When we discuss stock prices at Park Piedmont Advisors, we usually are referring to the price level of the S&P 500 stock index, a broadly diversified set of approximately 500 companies, mostly large and based in the US.
We also recognize that there are many other ways to participate in the stock market. To the extent these other alternatives are used, usually with the goal of outperforming the S&P 500, there is also the risk of underperforming and ending up with very different results in the same time period.
The following is a general discussion of a number of these alternatives; we can provide additional details as requested. Suffice it to say, investors can choose to emphasize any of these various parts of the stock market in developing the stock portion of their portfolios.
1) Company Size
This is determined by market capitalization, which multiplies the market price of the stock by the number of shares of stock outstanding.
The investment community typically splits company size into three levels: large, medium, and small. Until last year, several companies flirted with being worth $1 trillion, but after the stock price gains of 2021, a few have now reached that level, with Apple leading the way at almost $3 trillion.
While different market observers have different ranges of value to be considered “large cap,” any company worth $30 billion or more would probably be considered large, with $15 to $30 billion considered “midcap,” and under $15 billion considered “small cap.”
These ranges have increased dramatically over the past three years, given the substantial gains in US stock prices prior to 2022.
Most of the S&P 500 companies are considered large cap, and many of the large cap companies are household names. Large cap companies tend to be more stable than smaller companies, since they generate sufficient profits to be included in the top 500 companies to begin with.
But large cap companies also share a great deal of the price volatility of their smaller counterparts, and large cap stocks typically decline only slightly less than smaller stocks when the entire stock market is declining (the first quarter of 2022 being the latest example of declining stocks).
2) Growth and Value (P/Es)
Another way the overall stock market can be analyzed is to divide stocks into so-called “Growth” and “Value” companies.
The distinguishing characteristic of Growth stocks is that they sell for high prices relative to their earnings, while Value stocks sell for low prices relative to their earnings.
The relationship between market prices and company earnings is captured in the Price/Earnings (P/E) ratio.
If a company has earnings of $10 per share, and its market price is $100 per share, it is said to have a P/E of 10. Another company that also has earnings of $10 per share and has a market price of $200 per share has a P/E of 20.
It is obvious that the company with the 20 P/E has a higher P/E than the company with a 10 P/E, but the real question is why one company’s earnings are valued more highly. The underlying reason is that investors think the company with the higher P/E will grow its earnings faster than the other company.
While it is often a good sign for stocks to have high P/Es, if and when the company’s earnings growth rate disappoints the market, the price declines are often considerably greater than those of lower P/E companies.
Technology companies are an example of a group of companies with high P/Es, whereas Consumer Goods companies typically have lower P/Es. Note there is nothing inherently better or worse among these different groups of companies, only that investors should understand what to expect in the way of price changes based on how future earnings develop.
Note also that it is the price of the stock that is constantly changing, so companies can transition from a growth to a value company, and vice versa, based on the same earnings.
3) US and International Companies
Another way to diversify from US stocks is to add international exposure with companies based in “developed” and “emerging market” countries.
Most European countries and Japan are typically considered developed countries. China, India, and most of South America and Africa are typically categorized as emerging markets.
This distinction is harder to maintain in current times, as so many large companies do business in so many different countries. If Apple has a large percentage of its business outside the US, should it continue to be classified as US?
In this situation, investors should look to see what companies are actually owned in their various investments, or use broad-based index funds that capture the results of the parts of the markets they want to invest in, which is the PPA response to this issue.
4) More Specific Sectors
In addition to the categories discussed above, there are many investments focusing on specific sectors. Technology and Consumer Goods, mentioned earlier, are two of the many more targeted investments.
All of these subcategories of the asset class “Stocks” can be accessed using Exchange Traded Funds (ETFs), mutual funds (actively managed or passively indexed), and individual stocks.
Unless there is some compelling reason for the investor’s choices, PPA considers it likely that most investors will be better off using the most broadly diversified investments to meet their allocations to stocks.
Emphasizing one or the other of these many categories, to the exclusion or reduction of others, amounts to trying to figure out in advance of the occurrence which category will do better than some other category.
As an example of this advice, an investment company called MFS presents the performance of four of the categories we have been discussing (Large Cap Growth, Large Cap Value, Small and Midcap, and International, out of a total of ten categories, including Cash and Bonds) over a rolling twenty-year history through year-end 2021.
The results are that even the top performing sector over the entire twenty years was best in only five of those twenty years, and was in the bottom half of the categories in six of the twenty years.
The chart is presented in color coding and is available on request. It makes the point that “just because an investment type or style outperforms one year, there is no guarantee that it will outperform the next. Stay diversified.”
One other set of observations worth presenting during a period of substantial stock and more modest bond market declines appeared in a NY Times interview by Jeff Sommer of 2013 Nobel Prize co-winner in Economic Science Eugene Fama.
“Markets do not behave irrationally. What may look like craziness is just the markets attempting to evaluate information they can’t entirely digest… The markets are struggling to come up with prices for stocks, bonds, commodities, all kinds of things.
“We’re in a period where we have had an injection of uncertainty into the world, so speculative prices are going to go up and down in response… People are continuously trying to evaluate information. But it’s impossible for them, given the amount of uncertainty, to come up with good answers…”
Sommer asked whether Fama “reads the analyses of Wall Street investment houses that recommend strategies for coping with tumultuous markets,” to which Fama replied, “No, it’s investment porn…what do they really know?”
His recommended investment approach is to “eschew market timing and invest for the long term in diversified, buy and hold investments, precisely because it is so difficult to accurately forecast market returns… What isn’t adequately stressed in most professional investment analyses is that there is always risk in the stock market, always, and it’s impossible to know which way the market is heading.”
As our regular readers know, we think similarly to Professor Fama and dispense our advice accordingly.