On June 8, the S&P 500 Index1 temporarily recovered all its COVID-19 losses for 2020. Though the Index slipped lower again as volatility returned, it’s worth noting the so-called FAMAGs (Facebook, Amazon, Microsoft, Apple, and Alphabet (Google’s parent company)) have led the bulk of the recovery thus far.
Even before the pandemic, these were already some of the largest-listed companies in the world.
The crisis has amplified the demand for their technology, which helps us communicate, educate, and shop, as well as keep us entertained.
We wanted to find out how and why these companies have become so dominant. So, we spoke to Sean Markowicz, a strategist in the Research and Analytics Team, and Frank Thormann, a portfolio manager to get the answers.
The Rise of Big Tech
How Big Are These Companies?
Sean Markowicz: “In terms of market weight, big tech has grown immensely over the last few years. Its combined weight in the S&P 500 Index has more than doubled from roughly 8% in 2015. Today, FAMAGs make up 20% of the Index in terms of market capitalization.
That means these five stocks account for a larger slice of the market than the five largest stocks at the peak of the dot-com bubble did in 1999 (see FIGURE 1).”
The Largest Tech Stocks Have Doubled Their Market Share in the S&P 500 Index
Source: Refinitiv Datastream and Schroders. Data as of June 8, 2020.
How Have These Companies Become so Dominant?
Frank Thormann: “These companies have become incredibly innovative at solving important problems such as how we shop, collaborate, and keep in touch.
The solutions these companies provide have set the standard globally. That has resulted in an impressive spurt in revenue and earnings growth, which the pandemic seems to have accelerated.”
The solutions these companies provide have set the standard globally.
How Have Their Share Prices Performed?
Sean Markowicz: “During the crisis, these stocks have outperformed the broader market index. They have risen by an average of 18% this year, as of June 8. Amazon and Microsoft have led the pack, up 36% and 19% respectively. That compares with a 0.1% rise in the S&P 500.
However, it is a bit circular to compare the tech stocks’ performance to this Index, because the Index itself is heavily influenced by the tech stocks.
A better benchmark would be the S&P 500 Equal Weighted Index, which shows the performance of the average US company. That has fallen by 2.2% this year.
This means we are seeing the larger stocks outperform the smaller ones.”
Big Tech Has Held Up Much Better Than the Rest of the Market
Past performance is no guarantee of future results. Source: Refinitiv Datastream and Schroders. As of June 8, 2020. Indices are unmanaged and not available for direct investment.
The Risks Posed by Big Tech
Are Tech Companies Becoming Too Powerful?
Sean Markowicz: “Concentration of corporate power is not just a problem for tech companies, this is happening across a few sectors.
For example, in the year 2000, the top two telecom providers controlled about 30% of industry sales. Today, they control 70%.
If you take the US airline industry, the top four have taken their share of domestic air travel from around 50% in 1997 to around 70% today, according to the industry regulators. Competition today is much weaker than in the past.
What Dangers Does That Dominance Pose?
Sean Markowicz: “The concentration of power is on the regulator’s radar and that has the potential to stifle some of big tech’s momentum.
The concentration of power is on the regulator’s radar and that has the potential to stifle some of big tech’s momentum.
For instance, in the past, action was taken against telecom provider AT&T, software provider Microsoft, and tech firm IBM. As a result, stock valuations and prices fell between the time the lawsuits were filed and solved. That was followed by a fall in sales growth.
Tech companies have already faced a barrage of criticism over their anti-competitive behavior, from data privacy issues to unfair business practices. These could impact future growth prospects. It is something for investors to monitor.
What Risk Does “Big Government” Pose?
Frank Thormann: “Tech companies have been allowed to grow unopposed through their innovation and fruits of their own internal research and development.
The risks are that the companies become so dominant that they rest on their own laurels and future innovation starts to suffer.
If that happens, governments could take action to invigorate the competitive spirits.”
Are Tech Companies Becoming Too Big To Fail?
Sean Markowicz: “The crisis has highlighted just how important these companies are. Travel restrictions and social distancing rules illustrate our reliance on the services the tech companies provide, whether it’s shopping, entertainment, or keeping in touch.
There is an argument that these companies are so important to our society that they pose a systemic risk. That is where regulators could get involved.
At the moment, it is unclear as to how that would happen. So far, the only suggestion has been that their data becomes a public good that could be distributed among competitors. It won’t affect all firms, but the ones most likely to lose out would be Google and Facebook.
Limiting how they monetize data and which markets they participate in has also been discussed. But that is not to say that they won’t maintain their dominant market shares.
For instance, IBM is still the biggest supplier of mainframe computers. Microsoft is still the leading company for software.
There is a possibility that these companies could still be eclipsed, which is something we should be aware of.”
What Lessons Can We Learn From the Past?
Sean Markowicz: “Dominant firms seldom maintain their dominance over time. Half of all market leaders fall out of the top 10% during each business cycle, according to the Mckinsey Global Institute.
Think of Nokia and BlackBerry. We all used to own one but their market share has evaporated into thin air.
There is another study by investment manager Research Affiliates. It found that once companies achieve a dominant status they have historically underperformed the market and their industry. They call it the winner’s curse.”
What Remains So Desirable About Big Tech?
Frank Thormann: “Often, when companies become so dominant and successful they become complacent. They seem to think they are infallible and they should be a leader forever, which results in a decline in research, development, and innovation.
Dominant companies seem to think they are infallible and they should be a leader forever, which results in a decline in research, development, and innovation.
We have to analyze the speed at which these companies continue to innovate. One way to do that is to monitor their research and development spending.
As long as these companies don’t become complacent and succeed in making our lives more productive, there continues to be a positive future. But that is not set in stone.”
How Do You Value These Tech Stocks?
Frank Thormann: “Investors can use a variety of measures. They can compare the company’s valuation relative to its earning power today and relative to its perceived earning power in the future.
Even more important is the cash being generated. These tech companies are extremely cash generative, which makes them more attractive relative to other companies. So you can look at free cash-flow power today compared to the future.
The final point is research and development. Investors could look at the cumulative stock of all the research and development spending that has been undertaken by these companies. The total of which compared to their market valuation is another measuring stick of how much you are going to have to pay for the company. There is no broad answer.”
What Effect Could the Size of Big Tech Have on Portfolios?
Frank Thormann: “The bigger these companies become, the larger bearing their stock prices have on the direction of the wider market.
“It is something to be mindful of as an investor if you have purchased a passive fund that seeks to track the performance of the S&P 500. One-fifth of your investment by definition is invested in these five companies.”
1 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
Important Risks: Investing involves risk, including the possible loss of principal.
The views expressed herein are those of Schroder Investment Management (Schroders), are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders or Hartford Funds.