The Real Stock Market Story of 2003

Over the past two weeks, you've probably seen a lot of articles recapping the 2003 performance of the stock market. Results are typically defined in terms of the major market averages--the S&P 500, Dow Jones Industrials, Nasdaq Composite, or Russell 2000.

Rarely, however, does anyone talk about what happened to the average stock--in other words, stocks that aren't on the major indexes. That's an important distinction because most indexes are market-cap-weighted (or price-weighted, in the case of the Dow), so they don't present a robust picture of how the average stock performed.

With that in mind, I culled Morningstar's database to get a broader sense of how stocks did in 2003. Here's what I found.

Stock Performance in 2003
	Whole Database	S&P 500	Market Cap < $5B	Micro- caps	Tech Stocks	Nontech Stocks	Stocks with No Earnings	Div. Yield > 3%
Number of Companies	5,999	500	5,405	3,039	1,150	4,849	2,496	614
Percent Up in 2003	87%	94%	86%	78%	86%	92%	76%	93%
Average Return	90%	42%	95%	102%	137%	77%	117%	37%
Median Return	38%	32%	46%	45%	74%	40%	57%	29%
Median Mkt Cap ($Mil)	222	8,718	196	39	194	238	73	612
Median 12-mo. P/E	19.7	19.9	19.7	17.9	31.2	19.8	NMF	17.8
Median Fwd P/E	18.4	18.7	19.5	18.2	34.6	18.2	32.5	14.4
Median P/S	1.6	1.6	1.6	0.9	2.0	1.4	1.4	2.0
Median P/B	2.0	2.8	2.0	1.4	2.3	2.0	1.7	1.8
Avg Dividend Yield	0.9%	1.4%	0.9%	0.6%	0.2%	1.1%	0.3%	5.1%
Average Payout Ratio	30%	41%	27%	21%	11%	32%	--	107%
Data through 12-31-03.

Whole Database vs. S&P 500
There are 5,999 stocks in Morningstar's database. Of these, 5,201, or 87%, went up last year. There was literally no place to hide if you were a bear. The average return on all 5,999 stocks was a whopping 90%--much higher than the return of either the S&P 500 Index (28.8%) or the Nasdaq Composite (50.1%). As I mentioned above, the fact that these indexes are market-cap-weighted accounts for the difference here. My data is gleaned by simply taking a straight average of all 5,999 stocks.

Some real highfliers may skew this average, however, so I decided to look at the median return of all 5,999. The median return was much lower, at 39%, but still higher than any of the major indexes except the Nasdaq. Perhaps this is because small stocks, which have lower weightings in the indexes, performed better?

Small Caps vs. Large Caps
Yep, that is indeed the case. The average return of stocks with market caps lower than $5 billion last year was an incredible 95%. The median return on this group of 5,405 stocks was 46%. Even so, the trailing P/E of smaller stocks in our database is 19.7--almost exactly the same as for stocks with market caps above $5 billion. (Note: I only included stocks with positive trailing earnings in this calculation.)

The dividend yields on small stocks are lower, though--0.9% versus 1.4% for the average S&P 500 stock. That makes sense because these companies are younger and reinvest more of their cash flows. The average payout ratio of small stocks was just 27% last year, versus 41% for S&P 500 stocks.

Looking at the 3,039 micro-caps (stocks with market caps below $200 million) in our database, the average return last year was 102%, with a median return of 45%. The average P/E ratio of this group of stocks is 17.9, lower than the P/E of the average large-cap stock.

A P/E of 17.9 may look cheap by comparison, but keep in mind that these stocks are riskier because their business models are often unproven. Also remember that my P/E calculation includes only the 1,261 micro-caps that had positive earnings last year, so it excludes the 59% of these stocks that lost money in 2003. Factoring this in, the true P/E for the group is undoubtedly much higher, but our database doesn't allow the inclusion of stocks with negative earnings when averaging P/E ratios.

Stocks with Earnings vs. No Earnings
Charles Royce of Royce & Associates said in a recent Wall Street Journal interview, "There has been a tremendous benefit [in 2003] in owning speculative stocks." I hereby declare this to be the understatement of the century.

Out of 5,999 stocks in our database, 2,496 had negative earnings last year. These 2,496 stocks gained 117%, on average. They have a trailing three-year standard deviation of 102%. (Standard deviation is a measure of volatility--the higher the standard deviation, the more volatile the stock.) By contrast, stocks with positive earnings gained 68% last year and have a standard deviation of just 44.6%.

Financial Health
Morningstar assigns Financial Health grades to all the stocks in our database (A is the best grade, and F the worst). These grades are based on interest-coverage ratios and debt levels. Here's the breakdown of 2003 stock returns by Financial Health grade:

Grade      Average Return  
A                55.6%                
B                68.9%                 
C                94.9%                 
D              115.8%                 
F               110.7%                  

So it really does appear true that the riskier the stock, the better its return last year. This is why many of the same mutual funds and investment newsletter portfolios that were at the bottom of the performance rankings in 2002 came out near the top in 2003.

Tech Stocks vs. Nontech Stocks
I can confidently say that we're in a second bubble for technology stocks.

There are 1,150 technology stocks in our database (with technology stocks defined as those in the hardware, software, and telecom sectors). On average, these stocks gained 137% last year, with a median return of 74%. The median trailing P/E ratio of these stocks was 31.2 as of Dec. 31, and the forward P/E was 34.6. (The latter two statistics exclude stocks with no trailing earnings, or with no analyst estimates for next year's earnings, so they're skewed low.) The median price/book, price/sales, and dividend yields on these are 2.3, 2.0, and 0.2%, respectively.

Nontech stocks returned 77% on average last year, with a median return of 40%. The trailing and forward P/E ratios on these are 19.8 and 18.2, respectively. In addition to lower P/E ratios, these stocks have lower price/sales and price/book ratios and a higher average dividend yield (1.1%). They're not cheap by historical standards but probably aren't in a bubble, either.

It seems to me that 2003 closely resembled 1999--a bifurcated go-go market. There's one big difference, though: In 1999 you could find some really cheap stocks if you turned over just a few conspicuously hidden rocks. Old economy and small-cap stocks were dramatically undervalued, especially those with healthy dividend payouts, such as REITS, insurance companies, and small regional banks.

Today, that's not the case. We've already seen data showing that small-cap stocks are no longer very attractive after running up dramatically in 2003. But what about high-yield stocks?

Stocks with Dividends
High-yield stocks aren't cheap either, but they're certainly less expensive than growth stocks. Ninety-three percent of stocks with dividend yields above 3% had a positive return last year. These stocks had an average total return of 37% and a median return of 29%. The median trailing and forward P/E ratios on this group currently sit at 17.8 and 14.4, respectively.

Assuming the earnings estimates on these stocks are reasonably accurate, you'll get about a 7% earnings yield on them in 2004--pretty good considering there's nowhere else to put your money. This is a real (inflation-adjusted) yield because earnings growth should keep pace with inflation. Try getting a 7% real yield on a bond--or, for that matter, any other group of stocks. From looking at the data above, I can assure you it won't happen.

I'd take it.