August 19, 2020—After a historically volatile first half, the S&P 500 is back in positive territory, up roughly 5% for the year, but gains have been far from equally distributed. The top five companies by market cap, or FAAMG (Facebook, Amazon, Apple, Microsoft, and Google), are up 48%,1 while the bottom 495 have yet to break even. The group’s ballooning market cap share is the highest observed in at least three decades and has led many to question whether the dominance exerted by such a small group of companies leaves the broader market vulnerable. In addition, the elevated valuations across the group have fueled a flurry of comparisons to the tech bubble in 2000. In our view, given the substantial contribution of the top five to index earnings, resilient business models and current valuations, which look more reasonable when compared to the broader index, make the tech bubble an ill-suited comparison. Narrow market leadership, index concentration, and valuations are all risks worth monitoring but not reason enough to be bearish. Below we will walk through some supporting statistics and how we are thinking about the market’s bifurcation going forward.
Market concentration: How did five companies absorb 22% of the index, and can it continue?
In order to consider the sustainability of the FAAMG cohort’s outsized share of the market, it is vital to understand how they grew so large in the first place. Whether it be Apple’s role in pioneering the widespread adoption of mobile phones, or Amazon spearheading the growth of e-commerce, all members of the group have been at the forefront of generational shifts in consumer behavior and pivotal technological developments. Further, not only have these companies established a multitude of profitable revenue streams, but their burgeoning scale and network of expertise have enabled them to maintain continuous pipelines of innovation, underpinning investors’ high expectations for them in the future. The group’s expansion has also been a product of long-term secular trends, such as increasing use of the cloud and the broad shift to work from home, that accelerated during the pandemic and are expected to remain key growth drivers in the years ahead.
Since 2015, the five tech titans gained roughly 323%, more than doubling their share of the index, while the bottom 495 returned a mere 30%1 over the same period. A key differentiator during this cycle is that earnings growth reflects a comparable divergence. Over the same period, the combined earnings of the FAAMG group have grown by 11.9% annualized, more than double the 5.2% growth rate for the bottom 495. This dynamic has remained the driver throughout the pandemic, with 2Q 2020 earnings reports handily beating expectations despite the economic turmoil weighing on the large bulk of companies. The FAAMG cohort delivered an astounding 19% revenue growth y/y in 2Q, while the index is on pace for a decline of -11% y/y.
Importantly, unlike the tech bubble, the dominant market share of the top five today is supported by a more proportionate earnings contribution. In 1999, the five largest S&P 500 companies (Microsoft, General Electric, Cisco, Walmart and Intel) comprised 17% of the index by market cap but contributed only 8% of earnings. In contrast, today’s top five represent nearly 22% share but are on pace to deliver a more commensurate 17%2 of index earnings in 2Q 2020. Although market cap gains for the FAAMG group have outpaced earnings growth to some extent, their size today is far more justified by their contribution to index profitability. The potential for antitrust-related action from the federal government and a possible deceleration in growth rates relative to the broader market are important risks to monitor, but in the absence of larger scale industry disruption, we have little reason to believe that tech leadership shouldn’t continue in the years ahead.
Valuations: Have they lost touch with reality?
Many have postulated that current valuations have started to lose touch with reality, particularly across mega-cap tech stocks. Considering the price-to-consensus forward earnings multiple, the S&P 500 is trading at 23x, near the highest we’ve seen since the tech bubble, while the top five are trading at an even loftier 38x. An important point to consider is that this elevated valuation is currently a market-wide phenomenon. The explanation for this is twofold.
- First – The broad majority of companies have seen forward earnings estimates, the denominator in the price-to-earnings multiple, decline by a significant amount since the pandemic struck, while prices, the numerator, convey a more optimistic view. 12-month forward earnings estimates for the S&P 500 have been revised -14.9% lower since the beginning of the year, while prices for nearly half of all companies in the index returned to positive territory over the same period.
- Second – Historically low yields on corporate and government bonds, a product of accommodative central banks across the globe, and low growth expectations have made stocks arguably more valuable on a relative basis, particularly of companies like the FAAMG group that can generate their own organic growth.
Since multiple expansion has been ubiquitous (though to varying degrees), the FAAMG group is not as expensive relative to the rest of the market, as the top five were during the tech bubble—particularly if we exclude Amazon, which has traded at a considerable premium to the market since going public. As illustrated in Figure 1 below, the forward earnings multiple for the top five mega-caps has risen to roughly 2.1x that of the bottom 495 S&P 500 companies, and only 1.4x if we exclude Amazon. Both are well below the nearly 3.6x reached during the tech bubble. Although the group’s current multiple of 38x forward earnings is undoubtedly expensive and close to the highest we’ve seen in two decades, it is nowhere near the peak of the tech bubble, when the top five traded at an astounding 68x multiple with substantially less profit to show for it. Furthermore, the group’s valuation looks considerably less extreme after adjusting for the upward skew from Amazon.
Figure 1: Price-to-forward-earnings multiple–S&P 500 top five companies by market cap vs. bottom 495
Shows the cap-weighted 12-month forward price-to-earnings ratio of the five largest S&P 500 companies by market capitalization divided by the same metric for the bottom 495 names. Sources: Bloomberg, Macrobond, WTIA.
The top five have run up significantly this year, and may be short-term overbought with a lot of optimism baked in to current prices, but valuations are nowhere near the excesses seen during the tech bubble. Current multiples and the high concentration of this group are a market risk, leaving them vulnerable to an abrupt turn in sentiment, but are not reason enough alone to be pessimistic on the market. In fact, the relatively narrow leadership of the market thus far this year may actually create an opportunity for further gains in the months ahead should the rest of the market pick up some of the “slack.” As fast-growing, competitively positioned, and well-capitalized businesses, we like the mega-cap growth group long-term and believe they deserve to trade at a premium to the broader market. However, we continue to value diversification and, more broadly, are somewhat cautious on the market’s near-term direction. As a result, we are positioning client portfolios with an underweight to equities.
1Captures increase in market capitalization for the top five and bottom 495 S&P 500 companies.
2According to Bloomberg analyst estimates.
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