The Top 5

Will Today’s Behemoths Rule Tomorrow?

By: Chris Satterthwaite

Note to readers: This will be the last Verdad Weekly Research of the summer. We will return to weekly publishing again in September.

Earlier this year, AI-related enthusiasm led to a surge in a handful of large US equities, now dubbed the “Magnificent Seven,” which include AAPL, MSFT, GOOG, AMZN, NVDA, TSLA, and META. Much ink was spilled over the concentration seen in US equity markets, leading to a special rebalance of the NASDAQ 100 to address the overconcentration.

Starting in 2013, an annually rebalanced portfolio of the 5 largest stocks (a “Big 5” strategy) outperformed the S&P 500 and the large value portfolio by a wide margin, as shown in Figure 1.

Figure 1: “Big 5”, S&P 500, and Large-Cap Value Returns (2013—2022)

Source: Ken French, Capital IQ, Verdad analysis

This improvement in performance coincided with a decrease in the turnover among the top 5 largest stocks in the US market and a significant increase in sector exposure to Info Tech and Communications Services.

Figure 2: “Big 5” Trailing 5-Year Turnover and Info Tech/Comms Concentration

Source: Ken French, Capital IQ, Verdad analysis

We have no view on the staying power of the “Magnificent Seven,” but we do think it’s notable that historically there has been more turnover and diversification among the largest 5 constituents of the US equity market than exhibited over the last decade.

A concentrated strategy of the top n largest stocks over the last 10 years is, in effect, equivalent to a buy and hold strategy comprising the biggest winners of the last decade (e.g., AAPL, GOOG, MSFT). This would irrefutably have been a good strategy, but it was an anomalous outcome relative to history.

The phenomenon of the largest stocks delivering the best returns is new, in our opinion. In fact, from 1994 to 2013, an annually rebalanced portfolio of the largest 5 stocks (“Big 5”) in the US had a comparable return to the entire S&P 500. But both portfolios significantly lagged a large-cap value portfolio (per Ken French), as shown in Figure 3 below.

Figure 3: “Big 5,” S&P 500, and Large Cap Value Returns (1995—2012)

Source: Ken French, Capital IQ, Verdad analysis

The last 10 years have seen a concentration of returns to the tech sector and to a few companies within that sector. This is both notable and unusual. With the advent of exciting new technologies like AI and superconductors, we think it’s plausible that the top 5 largest companies 10 years from now may look quite different from the top 5 today. In which case, a diversified portfolio would likely serve investors better than a highly concentrated size-defined portfolio.