Stock pickers have had a challenging few years

The point of stock picking is to get better returns than from index funds. If stock picking does not deliver excess returns, the investor always has the option of capturing index returns with a low-cost index fund. As the tech giants have continued their strong rise, their relative weight in equity indices has increased. When a smaller group of stocks drives the index up faster than the rest of the group, it means that more investors are missing out on index returns. Stock picking has worked well in recent years, if it has focused primarily on the largest companies. This may not continue forever, but there are good reasons for this trend.

The S&P 500 has traditionally been relatively diversified, but now the weight of the top 10 companies is already hovering around 30%. Traditionally, the biggest companies have underperformed the general market, but super-companies like Apple and NVIDIA have been defying gravity for the past 10 years.

The superior performance of large companies has led to a situation where an unusually small percentage of fund managers have been able to beat indices. I believe the same is true for retail investors. In general, stock pickers tend to focus on the smaller companies in the stock market because they are the ones that are most mispriced. But over the past decade, the old rules haven't applied: the largest US companies have been consistently undervalued, resulting in better returns than the index. Ironically, the most followed and talked about companies have repeatedly managed to exceed expectations!

For the past couple of years, investors focused on Nasdaq Helsinki have suffered the consequences, as it has performed exceptionally poorly compared to the world's stock exchanges, especially the American ones.

However, the overperformance of the large companies and their higher-than-average pricing relative to the rest of the market (S&P 500 forward P/E without the Magnificent 8 is 18x, and with them it is 21x, as the Mag8 is priced at about 28x) is not entirely unwarranted. The Counterpoint chart below shows how the economic profits of US companies are distributed among them. The term economic profit used in the chart refers to the profit earned on invested capital in excess of investors' cost of capital. Last year, the top ten companies accounted for as much as 69% of all economic profits! Large companies, the tech giants at the forefront, are therefore creating most of the value added.

Over the past couple of years, the stock market's top dogs have been joined by the clearest winner of the AI boom, at least for now: NVIDIA, which sells hardware and software, or "AI factories," as coined by the company itself. Usually, the most valuable companies on the stock market sneak up to the top, as when Apple overtook oil titan Exxon in the early 2010s, and later when the Office empire Microsoft overtook Apple. NVIDIA has rocketed into the top three in just a couple of years and, at the current pace, will soon be the most valuable listed company in the world (see the graph below).

 

Historically, however, the most valuable company on the stock market has been a bad investment, because at some point it will reach its growth limits while the market continues to price the winner higher.

What we have seen in recent years is not a stock picker's market (at least not in a general sense), but an index investor's or momentum investor's market. If the largest companies in the stock market started to lag the indices and the market was driven more by a larger number of smaller companies, the golden age for stock pickers would begin. The bigger the stock market's largest companies grow, the closer this turnaround is likely to be. Unless the old laws of the market economy, such as competition and return to average, have been irretrievably broken.