The Concentration Conundrum
This year's performance of the MSCI World Index has been concentrated in just a few mega-cap US companies and driven almost entirely by multiple expansion. Ironically, some of these stocks have also fallen into value indices due to the vagaries of index construction. Historically, index giants have underperformed the market by a wide margin, and these mega-cap stocks often become tomorrow's opportunities for disciplined value investors. Meanwhile, the cheapest quintile is the only subset of stocks trading at a significant discount to its long-term average multiple.
A Narrow Sentiment Rally
This year, the market's (Russell 1000) 16.7% rally has been one of the narrowest on record. Remarkably, 73% of the performance has come from just 10 stocks, versus a 41% historic average contribution from the top 10 contributors. These stocks are all mega-cap glamour names, including familiar mega-cap growth darlings such as Microsoft, Apple, NVIDIA, Amazon, Tesla, Broadcom, and AMD. The top 10 contributing stocks are up 59% year to date, in contrast to a 25% historic average appreciation for the top 10 contributors (Exhibit 1).
Contrary to history, the concentrated performance year-to-date has been predominantly driven by multiple expansion rather than earnings growth. Historically, the top 10 index contributors generated slightly more than half of their returns from earnings growth. However, this year, 96% of the return has come from multiple expansion (Exhibit 2). It's important to remember that extreme multiple expansion has never been a reliable and sustainable contributor to long-term performance, accounting for less than 10% of historical market gains.
Mega cap growth stocks have driven the outperformance of the 10 largest S&P stocks, which have beaten the equal-weighted market index by over 44 percentage points on five-year ending periods, on average, since 2018. Historically, though, owning the largest stocks has, on average, been a recipe for massive underperformance over every period (Exhibit 3).
The Impact on Value Indices
As mega-cap growth stocks staged a sentiment-driven rally, stock market indices are once again nearing record levels of index concentration, which creates distortions in value index construction. For example, the MSCI World Growth and Value Indices match market caps at index reconstitution dates. To achieve market cap parity between the two indices, more stocks must be allocated to the value index, many of which are not true value stocks. As a result, the MSCI World Value Index now has more than 200 additional stocks compared to the growth series. This is a near record level, and many of these additional stocks aren't true value stocks (Exhibit 4).
Today's Darlings Become Tomorrow's Value Stocks
Conclusion
Markets dominated by sentiment-driven, runaway mega-cap growth stocks, like the one we have seen in the first half of this year, are a test of an investor's value discipline. As dedicated value investors, we will continue to avoid expensive mega-cap stocks due to their long history of underperformance. Our own experience bolsters our confidence that someday we may have the opportunity to buy many of today's mega-cap glamour companies at much cheaper prices. Instead, we are looking among the cheapest stocks in the market that have superior long-term records and are trading at significant discounts to their long-term averages. Among these inexpensive stocks, we are invested in a range of opportunities in good businesses trading at compelling valuations that have not participated in the sentiment-driven rally this year.
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