Can you have too much of a good thing?

• Compare stock market concentrations
• Fundamentals vs. fads
• What lies ahead?

“It’s summer, Papa. Can I have just one more ice cream?” This is what my nine-year old daughter rather cutely asked me the other day. Yet, knowing how easily I would say yes, my wife swiftly stepped in. “How much is too much for a day? She’s already had two ice creams.”

How much is too much is indeed the question that many market participants have been asking for quite some time. Watching the share of top 10 stocks in the S&P 500 Index go up dramatically over the last several years has led many to question the sustainability of the rally. Will some of those big-name shares eventually melt, like ice cream in the summer sun?

The financial press is full of news about how this situation resembles the tech bubble of the 2000s. Others have drawn comparisons with the famous Nifty Fifty craze of the early 1970s that eventually came crashing down. However you might see it, the top stocks of today kept marching on until this earnings season, when many of them disappointed against ever-higher expectations.

Does that mean it’s time to cut and run? Maybe or maybe not. After all, unlike the 2000 tech bust when unprofitable companies rose to extremes on stories, many of the bigger companies today generate massive free cash flow with high rates of return, pristine balance sheet and significant reinvestment opportunities. The key for investors is to stay disciplined in analyzing the fundamentals and act accordingly rather than taking decisions based on narratives.

Compare stock market concentrations

Being circumspect and having varied opinions are key ingredients of a thriving marketplace. While we respect that many market participants are prudent in asking tough questions, we find that some arguments are loaded with selective information without much focus on fundamentals.

For instance, the increasing concentration of top names in the U.S. markets (especially in the S&P 500 Index) led many analysts to conclude that one should diversify away from them as investors might be taking excessive risk in few top companies. Yet what most naysayers with this mindset tend to neglect is that the U.S. markets are still far more diversified than most other markets across the world, which have much higher concentration of top 10 stocks (see figure 1).

Figure 1: Stock market concentration in the largest global equity markets, 2023

Sources: FactSet & Counterpoint Global

Fundamentals vs fads

Being research-driven long-term investors, we focus our analysis on the business and its durability, rather than prevalent market narratives. Whenever we see comparisons of the current situation to a previous period, we try to understand the whole picture – comprising many individual details – instead of relying on a single perspective that makes broad assumptions. 

Take the “magnificent seven” as an example (Apple, Tesla, Alphabet, Amazon, Nvidia, Microsoft and Meta). Many people are comparing the rise of these firms to the tech bubble of the early 2000s. Rather than flowing with this narrative or dismissing it outrightly, we not only compared their weights in the S&P 500 Index, but also whether their earnings and valuations justified the shares becoming a larger part of that index.

A similar analysis was conducted by Michael Mauboussin and Dan Callahan¹ at Counterpoint Global recently. According to their analysis of stock market concentration, the top 10 stocks of the S&P 500 Index at the end of 2023 represented 27% of the market capitalization of that index, and these 10 companies earned 69% of the aggregate economic profit of all the firms on that same index. Investors must exercise judgement and evaluate what the right level of weight is for companies that contribute such a large portion of the total economic profits of the index.

What lies ahead?

It’s always hard to know with any precision what’s on the horizon, as the future is inherently unpredictable. Who can claim that today’s emperors cannot be dethroned tomorrow? Google, for instance, is currently facing its toughest battle since the launch of Artificial Intelligence related chatbots, assistants and searches. Can the company maintain its edge within such a rapidly competitive tech market?

Answering these and other questions is where a time-tested and proven investment process comes to our rescue. We weigh each opportunity on its fundamental merit, along with the risk reward it entails. And when we find a business that offers us compelling risk reward, we don’t hesitate to go against the tide and own it irrespective of the prevalent narrative, regardless of whether the firm is “magnificent” or otherwise.

So, can you have too much of a good thing? Though my daughter would suggest not, as investors we need to stay clear of the narratives and act objectively based on underlying fundamentals of the business, rather than its weight in the index.

Sources: Morgan Stanely, FactSet, Counterpoint Global

¹ Stock market concentration: how much is too much? Published by Morgan Stanley, June 4, 2024

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