Apple (Nasdaq: AAPL ) surpassed Microsoft (Nasdaq: MSFT ) in 2010 to become the largest tech company by market cap. It also became the second-largest constituent in the S&P 500 index and the largest in the Nasdaq 100 index.
That could be a bad omen for Apple shareholders, according to research by Jeremy Siegel, a professor at The Wharton School and author of Stocks for the Long Run. The special rebalancing of the Nasdaq 100 index on May 2 may be just the beginning.
According to Siegel, the 20 largest S&P 500 stocks have underperformed the index by more than 1.5% annually, on average. His research produced "a lot of evidence" that many of the 10 and 20 largest stocks in the index are consistently overvalued.
Looking for a greater fool
Opponents of market-cap indexing argue that investors do a good job of finding growth companies but then pay too much for the stock. The only way to beat the market after overpaying is to sell to a greater fool. Otherwise, the "buy high" investor is doomed to underperform. Unfortunately, greater fools are scarce when you want them.
The basic argument against market cap-weighted indexes is that because market cap is a function of price, market-cap indexes consistently overweight overpriced stocks and underweight underpriced stocks -- buying high and selling low.
Siegel believes that at any time some of the largest stocks in the S&P 500 index deserve to be there, but investors are overpaying for others. Therefore, he is a proponent of fundamental indexes, which weight stocks according to fundamental factors such as dividends, revenue, book value, and cash flow. Although market values don't always reflect fundamentals -- the tulip craze and dot-com boom are examples -- centuries of history show that market values always come back to fundamentals.
Fundamentally …
By removing price (market cap) from the weighting equation and evaluating stocks based on fundamentals, we may be able to identify potentially overvalued stocks in the S&P 500 -- those that Siegel's research suggests are at risk of underperforming. Siegel is a senior investment strategy advisor to fund company WisdomTree, which is a proponent of fundamental indexes weighted on dividends and earnings. Another proponent of fundamental indexing, Research Affiliates, uses four factors -- dividends, book value, sales, and cash flow -- in its RAFI fundamental indexes.
Let's compare the Top 10 holdings in the FTSE RAFI US 1000 fundamental index and the S&P 500 index, starting with RAFI.
FTSE RAFI US 1000 Fundamental Index Top 10 Stocks
|
Index Ranking
|
Security
|
% of Index Weight
|
|
1
|
Exxon Mobil
|
3.0%
|
|
2
|
AT&T (NYSE: T )
|
2.3%
|
|
3
|
Bank of America
|
2.2%
|
|
4
|
General Electric
|
2.1%
|
|
5
|
Chevron
|
1.9%
|
|
6
|
JPMorgan Chase
|
1.8%
|
|
7
|
Citigroup
|
1.7%
|
|
8
|
Pfizer
|
1.6%
|
|
9
|
Wal-Mart Stores
|
1.5%
|
|
10
|
Verizon Communications
|
1.4%
|
Source: Invesco.
Where's Apple?
Five of the Top 10 stocks based on the FTSE RAFI US 1000 Fundamental Index -- revenue, dividends, cash flow, and book value -- are also in the S&P 500 index's Top 10 stocks. They are Exxon, AT&T, GE, Chevron, and JPMorgan Chase. But Apple is No. 26 in the FTSE RAFI US 1000 index. IBM (NYSE: IBM ) , Microsoft, Procter & Gamble (NYSE: PG ) , and Johnson & Johnson (NYSE: JNJ ) are in the teens.
Top 10 Compared: S&P 500 Index and FTSE RAFI US 1000 Index
Source: S&P 500 SPDR.
Are investors overpaying for Apple, IBM, Microsoft, Procter & Gamble, and Johnson & Johnson? Are these stocks destined to underperform the S&P 500 index?
Buy low, sell high
Let's see whether valuation offers any clues. The following table shows popular valuation metrics for both the S&P 500 index and the Top 10 stocks in the S&P 500 Index.
|
RAFI Index Ranking
|
S&P 500 Index Ranking
|
Security
|
P/E Ratio*
|
Price / Sales Ratio*
|
Dividend Yield*
|
Price / Book Value Ratio*
|
|
1
|
1
|
Exxon Mobil
|
13.7
|
1.2
|
2.1%
|
2.9
|
|
2
|
8
|
AT&T
|
9.6
|
1.5
|
5.6%
|
1.6
|
|
4
|
3
|
General Electric
|
17.6
|
1.4
|
2.8%
|
1.8
|
|
5
|
4
|
Chevron
|
11.5
|
1.2
|
2.7%
|
2.1
|
|
6
|
7
|
JPMorgan Chase.
|
11.8
|
2.2
|
2.2%
|
1.1
|
|
13
|
9
|
Procter & Gamble
|
16.8
|
2.2
|
3.1%
|
2.8
|
|
15
|
10
|
Johnson & Johnson
|
12.7
|
2.7
|
3.6%
|
2.9
|
|
16
|
6
|
Microsoft
|
11.0
|
3.2
|
2.5%
|
4.4
|
|
17
|
5
|
IBM
|
14.2
|
2.0
|
1.6%
|
8.8
|
|
26
|
2
|
Apple
|
18.9
|
4.1
|
0.0%
|
5.8
|
|
N/A
|
N/A
|
S&P 500 Index
|
16.8
|
1.4
|
1.7%
|
2.3
|
*As of April 5, 2011, closing price.
Apple has the highest P/E of the group, with GE and P&G close behind. P&G is in line with the index. AT&T sports a single-digit P/E.
Apple has the highest price-to-sales ratio of the group, with Microsoft a distant second and another big drop to the remaining stocks. Chevron and Exxon Mobil sport the lowest P/S ratios, while GE is roughly in line with the index.
Siegel's research shows that high-yielding dividend stocks have higher total returns than low- or no-dividend stocks. Apple is the only stock in the group that doesn't offer a dividend. AT&T has the highest yield, with P&G a distant second and another meaningful drop to the remaining stocks. Other than Apple, only IBM's yield is below the index's.
IBM has the highest price-to-book value ratio of the group, with Apple a distant second, Microsoft a distant third, and a big drop to the remaining stocks. Half the stocks in the group have a book value below the index's. The technology companies' high P/BV ratios are a likely indication that technology revenue and profits are strongly influenced by intellectual property that doesn't show up in book value.
Foolish takeaway
Apple is a great company. What's more, its valuation doesn't seem exorbitant given its stunning financial performance and brand power. But therein lies the fallacy of identifying the great growth company and overpaying for the stock.
Apple shareholders may want to diversify into a cheaper stock, such as AT&T. ETF investors may find the PowerShares FTSE RAFI US 1000 (NYSE: PRF ) ETF of interest.
To stay updated on any of the companies listed above, add them to our free watchlist service.
RSS Headlines
Fool UK