I have CNBC on in the background all day while I work.
Admittedly, a lot of it is just “filler.” But I find it a good way to get the “mood” of the market.
And last week, every time I looked up at the screen, they were almost always talking about one thing: The “Great Rotation.”
For those who have better things to do than watch the financial press all day, that’s the term that’s been coined to describe flows out of mega-cap tech and into small-cap stocks.
And it’s not wrong, per se…
Small-caps were up 15% in a week (I must have heard that 1,000 times).
The Magnificent Seven stocks lost over $1 trillion in value.
Haters love to hate, so I heard that quite a bit, too.
I saw numerous charts showing the divergence of the Russell 2000 index and the Mag Seven stocks, seemingly proving that the mega-cap tech trade was over. Charts that look like this:
As you can see, only Tesla shares can compete with IWM, but even that is misleading. A couple of weeks ago in mid-July, TSLA was trading for $265. Today it’s trading for $216. So, like the rest of its Magnificent Seven brethren, it too has experienced a steep sell-off in recent weeks.
But not everyone was looking to jump off the big-tech bandwagon. Dan Ives’ crazy suits were distracting in my periphery, but I remember looking up to see him make his bullish big-tech spiel.
I don’t always agree with Dan’s ideas (or fashion choices). But, when he’s talking about buying the tech dip, saying that the recent sell-off was just a “speed bump” and not the end of the road, I agreed wholeheartedly.
But, for every big-tech bull there seemed to be a dozen small-cap rotation traders coming on air and I couldn’t help but smirk.
Suckers, I thought.
Being Contrarian Doesn’t Guarantee You’re Right
Everyone loves to wear a contrarian hat on Wall Street.
But sometimes the best approach to making money in the markets is the old K.I.S.S. strategy (keep it simple, Stupid).
I own many of the Mag Seven stocks myself. I’m a sucker for their amazing cash flows. On the other hand, I have no interest in trying to time the market with the Russell 2000, the index that’s chock-full of small-caps.
And despite what so many “experts” were saying, to me, this isn’t a time to try and get cute with small-caps.
So, what if the Russel outperformed for a week? Large-caps have outperformed small-caps for decades.
Moving forward, all of the long-term data that I see clearly demonstrates that the dominant large-cap companies are likely to continue this trend.
I’m happy to stick with what works.
I want to own stocks that can perform well in any market environment… in any economic backdrop… in any interest rate scenario. And that’s why I still favor owning the best secular growth plays, which are the big-tech stocks.
Letting the Numbers Speak for Themselves
I put together this chart, showing the long-term price returns generated by the iShares Russell 2000 ETF (IWM) and the S&P 500 (SPY).
As you can see, other than the last 30 days, the S&P 500 has beaten the pants off the Russell throughout the past decade.
Data like this is actually why so many people are ready to “rotate” into small-caps. Analysts have been talking about mean reversion and a small-cap “catch up trade” for over a decade.
But, as you can see above, it has yet to play out.
Usually, I’m all for a deep-value trade based upon a mean reversion thesis. And we have plenty of them in our portfolio with Intelligent Income Investor.
Typically, the pendulum always swings both ways in the market and depressed multiples eventually expand. But in this case, I’m not so sure that it’s going to happen.
And there are a few reasons…
Why Small-Caps Lag
Not many people know, but the “small IPO” is nearly extinct. A chart from McKinsey, published a few years ago, tells the story.
What you’re looking at is the size of IPOs over the years. In the 2000s, it wasn’t uncommon to see companies go public at under $100 million. Many were under $50 million. But notice how those figures dwindled over the years. It’s rare to see a company go public at under $100 million. And the sub-$50 million IPO is basically gone. And, yes, these are inflation-adjusted figures.
Why is this happening?
We’re seeing companies stay private for longer, resulting in “unicorn” IPOs (companies that go public with a valuation north of $1 billion).
And the reason companies can do this is very simple: There has been a flood of venture capital over the past two decades.
In 2004, there was “only” $22.1 billion worth of venture capital activity. By 2021, that figure hit a high of $329 billion. And while the figures have come down recently, 2023 showed $172 billion worth of activity.
Put simply, there is plenty of private capital available to any promising young companies that want it. And as a result, they’re often much large by the time they reach public markets.
Frankly, when I look at IPO lists, the only companies that I’m very interested in owning are already large. They’ve already made it.
In the past, those companies might have IPOed sooner and started out in the small-cap index, but now there’s enough private/venture capital available to fuel long runways of growth.
Companies don’t need the public markets to serve that purpose anymore. This means that blue chip stocks often skip the Russell 2000 altogether, and that doesn’t bode well for the index.
These days, the S&P 500 and other large-cap, market cap-weighted indexes are extremely top-heavy. That’s due to the success of a select few stocks that now dominate the index. But that success doesn’t worry me. I celebrate it.
In recent weeks, we’ve seen mega-cap tech stocks like Alphabet and Microsoft post earnings.
Both stocks sold off in response to their numbers, fueling the fire that is calling for this small-cap rotation.
But, when you look past the headlines and examine the numbers, it doesn’t take long to realize that these companies are still performing very well.
For instance, Alphabet’s revenues came in at $84.7 billion, up 13.6% on a y/y basis.
The company’s operating income was $27.4 billion, up by 25.6% on a y/y basis.
GOOGL shares sold off because YouTube advertising revenue came in lighter than expected, but even so, we’re still talking about double-digit growth here.
Each of the company’s other operating segments (Google search, cloud, etc) all posted strong growth as well.
Sure, there are people seeing enormous capex figures here because of all of the investing that Alphabet is doing in the artificial intelligence space and there are fears that AI will be difficult to monetize
But let me ask you this… would you rather own companies that have the wherewithal to invest in the future (while still rewarding their shareholders with generous shareholder returns), or would you rather own something that is sitting on its hands while disruptive competition innovates all around it?
As for me, I’d rather own the stocks who invest heavily into research and development to defend their market share positions.
There’s No Need To “Rotate” Anywhere
So, this “rotation” must be about growth and total return potential.
I’ll admit that small-caps should benefit from rate cuts over the next 12-18 months.
On the contrary, rate cuts don’t really help the mega-cap tech names.
Why?
Well, they already have all of the money they need to buy anything they want to, anyway (at the end of their most recent quarters, Alphabet was sitting on $107 billion and Microsoft had $75.5 billion on its balance sheet).
Alphabet and Microsoft have two of the best credit ratings in the entire world at AA+ and AAA, respectively.
So, borrowing money was never an issue for them.
Even though I do expect to see rates fall, the fact that small-caps need lower rates to effectively invest doesn’t put my mind at ease.
I sleep well at night knowing that my holdings can make the necessary investments to grow regardless of where interest rates lie.
When I look at the companies that command the highest weightings in the S&P 500 index, I see blue chips with strong balance sheets and impressive secular growth profiles.
Call me boring for favoring mega-caps… I can live with that.
I can also live with the outstanding returns that they’ve generated in recent years and the double-digit growth that they generate quarter after quarter.
Over the last decade, investors who bought into those blue chip names outperformed those who were speculating on smaller-cap stocks by a wide margin. And, with quarters like the ones that Alphabet and Microsoft posted this week in mind, I don’t see that trend changing anytime soon.
Regards,
Nick Ward,
Analyst, Wide Most Research