The rise and rise of large caps
The S&P 500’s ten largest companies’ combined market capitalisation is now more than three times that of the entire Russell 2000 index of US small cap companies. This is the highest it has been in 50 years and each peak typically happens at the end of a decade.
Within the context of S&P 500, the percentage share of the top 10 companies of the index at 22 per is approaching highs seen in the 2000s. There are a number of reasons for this extraordinary performance including monopolistic financial performance based on network effects, extremely loose monetary policy and the rise of passive funds. But that could be about to change.
History shows that the track record of mega cap companies maintaining their status at the top of the S&P leader board from one decade to another is, at best, average. The top 10 list typically changes by at least 50 per cent over the following decade as the drivers of performance alter significantly and new trends emerge.
Table 1: Yesterday’s winners? The list of top companies changes from decade to decade
Source: Fidelity International, January 2020
Focus on small and mid-cap
Already many investors are on the hunt for the companies that will form the next top ten in the S&P 500 in the 2020s. But we believe that a more prudent strategy would be to focus on smaller and mid-sized companies at this point in the latest “mini” cycle of this multi-year bull market, avoiding both the overvaluation and concentration risk in the larger cap area while also benefiting from the emerging long-term structural trends fuelling corporate growth lower down the scale.
The recent jump in the ISM Manufacturing Index, which is closely tied to the performance of small caps, and signs of a truce in the US-China trade war bode well for these domestically-oriented companies. Indeed, there are signs of improving risk sentiment: the Russell 2000 hit new highs in December but remains largely undervalued compared to large caps. And if the global economy picks up, these companies stand to do much better than the broader market.
Source: Strategas Partners, December 2019
While it may be difficult to envisage today how or why mega caps will underperform given their sustained rise or which of these companies will be replaced by others, continuing to invest in them as a group risks missing out on better value elsewhere, as well as evolving trends. The view that “this time is different” may not hold. After all, it is brave to bet against the crowd but braver to bet with the future.