Why Investors Should Think Twice Before Focusing Their Investments on a Handful of Very Large Technology Companies

Client Question of the Week:

It seems that the world is changing and this crisis has cemented the dominance of a handful of very large technology companies (FAANG). Given their scale and recent outstanding performance, why shouldn't investors just focus on them? 

• The stocks commonly referred to by the FAANG moniker—Facebook, Amazon, Apple, Netflix, and Google (now trading as Alphabet)—have posted impressive gains through the years, and recent strong performance in light of a struggling economy has caused some to question if these large tech companies will continue to dominate the market.
• Investors may be surprised to learn that it is not unusual for the market to be concentrated in a handful of stocks. As we see in Exhibit 1, the combined market capitalization weight of the 10 largest stocks, just over 20% at the end of last year, has been higher in the past.
• Additionally, technological innovation dominating the stock market is not new. While the definition of “high-tech” is constantly evolving, firms dominating the market have often been on the cutting edge of technology. AT&T offered the first mobile telephone service in 1946. General Motors pioneered innovations such as the electric car starter, airbags, and the automatic transmission. General Electric built upon the original Edison light bulb invention, contributing to further breakthroughs in lighting technology, such as the fluorescent bulb, the halogen bulb, and the LED. So technological innovation dominating the stock market is not a new normal; it is an old normal.

 

 

• More importantly, any expectations about the future operational performance of a firm are already reflected in its current price. While positive developments for the company that exceeds current expectations may lead to further appreciation of its stock price, those unexpected changes are not predictable. To this point, in Exhibit 2 below, we charted the performance of stocks following the year they joined the list of the 10 largest firms. On average, these stocks outperformed the market by an annualized 0.7% in the subsequent three-year period. Over five- and 10-year periods, these stocks underperformed the market on average.

• Overall, these results are consistent with the insight that security prices quickly incorporate new information and reflect the aggregate expectations of market participants, including information and expectations about economic growth, technological innovation, new business models and their potential impact on the future cash flows and discount rates of companies and industries.
• The market is constantly evolving but the story remains the same. While these high-flying tech stocks may be atop the market today, it remains impossible to systematically predict which companies will outperform the stock market going forward. This underscores the importance of having a broadly diversified equity portfolio that provides exposure to a vast array of companies and sectors.