Superb businesses
The Class of 2023 mega-caps
Much has been written recently about how seven stocks have driven the performance of the S&P 500. The numbers are quite striking. Just seven stocks currently make up 29% of the market capitalization of the S&P 500. In the first ten months of this year the share prices of the seven rose by 52%. By contrast, the price of the remaining 493 stocks fell by 2%. Putting the 7 and the 493 back together, the S&P 500 was up 10.69% to the end of October. The Economist
The issue I will discuss in this post is whether this bifurcation is a problem for investors.
The conclusion I come to is that it is not a problem for index investors, nor is it a problem for investors in individual common stocks.
Cap weighted
The seven are Microsoft MSFT, Apple AAPL, Amazon.com AMZN, Nvidia NVDA, Alphabet GOOGL, Meta Platforms META, and Tesla TSLA. These are the Class of 2023 mega-caps.
The S&P 500 is a market cap weighted index. The essence of a market cap weighted index is that the largest cap weighted companies have the largest impact on the price returns of the index. By way of contrast, the Dow Jones Industrials is not cap weighted. Curiously, with the DJIA, a smaller company with a $100 stock price has twice the impact on that index as a larger company with a $50 stock price.
What is clear with the S&P 500 is that the leading companies in the index change over time. In January 2000, twenty-three years ago, the ten largest capitalization companies in the S&P 500 were Microsoft, Cisco Systems, Exxon Mobil, Intel, Citigroup, IBM, General Electric, Oracle, and Home Depot. They were the Class of 2000 mega-caps.
Whatever happened to those ten companies? Only one, Microsoft, is still at the top of the market cap heap.
To understand what is going on, both index investors and investors in individual common stocks need to understand the idea of company life cycles.
Company life cycles
Companies are born, some grow and some prosper, and almost all get old with time and fade.
A perceptive report from Michael J. Mauboussin and Dan Callahan dated September 26, 2023 published by Morgan Stanley Investment Management describes the different stages of life of public companies.
They point out that: “Early on, companies have profitability that is below their ultimate potential and they have abundant investment opportunities. It is common for them to invest more than they earn. In the middle stages, companies reach their peak profitability and investment prospects are more limited. Earnings are greater than investments. Finally, in the later stages, companies see their profitability and investment options wane.” (Emphasis added)
This is depicted in the follow chart, Exhibit 1.
Recognizing the stages of life
Reference is made to the work of Victoria Dickinson, a professor of accounting at the University of Mississippi, who has created a way to place companies in one of five stages of the life cycle based on results from the statement of cash flows. The stages are introduction, growth, maturity, shake-out, and decline.
Mauboussin and Callahan report: “Dickinson’s insight is that the combination of results from each part of the statement of cash flows indicates where a company is within its life cycle. Cash flow from operating activities reveals the cash in and out from customer activity and therefore indicates profitability. Cash flow from investing activities shows the magnitude of the company’s investment in pursuit of growth that ostensibly creates value. Cash flow from financing activities reconciles the difference between the cash flows associated with operations and investments.” (Emphasis added)
This insight makes it clear that by looking carefully at the company statement of cash flows investors can identify where a company is within its life cycle.
And Warren Buffett tells us what we are looking for.
Investing incremental capital at very high rates of return
As Warren Buffett puts it: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. 1998) p.86. (Emphasis added) These are what Buffett calls the seven footers, to use his trope of creating a basketball team.
What investors are looking for is companies that are in the sweet spot in their life cycle. Every superb company will have two components: It will have a value based on what Mauboussin and Callaghan call ‘steady state’ and it will have a value based on the future opportunities for value creation.
They explain: “You can think of valuation in the growth and maturity stages with this breakdown in mind. The value of growth businesses will rely more on future value creation, and the value of mature businesses will depend more on the steady state. In all cases, understanding the magnitude and return on incremental investment is crucial.” (Emphasis added)
What does this mean?
Index investors simply need to know that sticking with the index over the long haul they will share in the growth of current and future Magnificent Seven/FAANG/mega-cap members. The membership will change over time. Many of the companies in the group today will not be in the group tomorrow. Some companies that are not in the group today will be in the group tomorrow.
There are two essential problems with index investing.
First: A lot of the companies in the S&P 500 are past their prime. They are on the down slope of Exhibit 1: They have failed to continuously reinvent themselves; their products or services have become obsolete; their management are incompetent or prefer managements’ interests over shareholders; or, they have simply lost their way. This is what happened to some of the Class of 2000 S&P 500 mega-caps.
Second: Many companies in the S&P 500 are overpriced. For example, Morningstar puts a fair value estimate on Apple AAPL of $150. The last closing price, as I write, was $ 189.69. You buy the index, you get AAPL at $189.69.
On the bright side, as some companies start to flag, like the Class of 2000 mega-caps, others like the Class of 2023 mega-caps, have come to take their place.
All things considered, investing in an S&P 500 index fund will provide a satisfactory return over time. It is well recognized that most professional money managers who actively manage stock funds do not outperform the S&P500 after fees are taken into account.
For investors in individual common stocks, the top-heavy weighting of seven stocks in the S&P 500 is not an issue. An investment process of investing only in superb companies that generate handsome returns on their invested capital and have opportunities to invest back in the business at high rates of return will continue to work. The portfolio needs to be monitored to make sure to weed out companies that reach their best before date, that start to lose their way and head into a life cycle decline.
Some commentators have argued that you have to invest in the FAANGS or the Magnificent Seven to achieve superior results. This is not true. There are sufficient superb companies to invest in that have much lower market caps. One doesn’t have to identify the next Microsoft. I have discussed this issue in Do investors need to identify and invest in future FAAMGN stocks?
Concentration risk
It has been argued that the rise of the Magnificent Seven “has led to the increased concentration of market-like portfolios [read index funds] reducing the benefits of diversification and increasing a portfolio’s exposure to idiosyncratic risks.” I don’t buy this. Over the long haul a portfolio of 500 of some of the best companies in the world’s most dynamic economy, is well diversified if not over diversified. Some of the seven will flag in years to come, but others will rise to take their places. As for idiosyncratic risk, even a catastrophe at one of the seven would not make much of a dent in a market index fund. Smaller idiosyncratic risks to individual companies of the Magnificent Seven would make no significant difference to the long-term performance of the fund.
Another commentor has argued: “Concentration can be a killer. Holding concentrated positions in the stock market gives you the opportunity to outperform but also increases your chances of underperforming by a wide margin.”
The essence of their argument is: “You could pick a stock in any sector and hold it for ten years, and there is a greater than 50% chance it will end up a loser.”
My simple response to this line of thought is that intelligent investing does not involve picking ‘any’ stock and holding it for ten years. Intelligent investing involves investing only in the best business ‘that over an extended period can employ large amounts of incremental capital at very high rates of return.’ Portfolio management means weeding out companies that no longer meet this high standard. This is known as sticking to one’s Graham-and-Dodd knitting.
Roger Lowenstein’s classic book on Buffett explains: “Most of what Buffett did, such as reading reports and trade journals, the small investor could also do. He felt very deeply that the common wisdom was dead wrong, the little guy could invest in the market, so long as he stuck to his Graham-and-Dodd knitting. But people, he found, either took to this approach immediately or they never did. Many had a “perverse” need to make it complicated.” (Lowenstein, 1995,2008) p.331’
Conclusion
Investing in S&P 500 index funds over the long haul is a simple and effective way to take advantage of the returns offered by common stocks. Having a small group of mega-cap stocks exert oversized influence on index fund returns is perfectly normal. The group of mega-cap stocks will change over time but that is no matter. For investors in individual stocks the index concentration of a group of mega-cap stocks is also of no consequence. Some of those mega-cap stocks will find their way into the investor’s portfolio if they meet the investor’s quality standards and can be bought at a very attractive price.
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