The Case for Avoiding Mega-Caps

A little over two years ago, I wrote an article arguing that it doesn't make sense to take on the risk of owning a single stock if this stock can't beat an exchange-traded fund tracking its sector.

The stock in question was Microsoft(MSFT Quote) and the ETF was the iShares DJ Technology Index Fund(IYW Quote).

The idea is important enough that it's worth revisiting. Understanding how volatile a portfolio is and where the volatility comes from is crucial to managing risk.

A theory that I have had for several years -- and it has been playing out in the market -- is that certain stocks, as a function of their size, cannot outperform their respective sector for any meaningful period of time.

Buying an individual stock assumes a certain amount of risk, more risk than buying a sector fund. Any stock purchased should provide a reasonable chance of adding value one way or another vs. just buying a sector fund.

Adding value doesn't just mean appreciating in price, it can also mean paying a meaningful dividend or provding access to a unique line of business (FPL Group, for example, is a huge wind power provider with a large dividend in the utility sector) or some other trait important to you.

The reason I chose Microsoft to make my point two years ago is it is obviously widely followed and widely held. The idea at the time, and it is still the case now, is because of Microsoft's weight in IYW, currently 13.10%, the best result that could be hoped for, over any meaningful period of time, is that they perform the same.

Obviously, with weighting of over 13% the correlation between Microsoft and IYW will be high. Any short burst of outperformance means that Microsoft's weight would only increase, so if anything, the correlation, as high as it is now, would only go higher, reducing the chance for any further outperformance.

Microsoft vs the Tech Sector

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The effect of a period of outperformance can be seen more vividly in looking at a chart comparing Cisco (CSCO Quote) and IYW. You can see that after a great four months in 2006, which took its weight up to almost 8% of the fund, the stock has been unable to sustain any outperformance.

Cisco vs the Tech Sector

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Obviously any mega-cap stock could outperform its corresponding sector ETF at anytime and do so for an extended period, but the point here is that the probability is low. This makes an argument for choosing your spots for trying to add outperformance with stock-picking. Clearly many smaller, not necessarily small-caps but companies with smaller weightings in the ETF, are capable of tremendous gains.

A big stock would need a big catalyst to pull away from the sector. In looking at some of the larger holdings, I'm not sure I see such a catalyst with Microsoft or Cisco, but the number three holding, Apple(AAPL Quote), does have a catalyst.

AAPL is up more than 120% YTD vs. just 15% for IYW in 2007, and there is visibility, not certainty, for AAPL to continue to outperform as the iPod has evolved into the iPhone and then whatever comes next, even though AAPL, like Cisco, has a 7% weight in the fund.

If a stock doesn't give a realistic chance of adding value, it doesn't make sense to take the added risk. A portfolio can only budget so much toward risk and volatility based on personal tolerances. In that light, deciding where to allocate risk and volatility becomes very important. Don't exhaust your volatility budget on the wrong part of your portfolio.