Han Dieperink: More returns with megacaps

August 20, 2024

Equity

_{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

A large part of the stock returns in recent years has been achieved by companies with a very large market capitalization: the so-called megacaps. One consequence is that the market capitalization-weighted index performs better than the equal-weighted index. In the long term, however, it is the equal-weighted index that performs better.

Many investors therefore view the strong outperformance of megacaps with skepticism. They see it as a hype and believe that they would be better off looking for smaller and better companies to invest in. Strangely enough, the megacap hype is not only in the prices, but also in the organic growth and profit margins. Smaller capitalizations are lagging behind in that area as well. Valuation-wise, there is sufficient room for further outperformance of the megacaps.

Dutch East India Company

Megacaps are companies with a large market capitalization. The most appealing barrier in recent years has been breaking the $1 trillion (1 trillion) market cap mark. There are now several companies with several trillion in market capitalization, companies that are much larger than countries.

Yet this is not the first time in history that this happens. There have been bigger companies. Adjusted for inflation, the value of the Dutch East India Company quite easily exceeds that of today's largest megacaps: $8.3 trillion, in today's dollars. This was partly because the Dutch East India Company had a monopoly on trade with Asian countries. Due to its size, the Dutch East India Company could conclude trade agreements, wage war and govern overseas territories just like a country.

Number two (Mississippi Company with $6.8 trillion) and number three (South Sea Company with $4.5 trillion) were both monopolies as well and larger than today's megacaps.

Monopoly or oligopoly

Many of the current megacaps have in common with the historical megacaps that they have is a monopoly. Nowadays this is often because they have gotten miles ahead of the competition as a result of disruptive innovations. Other megacaps are usually part of an oligopoly.

Both market forms are very attractive to investors. They have a defensible position that allows them to achieve above-average returns. This makes it almost impossible for them to go bankrupt and if they do risk going bankrupt, they will probably be rescued under the guise of 'too big to fail'. Their size allows these companies to make better products at lower prices. Possible competitors are often incorporated at an early stage and can negotiate large discounts due to their size. Moreover, these companies are so powerful that they have an increasing influence on politics.

Breaking up megacaps

These companies are regularly investigated to determine whether they have too much market power and whether they abuse it. The big advantage nowadays is that governments are very slow in tackling these companies, thwarted by the strong lobby of these companies. By the time a conviction follows, new technology is often available, so the measures have little effect. Furthermore, it has been some time since such large companies were split up. Existing shareholders do not necessarily have to suffer from this, as events at companies such as Standard Oil and AT&T show.

Winner takes all

Thanks to the advent of the internet, there are no longer any 'barriers to entry' to starting a business, but scale is becoming a new 'barrier to entry'. This is due to the phenomenon that on the Internet the winner simply gets a large market share. Helped by network effects and economies of scale, consumers always ultimately choose the winner. The 200 largest companies in the United States accounted for all corporate profits in 2015. This means that the remaining 3,281 listed companies were on balance loss-making.

Instead of being tackled by antitrust authorities, these large companies are often helped by the legislature through complex legislation such as Sarbanes-Oxley and Dodd-Frank. Regulation mainly benefits the megacaps. These megacaps can produce anywhere in the world (often in the cheapest location) and also have customers all over the world. This has effectively made them intangible to the government.

The role of the index

Megacaps are in every index. This is because index builders select companies based on market capitalization and have a clear preference for liquidity. Moreover, there are numerous indices with a more thematic interpretation and, strangely enough, all megacaps are included. They also score high in the field of sustainability, because they have the resources to report well on this and because they can afford a Chief Sustainability Officer. Not every investor uses the same index as a benchmark, but ultimately the index can be beaten with an index of megacaps.

Safe haven

Megacaps are currently also a safe alternative to bonds. Long-term US treasuries used to be the main safe haven, but times are changing. The US budget deficit, combined with the US current account deficit, remains high and polarization in US politics is high. Much more importantly, long-term US treasuries have lost more than 50% of their value due to the rise in interest rates in recent years. That's even more than the stock market's interim losses this century. It is therefore difficult to label bonds as a safe haven.

Moreover, the other safe haven (cash) provided zero returns for a long time and even now the compensation lags behind a market-based interest rate. Those investors prefer to buy Apple, Microsoft or Nvidia, because things always work out well in the long term. At least, that is increasingly the starting point for large institutional investors such as sovereign wealth funds.

Long-term winner

One by one, the megacaps will knock other companies that previously somehow managed to beat the market off their pedestals. For example, there may be legitimate doubts about the smallcap premium, although this is also due to the growth of private equity.

But how will other factors, such as value or low-vol, fare against the megacaps in the long term? Fortunately for the factor investor, there is always momentum and quality, something that megacaps score well on. Just note that factor investors often invest in equally weighted portfolios and megacaps are by definition underrepresented.

And what about family businesses? Now that performance is lagging behind, there is little left of the sustainable business model. Now the alleged outperformance of family businesses has always been questionable. After all, only successful family businesses are taken into account, not the many family businesses that are failing. It won't be long before the first scientific study will be published on the megacap factor premium.