Is the S&P 500 too concentrated? Let's discuss...
Another tech bubble or not?
«Stock market experience level: Intermediate»
Hi readers,
I have mentioned in a recent post that I am reducing some of the passive/index exposure in my portfolio for more active exposure. This is because the index I invest in is a market cap. weighted index and thus is heavily concentrated (c.30%) in the Magnificent 7 stocks. But what do I think of the long term outlook of these companies?
Well without going into my thoughts for each individual company, (which I do for paid subscribers), lets analyse the group of them together.
We can see what implied growth rates these group of stocks are expected to achieve by using something called a reverse DCF.
Some background…a DCF stands for discounted cash flow. It is a model which is the bread and butter of how analysts such as myself value companies and decide if they are cheap compared to what the current stock price is. Essentially, you look at the cash a company is expected to generate and how that will grow over time and discount that to the present day. If all the future cash flows you are expected to receive are worth more than the current stock price/value of the company then you are getting a good deal.
A reverse DCF looks at this calculation it in the opposite direction. It takes the DCF formula and plugs in the current stock price to see what is implied in terms of cash flow growth. Subscribe and message me and I’ll send you a DCF template - you can play around with the inputs yourself and see how that affects the average growth level compared to the market’s estimate - I certainly have a different figure compared to the market!
Doing this reverse DCF exercise to get the market’s expectations for the Mag 7 stocks, churns out a 15% earnings/cash flow growth on average for the next 10 years until they begin to grow in line with the economy at an assumed 2.5% growth rate. This level of growth isn't terribly far off the 16% on average that these companies have delivered over the past 10 years. The big question for you to ponder - will AI drive a similar transformation that the microprocessors, 3G mobile networks and battery technology did over the past decade?
Next, we look at how this would affect the S&P 500 and compare that with the economy, because no matter how great a group of companies are, they can't grow so big and become an entire economy.
So, after 10 years, the Mag 7 earnings growing at 15% pa would make up 42% of S&P 500 earnings vs 24% now, and overall S&P 500 earnings growth would be 8% but rise to 9.5% by year 10. While this looks generous it is not inconceivable. The S&P 500 earnings have grown at an average of 7.5% annually over the past 12 years.
When we compare this with the total economy, the S&P 500 total earnings would tick higher to 17% of the economy (total GDP) from the current 11% now. This, like the figures above, would give us unprecedented levels of Mag 7 contribution, but not something that I think would be a major cause for alarm.
In this scenario I also assumed 3% growth for the non-corporate part of the economy too, so there is less likely to be any onerous anti-competition regulation on these companies that would mean giving up some of their corporate profits. I believe a similar threat reared its head in late 2018/early 2019 which led to a correction and underperformance from some Big tech stocks.
We are missing a big point though - ex-US growth. The Mag 7 stocks have on average 53% of revenues exposed to outside the US, or alternatively roughly 20% of revenues exposed to China and emerging market countries which are likely to offer greater growth opportunities, so both the above calculations are likely to be less worrisome due to the S&P 500 becoming more international overall.
So, what does this all mean?
This is admittedly, a very rough analysis but it means that just because there is a high concentration currently doesn't mean that these companies are doomed from here or that passive exposure is going to leave you regretting not picking your own stocks (see my post on active vs passive investing.)
Ultimately, it will come down to how these companies deliver relative to that implied 15% growth rate. Also, taking a different approach, on current valuations the Mag 7 stocks trade on a PE of 30x i.e. you pay $30 for $1 of earnings, vs 52x for the biggest companies at the peak of the 90s tech bubble and 34x for the leading companies in the “Nifty 50” bubble of the late 60s.
However, as a reminder we are looking at an average of the Mag 7 stocks, and clearly some imply more reasonable growth rates than others (Alphabet and Tesla is the biggest differential, and is why I am overweight one and don't hold the other!) Just because the past 10 years there hasn’t been much change in the top stocks, doesn’t mean that won’t be the case going forward. Compare the top 10 in 2011 with those in 2000!
Hope you enjoyed this post.
As always, comments, requests and feedback all welcome.
the Islamic Investor