Remember when a trillion dollars was a lot of money?
With five American companies having touched that astounding level of market value recently and one, Apple, on the cusp of breaching $3 trillion, investors should ask what it means for their portfolios. The precedents aren’t encouraging.
One obvious reason is that even passive investors are increasingly betting on just a handful of stocks vulnerable to a dud product or regulatory setback. Thinking of it in terms of buying an entire business is helpful: Would you rather own the iPhone maker or all of McDonald’s, Walmart, AT&T, Philip Morris, Berkshire Hathaway, Procter & Gamble, JPMorgan Chase, Starbucks, Boeing, Deere and American Express combined? A lot would have to go wrong all at once to torpedo that diversified group of blue-chip stocks.
It may be difficult to imagine a company as dominant as Apple stumbling, but that has always been the case with past market champions. The top stocks in the index 10, 20 and 40 years ago were Exxon Mobil, General Electric and AT&T, respectively. Only Exxon Mobil continues in recognizable form today.
Aside from the concentration risk, the rise of megacompanies has been bad for stock returns in general. Apple and the other nine largest constituents of the S&P 500 comprise nearly 30% of its market value, well above the previous concentration peak seen at the height of the tech bubble before a brutal bear market.
Even if that doesn’t happen this time, owning any company that has mushroomed in value means it is hard for it to outperform for much longer without getting uncomfortably large. Dimensional Fund Advisors looked back over the decades to what happens to a stock that has joined the 10 biggest in the S&P 500. In the decade before getting there it has, on average, outperformed a basket of all U.S. companies by an impressive 10% a year on average. In the next 10 years, though, it actually has lagged behind the market by 1.5% a year.
Part of the reason very big companies get that way is that their earnings grow quickly, but another is that investors increasingly feel safe putting their money on those recent winners. Even if they are wonderful businesses, that can leave them overvalued. The trailing price-to-earnings ratio of the S&P 500’s top 10 constituents in November was 68% above their average multiple over the past quarter-century, which includes the tech bubble years, according to J.P. Morgan Asset Management. The P/E ratio of the remaining companies was just 28% above average.
It isn’t just a tech-stock phenomenon either. Back in 1972 a group of “one-decision” stocks increasingly favored by fund managers—the so-called Nifty Fifty that included Walt Disney and Philip Morris—sported lofty multiples more than twice as high as the overall market at their peak. Most survived and even thrived, but their shares lagged behind the market for years as their valuations reverted to the mean in the ensuing bear market.
While there is no way to say when the next market tumble will happen, one way to soften the blow while remaining invested is to recognize that recent winners tend to be relative losers and to bet accordingly. An Invesco index fund launched in April 2003 that holds S&P 500 constituents in equal amounts beat a standard capitalization-weighted ETF owning the same stocks by 58 percentage points in its first 10 years of existence. Since then, though, it has given up most of that edge, trailing its counterpart by 43 percentage points.
Having the same exposure to O’Reilly Automotive, Conagra Brands or Hasbro as to Apple isn’t as crazy as it sounds: Small might be about to become beautiful again.
Write to Spencer Jakab at [email protected]
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