The size and scale of this innovative wave makes sense when viewed through a historical lens, and this concept of innovative cycles was actually first introduced in 1942 when economist Joseph Schumpeter coined the term ‘creative destruction’ – concluding that industries are both created and destroyed by way of innovation. This concept of disruptive innovation was later expanded upon by Gordon Moore, co-founder of Intel, when he observed that such technologies also tend to proliferate at an exponential rate – a phenomenon now known as Moore’s Law. While their findings may seem obvious in hindsight, it shouldn’t be a surprise that this innovative wave – characterized by artificial intelligence, cloud-based technologies, and gene-editing therapeutics (among others) – is more revolutionary and proliferating more rapidly than ever before.
A handful of large technology companies have become incredibly popular given their outsized returns in recent years, and this group – commonly referred to by the acronym FANMAG (Facebook, Apple, Netflix, Microsoft, Amazon, and Google) – has significantly outperformed the S&P 500 in the eight years they’ve collectively been public companies (Facebook went public in 2012).This market leadership makes sense when you consider the profound conveniences of social media and two-day Prime shipping, but at what point does a company become too large – or better yet, too expensive? These tech titans were already huge prior to COVID-19, but the pandemic proved their worth in a time of crisis and propelled their collective valuation by nearly two-fold in just 18 months. As a result, FANMAG’s combined market capitalization now sits at a staggering $9.4 trillion – representing approximately 25% of the S&P 500. This metric is even more impressive (or concerning) when viewed in time-series format, and while the below graphic does exclude Netflix (the smallest of the FANMAG constituents) from the analysis, it clearly illustrates how abnormal this relationship is.
Even more interesting is the sheer size of Apple – the largest member of the FANMAG social club – whose market capitalization exceeds the gross domestic product (GDP) of more than 96% of countries in the world. In fact, only seven countries in the world have a higher GDP than Apple’s market cap and sales from the company’s individual product lines exceed that of most companies in the S&P 500. Once again, an incredible feat of economic prowess but one that complicates the traditional notion of sound diversification – especially if so many investors are relying on the S&P 500 as a well-diversified staple of their portfolio.
This issue of diversification (or lack thereof) is top-of-mind for many investors, but couldn’t you make an argument that over-allocating to the strongest names is well-justified given their track record in recent years? You could, but not without mentioning the even more critical piece to this puzzle – valuation. Now you may be asking yourself, can traditional valuation metrics such as the price-to-earnings (PE) ratio be relied upon given the unprecedented nature of COVID – a time in which the market has been dominated by multiple expansion amid earnings depression? Great question!
While traditional price ratios can in fact be quite volatile, cyclically-adjusted ratios such as the Shiller PE ratio – which relies on average inflation-adjusted earnings over a rolling 10-year period – can be used to offset the cyclical nature of profit margins and earnings. Interestingly enough, the S&P 500’s current Shiller PE ratio of 38.50 exceeds its unadjusted PE ratio of 34.57 – which now sits at its highest level since the dotcom bubble of 2000 nearly 2.5x its long-term average.
It’s no wonder that the S&P 500 appears to be so grossly overvalued when it carries a 25% allocation to six companies with a combined Forward PE ratio of 35.9, but then again, what’s to say the party has to stop anytime soon – especially with record low interest rates and $4 trillion in fiscal stimulus? While many investors have of course benefitted from FANMAG’s impressive bull run and timing any sort of market pullback is incredibly difficult – it begs the question of whether the S&P 500 can truly be relied upon as a well-diversified, properly-valued index. Conveniently enough, all six members of the FANMAG family recently reported their second quarter earnings in late July, and generally speaking, the results were impressive as always. Growth was explosive, margins were fat, and for a moment – the elevated multiples seemed justified. That was until investors appeared to be unamused by said results, focusing instead on Amazon’s revenue miss (despite a 50% jump in profits to deliver on earnings) and Facebook’s pessimistic outlook on near-term revenue growth.
Despite these blemishes, many analysts expected FANMAG to deliver on Q2 earnings (as they did) and for said results to serve as a tailwind heading into the month of August. Coincidentally the opposite rang true, and each of the six constituents have since underperformed the S&P 500 since their earnings call. While one should never place too much emphasis on short-term volatility, this once again puts the spotlight on America’s tech titans and reintroduces the very question we posed earlier – what happens to the broader market should FANMAG catch the flu?
There’s no denying the power of innovation and the tremendous amount of value that has yet to be created for each of these companies, but increasingly concentrated exposure to a few names with lofty multiples has added to structural market risk – the effects of which could be detrimental for those relying solely on the S&P 500 for equity exposure. The S&P 500 has historically been one of the best vehicles for passive equity exposure, and while its effectiveness in portfolio construction cannot be argued, its limitations should also be acknowledged. We at Silicon Hills rely on a number of techniques to confront such issues, to which my colleague – Scott Wimmer – offers some helpful insights in his recent posts on systematic approaches to factor-based investing. All in all we remain bullish yet cognizant as we close out the summer months, and though the market can at times be unpredictable, our passively-active approach to risk allocation allows us to stay the course while adjusting the sails – even if the water gets choppy.
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