last year, the return virtually just disappears almost.
JW: Well—
PW: So that’s not unusual is what he’s saying.
JW: And we look at this—so right now, and this is a great example, that “Apple makes up 4.7% of the current U.S. market, in 1967, IBM represented a much larger 5.8%.”
PW: Wow. Yeah, that’s really interesting because IBM was, you had entire rooms filled with computers that now you walk around with one in your pocket that is every bit as powerful as the ones that filled an entire room back then.
JW: And this article gave a great chart decade by decade, the top 10 firms in 1930, 1940, and then so. And it tracked the firm’s placement in each of these decades, and so you see firms come and go, some that stay.
So just as a guess, I actually asked Chad, one of the gentlemen we work with, what he thought was the company that appeared in the top 10 the most times. And of course I added my guess.
But I’ll throw that to you. What do you think it could be?
PW: GE
JW: That was my guess.
PW: Did I not get it right?
JW: And that is wrong.
PW: No!
JW: They’re one of the top ones and—
PW: Coca-Cola
JW: Top one: Exxon.
PW: Exxon, oh yeah. Okay, all right.
JW: Nine out of 10 decades. AT&T were in eight out of 10 decades.
You have just some recently. Amazon’s only in the last decade, was in the top 10.
And so you have so many of these coming and going. But what’s interesting, following this chart, is how do these stocks perform once they reach the top 10?
And in that Dimensional study, they found out that over the next five years they went on to underperform the market by 1.1%. And over the next 10 years—
PW: Now what is the market though? Are you talking about the S&P 500?
So it underperformed—I know what you’re talking about—so it underperformed the area of the market that has the long-term lowest expected return, which is, that’s really telling you something.
JW: Which area of the market that those stocks inhabit as well, which is S&P, like you said.
PW: Right. But why? Because they’re growth companies, and as we just walked through, growth companies have a lower long-term expected return.
Why? Because they’re terrible investments?
No, because they’re really great companies, and great companies don’t have to pay much to use your money. That is what people do.
And I was reading an article this week about younger investors. And it was just like, “Well, what are your younger investors doing?”
And it’s both bad: it’s individual companies—growth companies—and cryptocurrencies. And I just shake my head and go, “Well, that’s why we tend to work with—our clients tend to be in their 50s-plus because they’ve been burnt; they’ve been down that road over and over again.”
As much as I would love to have younger investors, and some—there’s, we got younger clients, we got some, so I’m not going to throw them all under the bus—but we find just that, typically you’ll find that people have to learn from their own experiences.
JW: And just some final numbers on this whole thing is right now the top 10, in 2020, top 10 companies taking up 21.7% of the market.
PW: Mm-hmm.
JW: 1930, the top 10 was 26.8% of the market.
PW: Wow.
JW: 1940 it was 33% of the market.
PW: What?
JW: 1950, 26.7—
PW: Did you say 1940 it was 33% of the market?
JW: Uh-huh.
PW: So—
JW: And that was AT&T, General Motors, General Electric, Exxon, Marathon Oil.
PW: Okay.
JW: Texaco.
PW: Energy?
JW: Sears.
PW: Okay, retail. Everybody wanted to burn the Sears catalog because Sears was undercutting all of these stores around the country.
JW: Yeah, and Sears was in the 1940 and in 1950. And what happened to Sears?
PW: Oh yeah, exactly, great point.
JW: They haven’t been there anymore since then.
PW: Wow.
JW: And finally, in 1940—this one surprised me—was Coca-Cola was the 10th company.
PW: So I said Coca-Cola earlier, but I was way off. Okay. Wow, that’s so interesting.
So companies, people you hear about that are just the companies that are in the news all the time—and I think of Tesla, and I think of Apple, and I think of Microsoft, and I think of all these companies that are making the news.
Everybody talks about them, and younger investors are just thrilled with them, think they’re the best thing ever. Chances of them being the best thing ever forever is pretty slim, really slim, if history is any guide.
Paul Winkler, “Investor Coaching Show” along with Jim Wood. And we’ll take a break and be right back after this. Stay tuned.
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