There has been significant talk in the media about a few stocks leading the market. In this piece we examine the market concentration of the largest U.S. firms relative to historical levels, and explore the potential impact concentration could have on the valuations of leading companies.
At first glance, it is difficult not to be taken aback by the sheer size of the largest market capitalization stocks in the S&P 500. The two largest stocks, Apple and Google, for example, each have market capitalizations of approximately $700 billion, bigger than the combined market capitalizations of Wal-Mart Stores, Coca-Cola, and Procter & Gamble. In addition to Apple and Google, there are an additional four companies (Microsoft, Amazon, Facebook and Berkshire Hathaway) that each have market capitalizations of greater than $400 billion, an accomplishment that only one company (Apple) could claim at the end of 2014, and no company could claim at the end of 2010, merely seven years ago.
Over the past few months some of these large-capitalization companies, in particular the technology-related companies, have outperformed the market by a significant margin, raising concerns about too much concentration at the top, and a market driven just by a few companies.
However, to our surprise (see graph below) we found that the market capitalizations of the top five and 10 companies represented only 13% and 20%, respectively, of the S&P 500 total market capitalization. These are levels of concentration that are clearly in line with historical averages, and well below peak levels.
The 13% and 20% levels for the top five and top 10 suggest that the average market cap of each stock within those groups represents approximately 2%-3% of the S&P 500 market capitalization. This is consistent with a previous study in which we showed that size becomes restrictive for valuation when individual stocks reach concentration levels of 4%-5% of the total U.S. market capitalization (as illustrated in the graph below).
What Are the Investment Ramifications?
According to financial theory, the level of market concentration is irrelevant to valuation, as supply is assumed to be elastic (i.e. market cap is independent of supply). Nevertheless, in practice, investors and especially professional investors, want diversified portfolios. They want to avoid being overly exposed to individual assets, which at the margin can place a lid on valuation. (For related reading, see: Diversification: Protecting Portfolios From Mass Destruction.)
Consider the case of Apple in 2011-2012. Why did the stock trade at a low multiple in spite of being a well-known company, covered by many analysts with bullish outlooks, a leader in its field, and admired worldwide? We dare to speculate that one of the reasons the stock became less sensitive to earnings and improving fundamentals, resulting in a lower multiple, was that all the “bullish” investors had reached close to their maximum potential allocation to the stock (maybe 5-7%) if they were to remain diversified, and those who didn’t own the stock were unwilling to buy it at the level of the market price. These two factors resulted in a peak market cap being reached, at 4% of the S&P 500, as depicted in the above graph.
Thus, at the extreme, market concentration could be an important barrier to higher valuations, irrespective of short- and medium-term market fundamentals.
(For more from this author, see: Why Investors Should Use Duration to Compare Bonds.)
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