The Paradox of U.S. Mega Caps

The largest domestic stocks have wildly outperformed during a decade of low volatility. That’s not stopping Principal Global Investors from expecting these stocks to protect investors in a period of market uncertainty.

Michael Nagle/Bloomberg

Michael Nagle/Bloomberg

Most investors don’t expect much after over a decade of good results. But even after 12 years of U.S. mega-cap stocks delivering the best returns — with lower volatility — in the MSCI all-country world index, Principal Global Investors is arguing that the asset class will help protect investors as markets adjust to slowing global growth and continuing low interest rates.

Using a peak-to-peak analysis— October 2007 to April 2019, rather than the standard evaluation of markets from the lows of 2009 to today — Principal determined that U.S. mega-cap performance was largely driven by what it calls a “consumer and technology renaissance.” The types of companies that made up mega-cap stocks changed during that period, with the most additions coming from the communications services, consumer discretionary, and information technology sectors, according to recent research from the firm.

“Tech is disrupting everything and mega-cap names have been best at exploiting the benefits. Large companies, whether it’s pharma companies designing better drug trials, or oil and gas companies using tech in horizontal fracking, have been driving real-time change and disruption in their industries,” said Todd Jablonski, chief investment officer of PGI’s Principal Portfolio Strategies, the firm’s asset allocation boutique, in an interview.

“It’s our view that in a low-rate environment that firms will struggle to grow revenue, and there will be a premium to any institution that can deliver growth,” Jablonski said. He argues that the largest companies have been able to leverage advanced technology for revenue growth in a way that smaller businesses have not. PGI’s recent overweight of U.S. mega-cap stocks is a key part of its target risk portfolios.

Between October 31, 2007 and April 30, 2019, the largest 100 U.S. companies delivered 147.6 percent in cumulative total returns, compared to the Russell 1000 cumulative return of 145 percent. And mega-cap stocks achieved that return with less volatility than the Russell 1000.

“U.S. mega caps hit triple-digit cumulative returns, while other developed markets (in USD terms) returned less than 20 percent,” Principal said in a paper on the research. “That’s an astounding gap.”

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According to Jablonski, concentration is driving the market. “U.S. mega caps have become even more mega,” the paper stated. “The weighted-average market cap of the top 100 names in the U.S. universe more than doubled over the period — further testament to the importance of those technology and consumer exposures.” Principal’s study showed that these stocks have become more profitable, with margins increasing from 20.9 percent to 27.8 percent.

At the same time, the largest companies in other developed markets have not experienced the same benefits.

“The mega-cap strength story doesn’t hold true in other developed markets, where returns were half of the overall market and volatility was slightly higher,” according to Principal’s study. “Outside the U.S. in developed markets, being big doesn’t help,” added Jablonski.

The 100 largest companies in developed markets outside the U.S. delivered just 6.2 percent in cumulative returns during the same period, and with far more volatility.

Still, there are risks to Principal’s view on mega caps. One is the ongoing trade conflict between the U.S. and China. “The persistent negotiation mode that our administration is in makes it hard for firms to plan,” Jablonski said.

Another is investors’ expectations around the impact of loose monetary policies by the Federal Reserve and other central banks. Things that worked in the past may not work in the future, Jablonski said.

“We’re returning to an era of very accommodative monetary policy,” he said. “People expect that the same asset classes and investment styles will continue to work as previously. But we’re in a completely different place than we were ten years ago.”