Bob Gruendyke, senior portfolio manager for Allspring’s Dynamic Growth Equity team, analyzes the current market environment for growth stocks and the impact of extremely high concentration in just a handful of mega-cap growth stocks.
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Marilyn Johnson: I’m Marilyn Johnson and you’re listening to On the Trading Desk®. Joining me today is Bob Gruendyke, senior portfolio manager for Allspring’s Dynamic Growth Equity team, and we’re going to discuss the current market environment for growth stocks and the impact of extremely high concentration in just a handful of mega-cap growth stocks. Welcome to the program, Bob.
Bob Gruendyke: Thanks for having me. It’s great speaking with you, Marilyn. I always enjoy the discussion.
Marilyn: So, Bob, it’s been quite a tough market for growth stocks lately. What else is going on that can make it particularly challenging for active managers in this category?
Bob: It’s apparent that growth stocks have been pressured by macroeconomic and stylistic headwinds. It’s what’s in the news and we hear discussed on CNBC on a near daily basis.
But another challenge to growth investors has been the increasing concentration of returns in the benchmark, driven by just a handful of the largest names. This is a problem unique to large-cap growth, the concentration challenges not present down the market-cap spectrum.
So over three quarters of the return in the Russell 1000 Growth in the last five years has been driven by just the top 10 stocks and over half of the return in the Russell 1000 Growth in calendar-year 2021 was driven by 5 stocks and 5 stocks alone. And that concentration was even more pronounced in the fourth quarter of 2020 when 5 stocks drove over 60% of the return.
As a result of the strong performance in a handful of names, the benchmarks have become highly concentrated. The top 10 names in the Russell 1000 Growth benchmark make up now just a hair under 50% of the entire indices. These are the mega-cap companies that most investors are familiar with names like Apple, Microsoft, Alphabet, and Amazon. Back in 2015, the top 10 in the benchmark were just 25% of the entire indices. So concentration has effectively doubled in the last seven years.
As active managers, we don’t mind a concentration of returns. We also don’t mind a concentration of names in the benchmark. However, when the two overlap, it presents a considerable challenge to managers such as ourselves. Unless you’re overweight these handful of very large size positions in the benchmark, it has been very difficult to outperform. Yet it’s very difficult to overweight these names and still run a diversified portfolio of 70 to 100 stocks.
Marilyn: How did this handful of mega-cap companies get to be so big?
Bob: It’s not a fluke. These are fantastic businesses with much higher growth than one would expect, given their size and scale. They’re highly profitable with strong cash flow generation and have, what we would call, fortress balance sheets. Their size and scale create large barriers to entry on their core businesses and allow them to move into large adjacent adjustable markets.
Just an example to frame this point, think of Microsoft, a company that’s been around for decades. Just 10 years ago, Microsoft was growing top-line revenue in the mid-single digits. In the last five years, Microsoft has grown in the high teens. This is the fastest top-line growth over a five-year period since the late 1990s for Microsoft. They have had tremendous success transitioning the business to more recurring revenue streams and also entering new markets, like their infrastructure-as-a-service platform called Azure. At the same time, they’re doing this profitably and at scale, generating free cash flow returns on capital in excess of 25%. As a result, the price/earnings multiples expanded from around 10 times over 10 years ago to 25 times currently.
Marilyn: Bob, do you see any changes in terms of benchmark concentration going forward?
Bob: We can’t give you one specific catalyst, but historically speaking, indices do go through these concentration cycles and eventually returns do broaden out. We’ve done a lot of work on this as a team and analyze benchmark concentration over the last couple of decades. In that time, periods of increasing or decreasing concentration last, on average, five-and-a-half years. The current period of increasing concentrations has lasted longer than the five-and-a-half-year average, but the concentration does appear to be topping out as of late.
We get questions from clients all the time around what could change the paradigm, what could stop this concentration. We have seen regulators around the globe look more closely at these business models and their investigations are still largely ongoing. It is apparent that global regulators are not going to allow these mega-cap companies to do large acquisitions, which may ultimately open the door for more competition. We’ve also seen strong underlying fundamental performance by companies down the market-cap spectrum at lower overall valuations. And, eventually, this should garner more investor attention and could drive a rotation away from the mega caps.
Marilyn: As you discussed earlier, it has been a difficult and volatile market environment, particularly for growth. Wouldn’t investors want to continue to ride these big mega caps in this market?
Bob: Yes, that’s likely true in the near term. As I mentioned, they tend to have dominant market positions and strong recurring cash flows, which are defensive characteristics that are highly coveted in periods of market stress. The current earnings season I would characterize as mixed with stock moves sometimes disconnected from strong underlying company performance.
An example is a company called CrowdStrike, which sells cybersecurity software. Since the beginning of February, we’ve seen forward earnings estimates revise higher by 17%. Yet, since mid-April, the stock has underperformed by 35 points relative to the Russell 1000 Growth benchmark. There will come a time when the market will become less focused or concerned with geopolitics, inflation, and interest rates. When that happens, the focus will return to underlying fundamentals—sales, earnings, free cash flows. Our job is to stay focused, stay disciplined, and continue to find those companies that can generate secular growth over a longer time period. Often turbulent markets such as these offer the best time to buy into long-term growth franchises.
Marilyn: Thanks for explaining that, Bob. It makes a lot of sense. Do you have any final thoughts you’d like to leave with our listeners?
Bob: Yes, thanks. It’s a unique and challenging market that we’re currently in. However, now is not the time to abandon diversified strategies. We are staying balanced, finding ideas across the market-cap spectrum. Mid- and small-cap growth have underperformed significantly relative to large-cap growth and relative to value. Historically, we find a lot of big winners in those segments. Market sentiment will improve for those stocks, and our portfolios are positioned to do well when we see strength across those market-cap segments. We’ve seen these cycles before. Our team history goes back more than 25+ years. We aren’t perfect. We’ve had our bouts of underperformance, but we’ve always followed it up with consecutive years of outperformance. We’re confident in our process and what we can deliver for our clients.
Marilyn: Thanks, Bob, for being with us today and sharing your insights
Bob: Thank you.
Marilyn: That wraps up this episode of On the Trading Desk. If you’d like more information on today’s topic, you can find it in the Dynamic Growth Equity team’s research paper titled Managing the Concentration Cycle in U.S. Growth Equities at our firm’s website, allspringglobal.com, where we’ve published a wide range of market insights and investment perspectives.
To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or whatever podcast subscription service you use. I’m Marilyn Johnson and thanks for listening.
The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price/book ratios and higher forecasted growth values. You cannot invest directly in an index. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. 100 basis points equal 1.00%.