For the second quarter, as mentioned earlier, large-capitalized stocks performed better than small-cap stocks. The NASDAQ was the best performer, helped by the gain achieved by the omnipresent Amazon (NASDAQ:AMZN) and other mega-cap technology stocks. While different styles generally have some dispersion in returns from quarter to quarter, this past period was very dramatic. We expect this wide dispersion in returns to narrow in the future.
In last quarter’s letter, we discussed the trend of investors allocating more of their capital to passive strategies like index funds and exchange-traded funds (ETFs) and away from active managers. AMZN and other stocks in the S&P 500 are where the large flows of capital have headed. It is worth noting that the 2017 ETF inflows, depicted below, are through the middle of June, so we are on pace to double the record inflows experienced last year.
Currently, passive investors own roughly 15% of AMZN’s equity through index funds, ETFs and the like— or roughly $70 billion worth of AMZN’s value. They hold nearly 18% if you exclude what Jeff Bezos owns. A decade ago, passive investors owned just a few percent of Amazon’s stock. Because index funds and ETFs buy and sell stocks in their respective index, or sector, based solely on flows of money into and out of their funds, by nature these passive strategies are indifferent to valuations—including outrageously over-valued securities. Obviously, AMZN is a dominant web retailer with a profitable cloud-service segment that is growing rapidly. However, AMZN is trading at 40x EV/EBITDA and 190x EPS. We believe some of AMZN’s rich valuation, and that of other stock’s as well, is attributable to the passive investment strategies’ indifference to valuations. These passive investors and benchmark-hugging active-management strategies are often the marginal buyer and, as mentioned earlier, they do not consider a stock’s valuation as a pre-requisite for buying or selling any security.
We recently analyzed the largest 15 U.S. publicly traded companies by market capitalization and found that the average P/E ratio was 36.3x versus 21.5 for the entire S&P 500 index. Moreover, passive investors own between 13% and 21% of the equity for each of these massive companies, or an average 17% ownership rate. Interestingly, just like with Amazon, passive investors owned just a few percent of each of these companies a decade ago.
We also found that the volatility, using the average five-year beta as a volatility proxy, of the 15 largest mega-cap companies in the S&P 500 in aggregate was identical to the market itself. The smallest market cap companies by decile of the S&P 500, on the other hand, had on average a beta 30% higher than the index.
This difference in volatility makes sense, and the following example illustrates why. Assume an active small-cap manager with $2 billion in assets is fired, and the manager’s largest position was a 5% weighting of a $1 billion market-cap company. Therefore, the manager has a $100 million investment in the company, which represents a 10% ownership stake. Depending on how fast the position is liquidated, the sale of 10% of the shares outstanding could have a very substantial impact on the price of the security. On the other hand, if an active large-cap manager with $2 billion in assets is fired, and the manager’s largest position is also a 5% weighting, but of a $200 billion market-cap stock, the impact on price will be negligible. The reason is that the manager’s largest position would represent only 0.5% of the company’s value. Clearly, we believe that there is an enormous difference in selling one-half of 1% of a company versus 10%, which often leads to greater volatility.
We believe the mega-cap’s lower volatility is also a significant factor in attracting capital from passive strategies, as well as capital from active-management strategies that are trying to keep up with the benchmarks. As more capital flows into these mega-cap stocks, the valuation for most of them becomes richer. Thus, the lower volatility of these mega-caps feeds a self-perpetuating cycle of more money being funneled into these mega-cap equities, which then helps drive the return of the passive strategies.
From FPA Capital's second quarter 2017 shareholder letter.
Also check out:
