Earlier this month, I noted that “concentration risk” in US equities is the highest it’s ever been.
There are a number of ways you can measure market dominance, but typically, the discussion revolves around the weight of the FAAMG stocks and their contribution to earnings and revenue growth.
As SocGen’s Andrew Lapthorne pointed out, nearly a third of S&P 500 market cap is now held in only nine companies (considering dual listings) and if analysts are correct, those companies will generate some 25% of 2022 EPS.
Read more: ‘Concentration Risk’ In S&P 500 Has Never Been Higher
Of course, concentration risk associated with the FAAMG cohort is nothing new, but one concern for 2022 is that the economic environment might shift.
If “slow-flation” and secular stagnation give way to persistent price pressures and robust nominal growth, perennial secular growth favorites could lose their macro tailwind. Indeed, that risk is part and parcel of Morgan Stanley’s call for US stocks to underperform in the new year.
“The macro backdrop of the last decade has buoyed FAAMG, as historically low interest rates and scarce growth meant these long duration and fast growing equities were highly valued by investors,” Goldman’s David Kostin wrote, in the bank’s year ahead outlook for US stocks.
The section on concentration risk is the usual compendium of large numbers and fabulous factoids which never seem to lose their capacity to “wow” despite being widely cited and discussed ad nauseam.
Most market participants are aware that the five largest companies comprise around a quarter of market cap, but note also that FAAMG accounts for nearly 40% of the Russell 1000 Growth index. Further, Kostin observed that over the past eight years, the FAAMG cohort has collectively bested the S&P 495 (if you will) by 16pp per year. He called that “remarkable.” And indeed it is.
Looking to 2022, FAAMG is expected to account for 17% of S&P 500 EPS. Over the past decade, “the stocks in aggregate have compounded their sales at a CAGR of 19%, fully 14pp faster than the rest of the S&P 500,” Kostin went on to write, adding that “the group has also consistently outperformed fundamental expectations, reporting annual sales 6% greater than analyst consensus expectations at the start of the previous year.” The typical stock, by contrast, has reported annual sales that are 0.5% lower.
You could spend days (literally) conjuring statistics like those, but there are two crucial takeaways from the concentration risk section of Goldman’s 2022 US equity outlook.
The first is simply that, as Kostin wrote, “FAAMG’s weight in the benchmark equity indices reflects the increasingly winner-take-all structure of the economy,” something the White House is keen to lean against.
One area where FAAMG could be constrained is M&A. Indeed, Goldman suggested the group is already feeling nervous. Together, they’ve announced just 20 acquisitions this year, nowhere near the 15-year average (figure below).
Needless to say, 2021 has been a good year for M&A, so the relative dearth of FAAMG deals sticks out.
That matters. If the giants can’t grow through acquisitions, they’ll need organic growth, and as Goldman emphasized, “finding productive uses of cash at scale may prove challenging.”
That brings us neatly to what Kostin called “the greatest risk” to the FAAMG stocks — namely, “the need to maintain their lofty expected sales growth rates.”
In a passage that recalls conceptually similar warnings from SocGen’s Albert Edwards, Kostin wrote that,
During the two years following the March 2000 Tech Bubble zenith, the five largest companies at the time (MSFT, CSCO, GE, INTC, XOM) collectively posted one-half the sales growth that had been expected by consensus (8% vs. 16%) and missed consensus margins by 300bps (12% vs. 15%). The group’s relative valuation contraction was dramatic.
Nevertheless, Goldman is constructive on America’s tech titans which, the bank remarked, trade much cheaper than the biggest stocks on the eve of the dot-com bust.
And even if FAAMG does slip, Kostin suggested Tesla and Nvidia could take the baton. “Should FAAMG lose its luster among investors, the recent rise of TSLA and NVDA highlights the extraordinary dynamism of both the US economy and the S&P 500,” he wrote.
I’d be remiss not to mention that recent price action in those two names also “highlights the extraordinary” power of weaponized gamma which, incidentally, is the new acronym for FAAMG to account for Facebook’s corporate rebranding.
Concentration risk is largely a function of the federal government’s abdication of its anti-trust responsibilities, with plenty of blame to go around (Republican and Democrat). Sooner or later, we will reap what we have sown.
From what I have read, the available supply of chips goes to GAMMA, et al, first. Then, whatever is left over goes to the mid-caps and then to the smaller companies, down the line based upon how large of a customer they are to the chip makers.
This was explicitly stated in several mid-cap September quarterly reports that I read.
So the sales for the largest companies will be the least affected by the chip shortage. Hopefully, the mid-caps get the chips they need sooner rather than later.
I understand this scenario from a business standpoint but how does it fit with auto company shortages. These guys are “midcaps”?
The second level issue with chips is that there are some very simple chips with a singular function (low margin/profit to chipmaker) and some more complicated chips (higher margin/profit to chipmaker).
If a chip manufacturer has to make a choice, they are manufacturing the complex, higher profit chip at the expense of manufacturing the simple, low margin chip. My understanding is that an automobile requires both complex and simple semiconductors.
The same is happening with appliances. The manufacturers are making the higher end (more profitable) appliances instead of the normal range of products, which would include lower end (less profitable) appliances.
Emptynester’s summary was on point, but simplified to the point of obscuring reality. Automakers aren’t buying cutting edge CPUs and GPUs, which is what all the new fabs will be building. The real shortages are in the dull edge chips needed for ordinary computational tasks, which are very low margin chips. The automakers reeled in their contracts when the pandemic hit, and some fabs had to go offline for lack of demand. The demand pickup has been way faster than the fab market could handle and car cos were late to get their orders back in. And, in the end, they are essentially “midcaps” in such a scenario when it comes to their demand for chips. Companies who renege on their contracts for chips aren’t usually the best customers for fabs to consider when demand is hotter than supply. So Emptynester really is right, it’s just not really “midcaps” sensu stricto, and I used too many words to say so.
The Tesla speculation continues to feel overly exuberant. In a different article it was noted that other new EV companies are being bid up because of their legitimately competitive offerings. The major automakers are also building EV’s with the Ford Mustang Mach E being a Model X competitor and the VW ID.4 looking very Model Y-ish. Ford has also invested in a major charging network to compete with Tesla’s. Throw in BBB, which has a plan to build a national charging network, and Tesla seems to be losing one of their competitive advantages. Finally Tesla’s major advantage thus far has been its software, with its autopilot looking less and less reliable as they continue to iterate it, I can see a future where a Ford creates something better. The EV market is sure looking like it’s about to be hyper competitive in the next 3-5 years, which in my opinion does not bode well for Tesla who has enjoyed essentially a monopoly.
It was ever thus- competition will crop up- that is the biggest risk to Tesla shareowners. In fact profits probably rise at Tesla pretty fast but forward valuations shrink faster. There may be more money to be made in Tesla for a couple of years but around 4-5 years from now the competition in EVs will be much stiffer and profit margins and valuations are likely to shrink. Same situation with the other stand alone EV companies.