A few weeks ago, two things happened which made me wonder whether we, meaning the management of the investment firm I co-founded, are deluding ourselves in continuing to compare our performance to the S&P 500 index. Honestly, we have never considered any other benchmark, as the S&P has represented, to us and our investors, a diversified portrait of the U.S. economy. However, perhaps we needed to rethink that premise.
First, several friends asked me if they should buy the same stock, Tesla. To call Tesla a strong performer is an understatement (It's up 377% this year)... It combines brashness, innovation (sustainable!!), and a product that everyone can describe (a CAR!!) into one shiny package.
Second, were some comments by clients, highlighting the wonderful results of other managers (not us), whose extremely tech-heavy portfolios, were beating us by a decent margin, even though we thought we were doing very well against our benchmark, the S&P. As one client noted, most of these dynamite stocks, such as Facebook, Twilio, Zoom, Netflix, Teledoc, and Shopify, didn't exist before 2000. Neither did Tesla.
At first, I saw no clear connection between friends eager to catch the momentum and the idea that a new "market" had emerged. Upon further reflection, I realized that the Covid experience had indelibly impacted investors. Veterans and novices alike have recognized the tremendous reward in stocks whose success relies on novel applications of technology where the demand has grown, not diminished, during the pandemic.
Tesla fits that description perfectly, a cult stock for years, whose futuristic innovations are packaged in a product everyone understands - (IT'S A CLEAN-ENERGY CAR), at a time when no one is flying, just driving.
Those winning stocks populate the Nasdaq Composite Index more completely than the S&P 500. While the S&P has roared back more than 50% from the lows in March, the Nasdaq Composite is up more than 60%. Those windfalls have not been evenly distributed. The COVID-proof or COVID-helped companies, such as the ones mentioned above, plus behemoths like Amazon, Apple, PayPal, and, of course, Tesla, all trade exclusively on the Nasdaq Stock Market, while laggards such as banks, airlines, retail, and energy are more likely to trade on the New York Stock Exchange.
The Nasdaq composite weight in technology is 48% and adding the three largest communications services names in the top 10 (Facebook, Google, and Netflix), brings that total to 75%. The performance of its largest components has caused investors to fixate on this index as a bellwether for opportunities in the market.
If the Nasdaq has risen in importance, has the S&P 500 lost relevance? It's happened before: The Dow Jones Industrial Average was the universal benchmark for most money managers until the 1980's, when it was replaced by the broader S&P. (The Dow made major changes Monday night to stay relevant.)
The drawbacks of the Dow, which is still cited by the media, were clear – there were only 30 companies; the higher priced stocks carried the most weight; the process of adding and deleted constituents was opaque; and, there was very little nod to technology as the greatest catalyst to the US economy. Even by 2012, only four of the 30 Dow names were tech firms.
What would be the rationale for changing our benchmark from the S&P to the Nasdaq? If stock prices reflect earnings growth now or in the future, there is no question that the Nasdaq, with the dominance of technology, digital platform businesses, and biotechnology, grows faster. However, because of the inclusion of so many pre-profit companies, the gap is less than expected, with the 10-year cumulative earnings per share expansion at 91.4% for the NDX and 52.7% for the S&P. Far more impressive is the price appreciation from 2010 until July 30, 2020 of 569% versus 265% for the S&P 500.
If switching benchmarks means more exposure to faster growing earnings and superior stock performance than the S&P, what could be wrong with that?
Actually, a few things. For one, the Nasdaq is more concentrated than we prefer – Apple, Microsoft, Amazon, Facebook and Alphabet – account for just under 51% of the entire index. In the S&P 500, where these names hold the same rank positions, their weight is currently less than half that amount (~23%). To outperform the Nasdaq, when these stocks are charging forward, many managers would be tempted to allocate at least half the portfolio to them.
That implies more risk appetite than clients may be aware they are taking. When those key stocks retreat, look out. That level of risk requires a strong stomach for both the managers and their clients.
The S&P 500 index criteria are more demanding, ensuring a level of valuation support not inherent in its counterpart. It includes the 500 largest companies by market cap, assuming they meet other conditions.
For example, the most recent quarter and the addition of the last four quarters must show positive income, and 50% of the outstanding shares must float publicly. There is no profitability requirement for the Nasdaq and there are no share liquidity rules.
While the Nasdaq Tech Sector, plus AMZN, FB, GOOGL and NFLX accounts for 75% of the index, that same grouping applied to the S&P 500 stands at 39% (27.5% Tech sector and 11.2% for the other stocks.) The remaining 61% of the S&P represent the biggest companies in all other sectors, which can be overlooked if benchmarked to the Nasdaq.
Weights adjust, as they should, based on share price driven by anticipated profitability. At the end of 2010, the S&P Energy weight was 11.9%, with both its revenues and profits accounting for 13% the total for the index. Today, Energy, hit by weak oil prices, excess supply, and divestment, holds a 2.5% weight, accounting for only 1.2% of net income.
Other sectors, such as Consumer Staples, Industrials, and Materials have fallen in prominence, impacted by evolving brand stature, globalization, and technology, while Tech, Communications Services (a newly-named grouping that combined elements of three former sectors), and Consumer Discretionary have grown with the rise of digital media, online shopping, and the technologies impacting consumer and business behavior. Technology, while the most profitable sector, still only represents 10% of the S&P 500 revenues, 18.5% of its profits, and 12% of its employees.
In searching for the best opportunities, we need to scour the investment universe across all market capitalizations and industries, including some very small Nasdaq-listed stocks. However, if we to re-focus our attention on beating the Nasdaq, there is a risk we might ignore the very wide potential embedded in health care, consumer, financials (still the largest sector by net income) and other groups well represented in our index.
I'll put that idea to bed.
Karen Firestone is Chairman, CEO, and co-founder of Aureus Asset Management, an investment firm dedicated to providing contemporary asset management to families, individuals and institutions.