A Fundamental Shift

By ranking companies on market cap rather than profits,
the big indexes promise more than they deliver

Rob McConnachie on long-term horizons
Globe Investor Magazine,
September 18, 2008
Illustration by Christian Northeast

As a fundamental investor, I don’t spend a lot of time worrying about the ups and downs of the broad market. I’ve got better things to do, like finding underpriced companies with long-term value. To me, fundamentals—sales, profits, dividends and so on—are what really matters.

That’s why I get so frustrated when I look at the S&P/TSX composite index. Like nearly all major indexes, it’s weight­ed by market capitalization. The bigger the company’s market cap, the bigger its footprint in the index—regardless of whether it makes money. When you buy the S&P/TSX composite, you’re buying into the consensus wisdom that a stock’s current price is the best indicator of future returns.

From an investment point of view, that’s pure speculation. It’s like snagging a high-priced apartment block in the hope that rents will, some day, rise to cover the mortgage, instead of going with a cheaper property that already pays for itself. Investors may not realize it, but cap-weighted indexes aren’t their friends. There’s plenty of evidence that in the long run, you’re better off with an ex­­change-traded fund.

Here’s how cap-weighted indexes can go awry. If a stock is trading well above fair market value, its fat capitalization earns it an ever-higher weighting. A vivid example is Nortel, which accounted for more than 35% of the S&P/TSX in 2000. Its weight has since plunged to about 1%, even though the company is more prof­itable today.

Enticed by the prospect of future gains, money managers pile into the most ex­­pensive companies, further distorting the index. But what goes up must come down. When the overpriced stocks even­tually take a tumble, they bring the rest of the index with them.

Life only gets worse for indexes that chase winners by picking up companies that have been on a roll. Look what hap­pened after the Dow Jones Industrial Average added Microsoft and Intel in 1999, near the peak of the tech bubble. When the dot-bomb hit, both stocks dragged the index down.

Outside Canada, several investment houses are targeting this basic flaw. The pioneer is Research Affiliates, whose strategies underlie more than $40 bil­lion (U.S.) worth of ETFs and other pro­ducts. As proof of concept, the Califor­nia–based shop tested its Fundamental Index against similar cap-weighted U.S. indexes over the past 45 years. The results speak for themselves: annual re­­turns that were 2% higher with less volatility.

Then there are the WisdomTree ETFs, championed by Wharton School finance professor Jeremy Siegel. The New York–based firm weights a company by total dividends paid—the number of shares times the dividend. Because dividends are what shareholders pocket after a com­pany has covered its capital costs, they’re a good signpost for profitability. Going back a century, more than two-thirds of the real returns on U.S. stocks have come from dividends, so Siegel has history on his side.

Adopting fundamentals as the mea­sure of a company’s worth would dra­matically reshuffle the S&P/TSX. Yes, some Canadian firms with the biggest market caps—Potash Corp., for instance—deal in products and commodities whose futures look bright. But at midyear, Pot­ash had a 12-month trailing net income of $2 billion versus $4.9 billion for RBC, yet both businesses had roughly the same market caps. Investors appear to be bet­ting that Potash’s record profits will keep growing many times over.

I’d be the first to admit that none of the methods of fundamentally weight­ing indexes is perfect. But at the very least, they would help curb the specula­tive excesses that periodically rock the cap-weighted world and keep investors up at night.

Rob McConnachie, CFA, is the chief investment officer of Dixon Mitchell Investment Counsel, a Vancouver-based wealth management firm.