Are the Largest Large-Cap Growth Stocks Where It’s At?

Depending on how you look at it, it’s actually much easier than I routinely propose to beat the general market year after year. Just look at the largest of the large-cap growth stocks: Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla. Tesla aside, the other five are by far the biggest companies in the U.S. market, currently making up nearly 20% of it; Apple alone represents around 6% of the U.S. market. And for the five years ending July 2020, an equal-weighted portfolio of these giants would have more than quadrupled in value, shooting out the roof and leaving a total market index fund investor in the dust.

So, why not just concentrate your investments in these biggest and most exciting companies? Between their extraordinary recent returns and their world-changing products and services, it’s easy to believe this time is different, and these are the only stocks you need to own.

As you might guess if you’ve read my past work, I’m going to describe why it’s worth thinking twice before moving everything into the largest large-cap stocks. We start out by looking back.

Market Quadrants Across History

The stock market can be sorted into nine broad categories based on size and relative price. Company size (small, medium, and large) is measured by its market capitalization. Relative price (value, balanced, and growth) is measured by the company’s price relative to some fundamental measure like its book value or earnings. Value stocks have low prices relative to their fundamentals, while growth stocks have high prices.

In this context, while market dominance by a handful of giant companies within the large-cap growth quadrant may seem like uncharted territory, it’s actually nothing new. For example, from 1927–1979, it was not unusual to have the largest company make up around 6% of the U.S. stock market’s value. General Motors, AT&T, and IBM took turns over that time period as the largest company in the U.S. market, routinely surpassing Apple’s current 6% weight.

The story is similar for the largest five and largest 10 companies’ historical contributions to the U.S. market’s total value.

The Latest Greatest?

So, it’s clear the current market heavyweights aren’t unusually huge relative to market history. But what about the extraordinary impact they’re having in our lives? The network effects, infinite scale, and ever-increasing data advantage that today’s biggest companies have does seem unprecedented.

But consider this: In the 1930s, AT&T was the largest U.S. company. Alexander Graham Bell had invented the telephone in 1876, and by 1885 his company began to build out the telephone network. Think about that for a moment. Telephones did not exist until this company started creating them, and then they built and owned the entire telephone network.

It’s no wonder AT&T became the most valuable U.S. company, and remained dominant for decades (as shown in the chart above). Other innovative companies have grown to tremendous size, and maintained similar dominance. General Motors created the electric car starter, airbags, and the automatic transmission. General Electric took electric lighting mainstream, playing a crucial role in shaping the world we live in today.

But as massive as these behemoths became, that has not necessarily made them good long-term investments. For each decade starting 1930, 1940, 1950, and so on through 2010, the 10 largest companies at the start of the decade have made up, on average, 23.6% of the U.S. stock market. But, in the decade that followed, the average annual return of those 10 largest companies has trailed the market by an annualized 1.51% on average.

High Expectations

How is it that these massive, successful, world-changing companies can end up trailing the stock market? It has to do with where those stock returns come from. There are two primary components:

1. An expected return: In theory, a company’s stock value is the discounted price the market is willing to pay applied to the company’s future expected profits. If you expect a company to deliver some level of profits, and you buy those expected profits at a 7% discount, you expect to earn a 7% return on your investment.
2. An unexpected return: The unexpected stock return comes from new, previously unknown information that gets included in the price once it becomes known. For example, let’s say a company releases earnings that were much better than expected. Its stock price may increase to reflect now-higher expectations for future profits. On the flip side, an unexpected pandemic might have the opposite effect.

Clearly, it is not possible to predict an unexpected return, so I think it’s sensible to focus on the expected return. In particular, what discount can an investor expect to receive when paying the price for the future expected profits from companies like Facebook, Apple, Amazon, Alphabet, Microsoft, and Tesla? Probably not much.

The relative price of U.S. large-cap growth stocks is always going to be high compared to the overall market. Growth stocks, by definition, are the most expensive stocks in the market. These high-flying companies have even higher-flying price-to-book prices relative to their fundamental financial measures. And when I say high, I mean really high.

In fact, the current expensive level for these companies is looking a lot like it did at the beginning of 2000. If you remember your history, 2000 was followed by a decade of negative returns for U.S. large-cap growth stocks.