The concentration conundrum: challenge or opportunity?

As with any investment, your capital is at risk.

It's hard to beat the formidable US stock market. Over the past decade, after delivering a remarkable 15.6 percent annualised return, around 90 per cent of active managers have underperformed. Against this backdrop and following a particularly challenging period in 2021-22, it is pleasing to have delivered US Growth clients with outperformance over 10-years.

In the past couple of years, part of the challenge has been a rise in market concentration to a level we haven’t seen in over half a century. The top ten names command over a third of the S&P 500 index and over half of the Russell 1000 Growth index, both of which are commonly used benchmarks for US equities1.

Driving the phenomenon, investors have crowded into the world’s largest companies, the so-called Magnificent Seven (or Mag 7 for short) – Alphabet (Google’s parent company), Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla.

Why does this matter for active managers? Historically, since 1957, the 10 largest stocks in the S&P 500 underperformed an equal-weighted index of the remaining 490 stocks. Yet, the last decade marks a notable departure from this trend, with the top ten stocks outperforming by an astonishing 5.8 per cent annually2. Their influence prompted S&P to launch a 'Top 10' index in 2023, shown below.

The US stock market has been led by the largest companies

These concentration levels mean the largest companies in the index have dominated returns; over the past two years, more than half of the S&P 500’s total return was generated by the Mag 7, and NVIDIA alone accounted for almost a third of that.

The temptation for investors might be to seek safety in the index. It was once said, “No one ever got fired for buying IBM”. That is probably today’s conventional wisdom for passive investing. The S&P 500 index is widely considered a safe bet. It consistently delivers the average result (the US market return minus a little in fees), but we believe that perceived safety comes at a high price – opportunity cost.

Every investment decision has an implicit opportunity cost. With the Mag 7 now commanding a collective market cap of around $18tn, even the most bullish investors face a challenge in expressing a positive view on these mega-caps on a relative basis. It requires allocating a disproportionate amount of capital in a portfolio.

Take Apple, for example, at more than 7 per cent in the S&P 500 and 12 per cent in the Russell 1000 Growth. To express a modest active weight (say, two or three per cent) means eating up 10-15 per cent of the portfolio3. Most of that capital will not affect relative returns, ie, it is effectively dead wood.

Investing large amounts in such companies may come at the expense of other, potentially more promising opportunities elsewhere. Strikingly, when looking at the broader Russell 3000 Growth index over the past year, 457 stocks have outperformed the median return of the Mag 7, and 48 stocks surpassed NVIDIA’s remarkable return4. For those looking for upside, there are ample opportunities to outperform the index and exceed the returns of the Mag 7 and even NVIDIA.

Expectations and upside 

Research shows that over the long term, returns follow fundamentals. The stock market rewards companies that deliver the greatest earnings growth. It also shows that the greatest relative returns can be found in companies where the market does not anticipate or appreciate that growth – it pays to think differently.

Five years ago, NVIDIA and Tesla were very different-looking investment propositions—substantially smaller, with evolving addressable markets and uncertain growth and profitability. However, exceptional operational progress has generated returns for NVIDIA (+2,600 per cent) and Tesla (+1,500 per cent), which now include them among the Mag 7 roster. That starkly contrasts with the much larger and more mature names Apple and Microsoft, where multiple expansion has made a significant contribution.

Our outlier philosophy focuses on identifying individually unlikely but rewarding opportunities we think are materially undervalued – exceptional growth companies. Part of our analytical framework is building conviction in a company’s addressable opportunity relative to its current size. Through the lens of asymmetry, we are positively disposed to companies earlier in their growth journey, companies with the potential for greater upside. Where we have sufficiently differentiated insights, the opportunity for the greatest relative returns lies. That is reflected in our investment decisions and portfolio construction5.

It was true of NVIDIA in 2016 when we first invested, but it is less accurate today. The fear of missing out on the graphic processor unit (GPU) specialist’s AI-fuelled growth and earnings has propelled the company to over $3tn in market cap. It was backed up by a pattern of beating estimates and raising guidance, which shares responded to accordingly. For the company’s most recent results, sales and earnings doubled year-over-year, yet shares declined, suggesting expectations may have caught up with the company’s extraordinary growth.

Worth considering is the fact that the Mag 7 are the most researched companies in the world today. The number of analysts covering them ranges from 45 to 68, the highest in the S&P 500. In our view, the best opportunities will likely lie away from the most analysed stocks.

Consequently, we’ve harvested gains from NVIDIA to fund other investments where the growth opportunity is at an earlier stage, asymmetry is more pronounced, or we have growing conviction in the upside prospects.

Abundant opportunity

Our job is to identify what will drive future returns. Through the lens of prospective upside, we think stock market concentration is a distraction and an opportunity cost from the abundance of other companies with the potential for far greater upside—those that could be the outliers of the next decade.

To that point, the portfolio’s top-returning stock over the past year was not NVIDIA but a salad restaurant business named Sweetgreen. Sweetgreen is harnessing automation with its Infinite Kitchen technology to produce salads 50 per cent faster than a human can. It’s not only terrific for speed, quality and portion control, but it improves restaurant profitability, too. We’ve been impressed by a management team with bold ambitions and a willingness to embrace technology, and we see successful store rollout fuelling growth in the years ahead.

The rise of Generative AI has added fuel to the dominance of the "Mag 7" tech giants. However, companies like Cloudflare are uniquely positioned to thrive in this new era. Cloudflare's global edge computing network, with data centres spanning 330 cities, provides unparalleled speed and efficiency for AI applications. Its Cloudflare Workers platform is already winning customers, demonstrating its critical role in AI inference. This unrivalled network infrastructure gives Cloudflare a significant competitive edge in the burgeoning AI landscape. Could Cloudflare become the next major cloud platform outside the tech giants?

We think the portfolio contains many other companies with the potential for substantial upside, from DoorDash excelling in last-mile logistics to Block disrupting financial services. What excites us about the US is that the investment opportunities are diverse, and the market often underestimates the effect of sustained growth. We are focused on our mission of finding and nurturing the next generation of exceptional growth companies.

Final thoughts

Today's Mag 7 casts long shadows across the investment landscape, dominating the indices. Yet the greatest opportunities for outsized returns likely lie away from the largest and most researched companies. We see extraordinary potential in companies like Sweetgreen, Cloudflare, and many others across the portfolio—businesses reimagining their industries with technological innovation and ambitious visions for growth.

While market concentration dominates headlines and column inches, we remain committed to the pursuit of investing in exceptional businesses with outlier potential. These companies may appear modest against today's mega-caps, but they possess the fundamental characteristics that could propel them to become tomorrow’s market leaders. We believe that in identifying and nurturing these opportunities is the path to generating outstanding long-term returns for our clients.

1 We refer to the S&P 500, Russell 1000 Growth and Russell 3000 Growth indices in this article. For index more information, please refer to the index providers websites.

2 by an average of 2.4 per cent per year. Source: GMO. 

3 Remarkably, that concentration level exceeds some regulators’ concentration limits in certain markets.

4 Based on analysis of the past 12 months to 29 November 2024, for the Russell 3000 Growth index (a representable investable growth universe). 

5 Active share of around 80 per cent versus the S&P 500.

Source: Revolution, S&P. US dollar. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised. 

Past performance is not a guide to future returns.

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