Ismael García Puente
Investment Manager and fund selector at MAPFRE Gestion Patrimonial
In the early 1980s, the pop group ABBA was famous all over the world. After winning the Eurovision Song Contest in 1974 with their song “Waterloo,” they conquered the globe with other huge hits such as “Mamma Mia” (1975) and “Dancing Queen” (1976). On July 21, 1980, following rumors of a possible split, ABBA released one of their biggest hits: “The Winner Takes It All.”
These five words have recently been used among large international investors to describe the concentration of profits or returns in the hands of a small number of companies. This aphorism couldn’t be more accurate, as investment concentration is reaching historic levels, demonstrated by the fact that:
- The top five companies by market capitalization in the US markets (Apple, Microsoft, Amazon, Facebook and Alphabet) already account for more than 20 percent of the S&P500 index. In 1980, the top five companies didn’t exceed 15 percent.
- Apple itself, for example, capitalizes more than the top 2,000 publicly traded small- and medium-cap companies listed on the stock exchange in the United States.
- Tesla is worth more than the 35 companies of our beloved Ibex 35.
It’s interesting to note that it hasn’t taken many years for these companies to reach these milestones, as only two of the companies mentioned above (Apple and Microsoft) were founded before the release of the famous ABBA song that inspired the name of this article. In the short-term, the market behaves irrationally, with the valuations of the most popular companies rising to unsustainable levels, leaving the most unpopular ones behind without (in the majority of cases) addressing the fundamentals of these companies. Therefore, in order to succeed in the short-term, you “only” need to measure the “temperature of the market” and stick to the warmer values. Try telling Tesla shareholders otherwise.
In the long-term, it’s been proven that the price of stocks clearly shows a positive correlation with the growth of corporate profits. Several studies have demonstrated that up to 75 percent of the variation in the price of a stock is due to variations in a company’s profit level, when we consider time horizons of 10 or more years. Below that time threshold, market performance has little or nothing to do with profits, as we saw in 2018: growth was +30 percent (with positive expectations of corporate returns for 2019, as well), yet the US market ended the year with drops of up to 10 percent.
So, are the valuations achieved by these companies reasonable? Without getting into a debate over the effects of passive management on the price of shares—which, of course, as an increasingly important player in financial markets, have an impact on the bullish and bearish spirals—the fact is that there is a common denominator among these variations: growth (or a lack thereof). In a world that has to print huge amounts of money to withstand an urgent level of debt, and where interest rates are kept below 0 percent to generate just a few tenths of economic growth, it’s normal that the price paid for a scarce commodity such as growth is higher than average historic levels. And if there’s something that most major market-capitalization companies have in common, it’s not just their economic sector (technology), but their incredible ability to grow profits on a sustained basis over time. And not even a global pandemic, which has paralyzed economies and international trade, has derailed this historic path of profit growth. What’s more, as we have seen in this situation, their services have become even more necessary.
Many investors typically resort to the topic of mean reversion when they explain why they stay away from these companies. In other words, they prefer to focus their investments on companies with much lower valuations and to wait for a rotation of flows from the most “lucky” to the most unlucky companies. Sometimes, they don’t notice the obvious: that a company’s (or a group of companies’) quote means nothing in itself, even if it’s the lowest it’s been in the last 50 years. For example, carriage-service companies were trading very cheaply when the railroad began to emerge in the United States and, as we can imagine, never returned to the prices that were seen only a few years prior. This does not mean that there is no mean reversion — in fact, there is. However, it seems like a vague argument in itself, given that “the market can remain irrational longer than you can remain solvent” (John Maynard Keynes).
The valuation of a company is no more the present discount from the company’s future profits. If we have 0 percent interest rates in the denominator (discount) and profits in the numerator, it comes as no surprise that those companies with higher numerators deserve a higher valuation. It’s pure mathematics.
To see our equity grow, therefore, we would only need to find companies with growing profits and wait for time to price the value generated by those companies. It’s that easy? Yes, if we have the help of better financial advisory services that allow us to invest in mutual funds managed by professionals who have spent their time and effort finding these companies since the ABBA years.