Commentary: What's next for high-quality growth stocks?

Active equity managers are faced with an important decision over the next market cycle. What is the appropriate allocation to high-quality growth stocks which have dominated returns thus far in 2023, as well as for much of the past decade? Year-to-date through Aug. 31, the 10 largest stocks in the Russell 1000 index have generated a return of 41.76% vs. returns of 18.62% for the broader Russell 1000 index, and now represent 28% of the index, creating the most concentrated market of the past 20 years. Is this a signal that returns are poised to mean-revert, and how should investors evaluate the dominant competitive positions and fundamental momentum of the largest companies?

Concentrated markets are not conducive to active managers who generally focus on less efficiently priced stocks outside of the largest names. History would imply that the largest companies generally lose their dominant position over time, as smaller, more nimble companies embrace emerging technologies and methods to offer superior products and services. Will this apply to Nvidia, Microsoft, and Apple, as dominant companies today with bright analyst prospects? While such companies may ultimately lose their competitive edge, historical returns provide limited clues with respect to timing. However, fundamental analysis combined with an understanding of investor preferences may offer guideposts for making this important decision.

Exhibit A displays the change in market concentration since 2001. Following the collapse of the dot-com bubble, concentration generally fell until the end of 2015. Only twice did it briefly increase, during the global financial crisis and three years later during the European debt crisis. In both cases, the weights of the largest companies mean reverted, as each crisis subsided and the flight to larger, safer companies ceased. Since 2015, however, market concentration has been steadily rising. The conditions favoring these businesses were low economic growth, the rise of dominant technology and communications services companies, a favorable antitrust environment and the pandemic.

In developing stock-level alphas generally, we think it is useful to consider five primary pillars of return: management success, fundamental momentum, analyst insight, dividend discount rates, and investor preferences. Management success identifies companies whose management teams have been able to generate cash flow growth organically. Fundamental momentum identifies stocks whose price momentum is supported by fundamentals and earnings news. Analyst insight measures the degree to which the analyst community has favorable revenue and earnings outlook in the coming year. Dividend discount rates provide a measure of long-term expected returns, by solving for the discount rate which equates today's stock price with future cash flows; and the final pillar, investor preferences for cyclical factors, identifies companies whose characteristics are favored in the current market environment. We believe that the combination of these five pillars balances important drivers of return, to develop a forward-looking alpha for each stock over the coming year.

In the case of some of the world's largest companies, we believe these factors can be particularly illuminating.

After a 15-plus-year period when alphas of the 10 largest companies generally ranged between plus-minus 50 basis points, and rarely held an advantage for periods longer than one year, the past five years have told a very different story. During this period, the alphas of the largest stocks have held a persistent advantage over the broader index: the 10 largest stocks (rebalanced quarterly) have outperformed the Russell 1000 index by 59.88%. The only year the alphas lagged was 2022, when the largest stocks underperformed by 15.54%. In 2023 thus far, however, the largest stocks have regained their momentum, with relative alphas approaching 1%.

As investors know all too well, rarely does a diverse set of signals point investors in one direction. Investors must often choose between successful companies trading at high valuations and cheaper companies with deteriorating fundamentals. Exhibit B displays the one-year moving average pillar exposures of the 10 largest stocks to the five pillars outlined. Unusually, for the 2017 to 2021 period, all five signals pointed towards an advantage for the largest names. These companies were not only more successful, with strong fundamental momentum and analyst support, but traded at reasonable valuations relative to expectations, with risk characteristics favored by investors, namely high-quality earnings and high long-term growth rates.

While alphas for the largest companies were generally negative throughout 2022, they are once again positive in 2023. Exhibit C provides the stock-level drivers of alpha as of Oct. 31, 2023.

What stands out most is that despite having negative exposure to fundamental momentum for much of 2022, five of the above names are again supported by positive exposures, while three have neutral exposures. Five of the names have favorable analyst support with eight having positive exposure to management success. Perhaps what is most surprising is that seven names have cyclical characteristics favored by investors, while four of them have favorable discount rates. Only Apple (low cyclical exposure), Tesla (low fundamental momentum and analyst sentiment), and Eli Lilly (low fundamental momentum) have negative alphas as of Oct. 31, 2023.

With the top names representing 28% of the Russell 1000 index, investors must carefully consider their exposures to each of these names or risk unwanted deviations from their benchmarks. While history suggests that this percentage will ultimately subside, the past eight years are an important reminder that the largest companies may dominate for extended periods of time. Rather than assume that their fates will reverse over the coming market cycle, investors can focus on important factors such as management skill, fundamental momentum, analyst support, investor preferences and long-term valuations as a guide to managing exposures and generating more consistent active returns.

Hal Reynolds is co-chief investment officer and Sidharth Madan is associate director, research at Los Angeles Capital Management. Both are based in Los Angeles. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.