S&P 500's resilience reflects corporate dynamism, why investors must diversify

WITH the benefit of hindsight, the five largest components of the S&P 500 index were a good place to shelter from the Covid-19 turmoil that caused a global economic slump.

Microsoft, Apple, Amazon, Google-owner Alphabet and Facebook are all trading higher now than they were when 2020 began. Amazon is up 49 per cent, while Microsoft and Apple are up 27 per cent and 24 per cent respectively. Alphabet and Facebook are relative underperformers in this rarified group of mega-cap growth stocks, rising a mere 8 per cent and 15 per cent respectively.

These five stocks have grown so large - three of them have market caps of more than US$1 trillion - that they now account for more than 20 per cent of the S&P 500.

And, they are a key reason that the benchmark US large-cap index is now less than 5 per cent below where it was at the beginning of the year, despite Covid-19.

To be sure, these five stocks are not entirely unaffected by economic downturns. Apple and Amazon's profitability would probably suffer in the event of protracted unemployment and a deep slump in consumption spending, while Alphabet and Facebook are very exposed to downturns in advertising spending.

Yet, these companies sit on digital technology platforms that have not only made them unassailable in their own fields, but given them an edge in quickly pushing into new growth areas. Their buoyant stock prices reflect the willingness of investors to "look past" the current Covid-19 turmoil, to an eventual recovery. In short, there is no doubt these market leaders will survive and continue to thrive.

The emergence of these stocks as major drivers of the S&P 500 reflects the dynamism of the US corporate sector as the world's largest economy grows and develops.

It is also a lesson to investors on the importance of maintaining diversified exposure to the market.

While being invested over the long term is important, market-leading companies come and go. Indeed, none of the five largest stocks in the S&P 500 today have very long histories.

Alphabet, Amazon and Facebook only came about with the advent of the Internet, and none of them were components of the S&P 500 until well after the dotcom bust in 2000. Apple and Microsoft were founded in the 1970s, but much of their growth over the past decade rests on the foundation of the online world.

Back in 2000, General Electric was the largest component of the S&P 500. Over the previous two decades - with the legendary Jack Welch at the helm - the company had chalked up phenomenal growth through a flurry of asset sales and acquisitions, expanding from a manufacturing company to an enormous conglomerate with significant exposure to financial services.

Mr Welch retired in 2001, and GE's stock price would never again see the highs it reached in 2000. It took a beating in the wake of the Global Financial Crisis in 2008, because of its exposure to financial services.

It subsequently tried to refocus on its traditional strengths but went through a period of leadership turmoil and even became the target of a short selling attack.

From its peak in the middle of 2000, GE has lost nearly 90 per cent of its market value.

GE isn't the only one-time index-leading stock to have fallen behind. The four next largest components of the S&P 500 back in 2000 - Exxon Mobil, Pfizer, Citigroup and Cisco - haven't displayed strong growth for a long time. In fact, they all have smaller market capitalisations today than at their peaks two decades ago.

Clearly, maintaining exposure to the broad S&P 500 would have been better than investing directly in the likes of GE and Exxon back in 2000. It would have resulted in investors having steadily higher exposure to companies that are succeeding and lower exposure to companies that are failing.

ACCELERATING DISRUPTION

This is becoming more important as huge new startups fuelled by massive private market funding upend many traditional industries dominated by venerable public-listed companies. According to a 2018 report by consulting firm Innosight, the average lifespan of companies as components of the S&P 500 is steadily declining.

Back in 1964, the average tenure of an S&P 500 component stock was 33 years. By 2016, the average tenure had narrowed to 24 years. And, by 2027, the average S&P 500 component tenure will shrink to 12 years, Innosight said in its report. Innosight figures that nearly half the S&P 500 component stocks could be replaced within 10 years.

Even since the beginning of this year, amid the steep fall and rebound in the index, there was a wide diversity of performance among its components.

Among the biggest losers were companies linked to air travel and the cruise business. Royal Caribbean, Carnival, Norwegian Cruise Lines and United Airlines are all down more than 60 per cent year-to-date.

At the other end of the spectrum, there were strong performances by many sizeable companies. For instance, Regeneron Pharmaceuticals, which has a market cap of more than US$60 billion, is up more than 60 per cent since the beginning of the year. Computer chip designer Nvidia, with a market capitalisation of more than US$230 billion, has rallied more than 60 per cent.

SOME WINNERS EXCLUDED

The S&P 500, like any other market index, isn't necessarily going to include every winning stock within its universe though. And, by the time some stocks are added, they might already have seen their best days.

For instance, Berkshire Hathaway has beaten the S&P 500 by a wide margin since 1965, when billionaire investor Warren Buffett turned it into his corporate vehicle. However, since 2010, when it became a component of the S&P 500, it has struggled to keep up with the index.

Mr Buffett himself has in recent years, suggested that investors might be better off investing in the S&P 500 instead of Berkshire.

Berkshire already had a market value of more than US$150 billion when it was included in the S&P 500. It was the largest US company that wasn't a component of the index at that point. It had been excluded because of the very low liquidity of its shares, which Mr Buffett had encouraged.

In 2009, Berkshire offered to acquire all the shares in Burlington Northern Santa Fe it didn't already own. It split its Class B shares to facilitate the transaction. Berkshire subsequently replaced BNSF in the S&P 500.

Today, one notable exclusion from the S&P 500 is electric vehicle maker Tesla. With a market cap of more than US$180 billion, the company is said to be one of the largest US-listed stocks not to be included in the index.

The reason for its exclusion is that S&P 500 companies must have reported positive cumulative earnings over four consecutive quarters based on generally accepted accounting standards. With its Q1 2020 results, Tesla has achieved three consecutive quarters of positive earnings.

Other hot companies could end up being excluded from the S&P 500 in the future as a result of tightening rules.

In 2017, for instance, it was decided that issuers of multiple classes of shares would be excluded from the index, on the grounds that such companies have corporate governance structures that treat different classes of shareholders unequally. But existing components of the index with multiple share classes - which include Berkshire and Alphabet - were not affected.

The move reflects a growing tendency of big investment firms that use indices like the S&P 500 as benchmarks to take account of corporate governance issues when allocating funds in the market. Yet, founders of fast-growing companies often want to maintain firm control when they come to market. Among the companies that were affected by the new rule was Snap.

Nevertheless, the S&P 500 still offers broad exposure to the largest companies in the US, and enables investors to easily maintain exposure to this dynamic asset class.