Why companies become too big to succeed

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(MoneyWatch) Many investors often expect the best company in a given industry to be a steady source of returns. But a recent study shows why you're better off staying away from those stocks.

Research Affiliates founder Robert Arnott and research analyst Lillian Wu examined the returns of "top dog" companies as ranked by market capitalization in each sector or market. They found that the stocks of these businesses were "dismayingly unattractive." Indeed, there's a "statistically significant tendency for top companies in each sector to underperform both the overall sector and the stock market as a whole."

The academic research demonstrates that larger companies typically exhibit a lower growth rate and earn a lower return on capital than smaller companies, eventually exhibiting "diseconomies of scale" as they grow. Investors often mistakenly focus on the great past performance, failing to realize that it won't continue. Such companies may be great businesses, but that doesn't mean they make great, meaning high-returning, investments. They often acquire their industry-leading market value by trading at high price-to-earnings multiples, and high P/E ratios are often associated with lower future returns.

In fact, the evidence shows that investors should anticipate the underperformance of the "top dogs" relative to the overall market. For the period 1952-2011, the average corporate sector leader by market cap underperformed the average stock (equally weighted) in its own sector by about 4 percent per year over one-, three-, five- and 10-year time horizons. On a one-year basis, only 42 percent of the sector leaders were able to beat the average for their respective segment competitors. And the rate of persistence declines with time -- over 10 years, fewer than three of 10 top dogs were winners.

The evidence is just as compelling in overseas markets. Over the 30-year period studied, the 10-year average shortfall ranges from just over 2 percent per year in Germany to 11.5 percent in Canada. On a 10-year basis, sector top dogs underperform their equal-weighted sectors by 5.1 percent per year, on average, across 12 sectors and eight countries.

Investors often make the mistake of buying yesterday's winners, but you can't buy yesterday's returns -- only tomorrow's. Investors make this mistake because the fail to understand that the forces that drove the top dogs to dominate their competition don't guarantee sustained growth in the future.

Money image courtesy of Flickr user 401(K) 2012

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.