Tracker/ETF | Review | North America | Large | 13 Mins Read | by
The S&P 500 is the United States’ blue-chip stock index. It offers a bet on US entrepreneurialism and business acumen - a bet that has paid off in spades. A quick look at the top ten S&P 500 stocks reveals why.
The four largest S&P 500 companies on 2nd April 2019 were Microsoft, Apple, Amazon and Facebook (in size order). Microsoft and Apple are 43 years old, Amazon is 24 years old and Facebook is only 15 years old.
Alphabet, the owner of Google, is the third-largest S&P 500 company after combining its two share classes. Google is 20 years old forms an online advertising duopoly with Facebook.
All five companies have strong market positions and in many cases dominate their markets. Four of the five businesses generate an EBIT margin of over 20% while Amazon’s EBIT margin is expected to approach 10% by 2021.
S&P 500 top ten – 21.4% of the index
The S&P 500 top ten also has a number of established leaders in the top ten, such as Berkshire Hathaway and Johnson & Johnson. Berkshire was taken over by Warren Buffett in 1965 and Johnson & Johnson was founded in 1886.
Johnson & Johnson is in the health care sector and makes medical devices, pharmaceuticals and consumer packaged goods. The company has increased its dividend for 56 years in a row.
Berkshire Hathaway is a conglomerate holding company with a strong position in insurance. The investment group has outperformed the S&P 500 over the long-term but has recently moved in-line with the index.
What does this tell us?
A quick look at the 10 largest US-listed companies is revealing.
The top ten are in the main high-quality companies. The only two top ten companies that are in weak sectors: JPMorgan Chase and Exxon Mobil.
New companies have eclipsed the old with the information technology (IT) sector powering the S&P 500. Not least if we consider Facebook, Alphabet and Amazon to be IT businesses.
Amazon is increasingly an IT business with profit growth driven by its cloud storage division. Facebook and Google are advertising platforms but it is their expertise in information technology that has enabled them to do well.
The United States has been able to create global leaders in new areas. There are also established leaders that should continue to stand the test of time i.e. Berkshire Hathaway and Johnson & Johnson.
The top ten S&P 500 companies highlight the quality of the index. They make up 21.4% of the S&P 500’s total market value.
According to Vanguard, the return on equity (ROE) for the S&P 500 is 16.7%. By comparison the Vanguard All-World ETF (including emerging markets) has a return on equity of 14.3%.
The US makes up 53.9% of the market value of the Vanguard All-World ETF. The All-World ETF ROE excluding the US is therefore 11.5%.
This means that US return on equity is 87% higher than the rest of the world at 16.7%
Every US$1 of shareholder equity invested in US stocks earns 16.7 US cents a year in net income. Every US$1 of shareholder equity invested in stocks outside the US earns 11.5 US cents a year in net income (in aggregate).
The medium-term outlook
The past is not necessarily a guide to the future.
But most of the top ten S&P 500 companies look set to continue to perform well. They are in growing markets and have strong competitive positions.
Microsoft has an installed base in the corporate world that is unlikely to move elsewhere. Amazon’s profit engine has been its cloud storage division, which provides a mission-critical business function.
Facebook and Google benefit from network effects with more users making both platforms more attractive. The more searches that are completed on Google the more data it has to learn from and the better its results become.
The position of Apple is open for debate. But the smartphone maker does have a loyal user base in the West - I am part of it. Berkshire Hathaway and Johnson & Johnson, meanwhile, should help prop up the S&P 500 during downturns.
Most of the top ten S&P 500 companies appear to have an attractive future. This suggests that the US blue-chip index is an attractive market to invest in.
The long-term outlook
The largest S&P 500 companies show that the United States has fostered more than its fair share of global winners. If this continues it will underpin the outlook for the S&P 500 index.
In other words, the emergence of another Microsoft or Amazon will enable the S&P 500 to perform well.
Whether the United States will foster new global champions is a question of judgement. In my judgment, it will continue to do so.
To quote President Calvin Coolidge, 1925
The chief business of the American people is business.
There are many reasons why the US is a breeding ground for corporate winners. It is a subject I will tackle in another article. A few thoughts are below.
Cooldige’s 1924 campaign slogan
Source: Time Travel blog
Why the US generates winners
The US is the world’s largest economy and operates as a free market under the rule of law. The country has a number of geographical advantages such as a good climate (see Prisoners of Geography, Tim Marshall).
New US companies benefit from a well-developed venture capital system and a strong business ethos. The home market allows startups to grow rapidly and then provides a springboard for global expansion.
Facebook, started in 2004, is one of the most recent examples of this process. The firm initially started in US universities before attracting funding and support from Silicon Valley venture capitalists.
The social network was a hit in the US before going global. Facebook is currently the fourth largest US-listed business.
US stocks versus emerging markets
The “emerging markets” label is sexy.
The logic is that fast-growing countries are great places to invest. But emerging markets have largely been about marketing spin.
The Chinese stock market has generated lacklustre returns despite strong economic growth. Companies in India or China haven’t been able to become global leaders.
The Chinese economy may become larger than the US economy in the coming decades. But the combined economic value of developed markets – Europe, Japan, and US etc – will remain larger than that of emerging markets.
A small company that can expand in developed markets has a large growth opportunity. A small company that can only expand in one emerging market has a smaller growth opportunity.
The ability to generate value over the long-term is not only dependent on growth. It is also dependent on avoiding "blowups." Emerging markets tend to have more blowups in terms of economies and companies.
US companies with strong franchises are, in any event, able to take advantage of emerging market opportunities. Microsoft owns the PC operating system that companies have to turn, whether they are in emerging markets or not.
US bulls and bears
Against this backdrop, the reader may well conclude that I am positive on the S&P 500 index. I am, over the long-term.
One of my key investment rules is simply this - the US is the best.
At the same time, the near outlook for the US equity market is uncertain. Bull and bear points for US stocks can be made at any time.
S&P 500 passive fund
When it comes to funds the three-stage analysis that this site uses is 1) where 2) how and 3) who. The where and the how is pretty clear when investing in a passive S&P 500 fund.
We perhaps just need to be careful on the who. Vanguard is a sound bet with the firm run and managed on behalf of its investors. The other large passive brand is Blackrock owned iShares.
I prefer accumulation funds because the dividends are automatically reinvested. I also tend to prefer exchange-traded funds (ETFs) because they trade like shares.
Vanguard doesn’t appear to offer an S&P 500 accumulation ETF. I, therefore, tend to look towards the iShares S&P 500 ETF (CSP1).
Passive funds are the default investment option in my view. It only makes sense to invest in an active fund if it is better than a passive alternative.
The S&P 500 is probably the best (diversified) passive fund available. It can serve as an opportunity cost benchmark i.e. only look at active funds that can beat it.
A look at the top ten stocks in the S&P 500 index is insightful.
The top five are relatively young companies with growth potential. Can anything stop Microsoft, Apple, Alphabet, Amazon and Facebook? These are not easy companies to compete with.
Johnson & Johnson and Berkshire Hathaway, meanwhile, are long-established businesses. There are businesses like them in the rest of the S&P 500 i.e. Visa, Mastercard, Procter & Gamble, Walt Disney and Coca-Cola.
The US appears to have the ability to develop new global leaders. If this remains the case, the long-term outlook for the S&P 500 is positive.
The chief business of the American people looks set to remain business itself.
1) US equity market valuation
1) US equity market valuation
US equity market bears currently point to the very high CAPE reading at 31.1X – 83% higher than the historic mean of 17X. This is the cyclically adjusted P/E ratio. In other words, how much you have to pay for cyclically adjusted profits.
The idea behind the CAPE P/E is that in strong economic conditions the P/E should be lowered to reflect this. Strong conditions won’t last forever and so we should be careful not to overpay.
How CAPE P/E looks on 5 April 2019
The quality of the US equity market has unquestionably improved in recent decades. As we have seen, the top five US stocks are high-quality businesses.
Profitable companies with strong market positions and growth do merit higher P/E ratios. This means that the relatively high CAPE reading may not be a cause for alarm.
An additional factor is that growth will reduce the P/E ratios of the top five companies. This is most notable with Amazon. The historic P/E of Amazon is 89X for 2018 but it is expected to fall to 31.4X in 2021.
Of course, the US bull market has gone on for some time now. It started on March 9, 2009, and so is now just over 10 years old. This is a long time for a bull market to run.
The US has also gone without a recession for a long time - 10 years. The economy and US markets will inevitably both weaken at some point.
However, the five largest US companies are profitable and resilient businesses. This contrasts with 2000 and 2007/2008 when the largest US companies were much lower quality.
The length of bull markets is also a question for debate. It depends on how we define them.
The S&P 500 only moved above the peak it reached in 2007 in early 2013. On this basis, the bull market is six years old.
A bear case for the market would be that negative events could impact the largest US companies. There has recently been the political talk of breaking up companies like Apple, Facebook, Amazon and Alphabet.
But enough market talk for now. The future is always unknown.
2) US stocks dominate developed markets
2) US stocks dominate developed markets
The iShares Core MSCI World Accumulation ETF (SWDA) offers exposure to global companies in 23 developed countries. The iShares website states that they cover 85% of the listed equities in each country.
What is instructive is that the United States stock market makes up 61.7% of the ETF. The next largest countries were Japan at 8.28%, the UK at 5.84%, France at 3.85% and then Canada at 3.49%.
As we have seen, it is the success of US companies that has made them so valuable. The US would not dominate the developed world stock market's if it hadn't produced global winners like Microsoft and Facebook.
When I look to active funds I prefer them to have the ability to invest in the US. Lindsell Train Global Equity, for example, is the only fund from Lindsell Train with the ability to invest in US stocks.
iShares World (developed) Acc ETF (SWDA) - 28 February 2019
We can also look towards the global equity market including emerging markets. If we take the Vanguard All-World ETF (VWRL) the USA makes up 54% of its total value.
Europe is 19.5% and emerging markets are only 10%. China is the world's fastest growing major economy. But its stock market makes up only 3.5% of the All-World ETF while India makes up only 1.1%.
Vanguard All-World ETF 28 Feb 2019
3) US stock market outperformance since 2011
2) US stock market outperformance since 2011
If the US equity market is so great it should have outperformed other markets. This has indeed been the case since the start of 2011.
A chart of the iShares Core MSCI World Accumulation ETF (SWDA) against the iShares S&P 500 accumulation ETF (CSP1) highlights this clearly.
The crux is that US makes up 62% of the iShares World ETF and so any outperformance is striking. It must mean that the 38% of the iShares World ETF not in the US has meaningfully underperformed the US stock market since 2011.
S&P 500 beats the World (developed) ETF
A key driver of the US stock market has been Information Technology (IT) companies like Microsoft and Apple. This is evident if we compare the S&P 500 IT sector to the S&P 500 general index.
The iShares S&P 500 IT sector ETF (IITU) appears to have only been listed in London in November 2015. It has handsomely outperformed the S&P 500 ETF (CSP1) since then (both are accumulation ETFs.
The IT sector has recently driven the S&P 500 index
4) US equity contrarian signals
4) US equity contrarian signals
The above article is positive on the long-term outlook for US stocks. This would be interpreted by some as a contrarian sell signal.
When magazine covers say but it is seen as time to sell and vice-versa. The most famous example of which is the 1979 cover of Business Week:
It is certainly the case that US stocks have benefited from a number of positive tailwinds. The most recent of which is the corporate tax cut from 35% to 21% from fiscal 2018 onwards.
The US equity market has also recently been powered by the IT sector. If the Democrats gain power we could see corporate taxes increase and more regulation of the large tech companies.
The US tech giants may also see tax and regulatory intervention in Europe. Companies like Alphabet and Facebook appear to have been using aggressive tax minimisation strategies outside the US.
Nevertheless, the largest US listed companies are well placed in my view. They are high quality businesses and have attractive long-term growth prospects.
An S&P 500 passive fund: iShares S&P 500 Acc (CSP1)
1) S&P 500 top ten and Alphabet
The two share classes of Alphabet are a mystery. I tried to Google it with little success (go figure). Presumably, they are added together to get the value of the company. This is because they must both represent shares in issue.
Of course, stating the "top ten" in the article is a bit misleading. There are only nine companies given the two Alphabet share classes. However, it is what ETF providers like iShares do and so I decided to remain on script.
If anyone has figured out the two share classes of Alphabet do let me know! I'll look at again sometime to see if I can crack it.