Morningstar - Q2 2024 - 7

EXHIBIT 1
So, if history is any guide, at some point the
earnings outperformance of the top 10 companies
should fade to more normal levels, with market
concentration diluting as a result.
But perhaps, given the magnitude of the artificial
intelligence revolution, it's hard to believe that
we'll see the same mean reversion we've
observed historically. So, let's envision a world in
which the top 10 companies keep delivering
and ask ourselves how probable that is.
For this exercise, we compared analyst earnings
estimates for today's top 10 companies
relative to the S&P 500 over the next five years.
We then calculated returns, holding yield and
valuations constant (an attempt at conservatism,
since investors would likely bid the top
10 higher if they demonstrated such persistent
outperformance), and calculated market
concentration at the end of 2028.
The results are shown on the right-hand side of
EXHIBIT 1. Should analysts prove accurate in
their estimates, the top 10 companies will account
for nearly 40% of the US equity market at
the end of 2028. And their aggregate earnings
would be larger than the present-day earnings
of all public companies in Europe. Possible?
Sure. Probable? No.
Remember the Range of Outcomes
Valuation isn't a timing indicator, except at the
extremes. As we start to forecast improbable
outcomes as the base-case expectation, I'd argue
we are getting closer to those extremes.
And don't forget, there's a cost to being wrong
on these extremes. Consider what we've
seen after previous periods of extreme market
concentration. From December 1972 through
September 1973, the Ibbotson Associates
Large Cap Stock Index lost 43%. In the wake of
the internet bubble-an arguably equally
transformative technology to AI-that same
large-cap index was down 45%.
The Path Forward
Growing concern about market concentration and
valuation risk doesn't mean avoiding these
top companies altogether. Timing is tricky, and
Market Concentration on the Rise The 10 largest companies continue to dominate
the S&P 500 index.
40%
02/2024 32.53
20
30
10
HISTORICAL
12/1973
12/1993
Sources: FactSet, Morningstar Investment Management. Data as of Feb. 26, 2024.
ANALYST CONSENSUS CASE
12/2013
12/2028
Top 10 Holdings
as a % of S&P 500
Market Cap
38.55
EXHIBIT 2
There's a Reason for Their Dominance Strong fundamentals drove the performance
of the behemoths.
Return Decomposition, 2018 through January 2024
USD
Largest 10 US Stocks
Morningstar US Target Market Exposure Index
Morningstar Global Markets ex-US Index
21.69
11.46
3.56
Total
Return (%) ≈ Yield (%) +
2.46
3.59
Sources: FactSet, Morningstar Investment Management. Data as of Jan. 31, 2024.
P/E
(%) +
1.92
1.07
3.21 -2.53
Margins
(%) +
Sales
(%) +
4.26
1.56
Other
(%)
3.89 13.43 -0.01
2.47
3.09
0.07
-1.77
the potential is there-however remote-that
these companies continue to defy all expectations
and ride AI to the moon.
But risk-management strategies can help. For the
active subset, I'd argue that individual stock
selection is critical. That's because, despite the
monolithic perception of these top names,
valuations vary by company. Our investment team
thinks that the more tech-heavy names that are
closer to the AI narrative have benefited from more
enthusiasm about their future earnings, but others,
including those in the communication-services
sector, have far more approachable valuations.
(See also " Are There Any Undervalued Opportunities
Left in AI? " on Page 34.) Thus, sorting among
the subset allows investors to have some exposure
to the market's dominant firms without taking
on the same amount of sentiment risk.
For passive investors, index selection can help.
A simple suggestion that's made the rounds:
Switching index construction from a market-cap
weight to an equal-cap weight will reduce
market concentration risk without sitting out the
biggest names altogether. I shouldn't hide the
ball here: Moving from a market-cap weight to an
equal weight amounts to a roughly 25% reduction
in the largest names. A significant switch.
For those leery of that kind of change in one fell
swoop, introducing the equal-weighted index
for new contributions and leaving the market-cap
index intact for already invested dollars could
help investors avoid exacerbating market
concentration risk. K
Marta Norton, CFA, is chief investment officer at
Morningstar Investment Management.
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