The Rise and Fall of "Mega-Capitalization" Stocks: Will Today’s Leaders Remain Tomorrow’s?
The last few years have witnessed the dominance of a handful of "Mega-Capitalization" (mega-market capitalization) stocks in market returns. While this dominance has been undeniable, the question arises: will this trend continue, and will the same companies remain at the helm? The answer might be more complex than one might think. The number of publicly traded companies has been steadily declining, as shown by a chart from Apollo, with factors like mergers and acquisitions, leveraged buyouts, and private equity playing a significant role. This contraction in publicly traded companies translates into fewer investment opportunities for large institutions compelled to allocate sizeable capital in short durations. Furthermore, with around 40% of the companies in the Russell 2000 index currently unprofitable, the options for these institutions become even more limited.
Key Takeaways:
- Shifting Leaders: The current dominance of a few "mega-cap" stocks is not unprecedented. In the past, the "Nifty 50" in the 1960s and 1970s and the "Dot.com" darlings in the late 90s enjoyed similar positions of influence. While today’s leaders are different, it is crucial to note that the leaders of yesterday are not the leaders of today.
- Earnings Growth: The Deciding Factor: One key indicator of continued market dominance lies in earnings growth. Investors are willing to pay higher prices when corporations are experiencing robust growth in earnings. However, 2023 presented a peculiar scenario where the top 7 "mega-cap" stocks accounted for all the earnings growth in the S&P 500. Without these seven stocks, the index would have registered negative earnings growth, potentially leading to a far less optimistic market outlook. Analysts are optimistic about earnings growth for the remaining companies by the end of 2024, but economic slowdown might dampen these hopes.
- The Law of Large Numbers: Companies like Microsoft, Apple, and Alphabet face a significant challenge in sustaining the rapid revenue growth that supports elevated earnings growth rates. Nvidia, being relatively young and operating in a fast-growing industry, has been able to achieve strong revenue increases. But, for a mature firm like Apple, achieving such high growth rates becomes increasingly difficult due to the law of large numbers. This is where the adage "Trees don’t grow to the sky" comes into play, highlighting the danger of assuming that a company with a high growth rate will continue on the same trajectory.
Passive Investing: A Double-Edged Sword
The rise of passive investing over the last two decades has introduced another dimension to the dynamics of financial markets. As mentioned previously, the top 10 "mega-cap" stocks in the S&P 500 index currently comprise over a third of the index. This means a 1% gain in these top 10 stocks is equivalent to a 1% gain in the bottom 90 stocks. With substantial inflows into ETFs in recent years, leading to further investment in these top 10 stocks, the illusion of market stability is unsurprising. While this strategy contributes to a seemingly robust market performance, it also creates a misleading picture. Due to the constant influx of dollars into the largest weighted stocks, the S&P 500 market-capitalization weighted index has consistently outperformed its equal-weighted counterpart.
This dynamic fosters a double-edged sword. For instance, consider the situation of Tesla, which previously constituted 5% of the S&P 500 index before Nvidia entered the top 10. As Nvidia’s rapid share price increase propelled its market capitalization, Tesla’s share price declined, consequently reducing its weight in the index. This forced index funds, passive fund managers, and other portfolio managers to increase their Nvidia holdings while reducing their Tesla positions. This implies that in the future, whatever new generation of companies captures Wall Street’s favor, today’s leaders might be forced out of the top 10 as passive flows mandate the sale of existing holdings to acquire new ones.
Share Buybacks – A Key Factor in the "Mega-Caps" Dominance
Finally, corporate share buybacks, which are projected to reach nearly $1 trillion in 2024, could be a contributing factor to the current "mega-cap" dominance. These large buyback programs are executed primarily by the largest companies with significant cash reserves like Apple, Microsoft, Alphabet, and Nvidia. Notably, Apple alone is forecast to account for over 10% of total buybacks in 2024. This is a significant indicator of the influence of share buybacks on market performance.
The importance of share buybacks in maintaining the current market dominance of these companies becomes clear when we examine the net equity buying since 2000:
- Pensions and Mutual Funds = (-$2.7 Trillion)
- Households and Foreign = +$2.4 Trillion
- Sub Total = (-$0.3 Trillion)
- Corporations (Buybacks) = $5.5 Trillion
- Net Total = $5.2 Trillion
These figures demonstrate that corporations have supplied 100% of net equity buying since 2000, underscoring the strong correlation between share buyback activities and market performance. As long as corporations remain major buyers of their own shares, the dominance of the "mega-caps" is likely to persist. It’s crucial to note though, that several factors could potentially result in the cessation of this trend:
- Changes to the tax code
- A ban on share repurchases
- A reduction in profitability, making share repurchases unsustainable
- An economic recession or credit event, forcing corporations to adopt defensive strategies
Whatever the cause, a reversal in corporate buyback programs could severely hinder the current market dominance of these leading companies. While it is difficult to predict when such a reversal might happen, it’s important to consider the possibility, especially considering that buybacks have constituted the entire net equity buying for the largest stocks.
Conclusion
The current dominance of the largest "mega-capitalization" companies seems logical, given their substantial contribution to earnings growth, revenue generation, and share buybacks. These companies are also at the forefront of the current "Artificial Intelligence" revolution, a trend observed over the past decade.
However, given the rapid pace of technological and economic shifts, it’s prudent to remember that today’s leaders may not be the leaders of tomorrow. As investors, it’s crucial to grasp the dynamics of each market cycle and invest accordingly. Those expecting the current "mega-cap" stocks to retain their dominance over the next decade might be in for a surprise, given their valuation levels. Even though there are several factors supporting the current secular bull market cycle, a short-sighted approach to investment can lead to subpar outcomes. Investors ought to approach their investment decisions with a nuanced perspective, taking into account the potential shifts and changes in the market landscape.
