Many investors consider market capitalization to be a central measure of risk. However, when one looks at an index qualitatively, as opposed to quantitatively, one may question the validity of this metric.
Consider that the S&P 500 Index (“S&P 500”) includes firms such as Amazon.com, Inc. (NASDAQ:AMZN) and Facebook Inc (NASDAQ:FB). The key question insofar as risk is concerned is whether or not these firms have risk characteristics comparable to companies such as The Coca-Cola Company (NYSE:KO) or The Home Depot, Inc. (NYSE:HD). If capitalization is a true measure of risk, then the index that effectively defines the large cap universe should include companies with comparable risk profiles. However, few would suggest that the risks of owning Facebook are comparable to the risks of owning Coca?Cola.
Generally, investors purchase investment products that track large cap indexes as a means of investing in mature, stable firms. The unspoken presumption is that mature, stable firms will have large market capitalizations, and firms with immature businesses will have small market capitalizations. It seems reasonable to suppose that Facebook’s business is still immature, large though it may be. That is the problem with capitalization as a risk measure, and it is reflective of a relatively recent shift in the manner in which new companies develop. In the modern world, it is possible to have a nascent, immature business that operates on a vast scale and merits a large market capitalization. However, that does not mean the company has low risk.
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To illustrate, suppose one were to exclude Priceline Group Inc (NASDAQ:PCLN) from the S&P 500. It is in the S&P 500 (INDEXSP:.INX) simply because it has a market capitalization of $60 billion and a rather high float—roughly 99% of its shares are held by the public (meaning that its management cares to own very little of it). Priceline has a trailing price to earnings (P/E) ratio of roughly 32x; if one excludes it from the S&P 500, arguably, the P/E of the Index would be reduced, albeit by a negligible amount. Also, arguably, the risk of owning the Index would be lessened. However, Priceline trades at 18x analysts’ estimates of its 2015 earnings, and its revenues are growing at over 20% a year. Very few firms in the S&P 500 can match that pace. Ergo, if Priceline were excluded, would one lower the future return of the S&P 500 by a measurable quantity? Similar remarks could be made about Netflix, Inc. (NASDAQ:NFLX), also in the S&P 500, and which trades at about 56x 2015 earnings as of this writing.
One might ask, then, whether the P/E ratio of the S&P 500, which is an averaged figure, is even meaningful given that the index includes both low P/E and high P/E stocks. It is at least arithmetically conceivable that the P/E of the S&P 500 could deflate. The deflation could be caused by that group of companies that trade at levels similar to Netflix or Amazon (which has an even higher P/E). The problem is that the system of classifying companies by market value was designed for the historical character of the S&P 500. Historically, the index consisted of relatively stable firms, such as Coca?Cola and The Procter & Gamble Company (NYSE:PG), as well as cyclical firms, such as United States Steel Corporation (NYSE:X) and General Motors Company (NYSE:GM), which were also large components of the Index. The cyclical firms usually would lose large amounts of money during weak economic periods and make large amounts during strong economies. Investors would try to optimize performance by gravitating between the cyclicals and the ‘defensives’.
Over the decades, on balance, this proved to be a remarkably unsuccessful approach, as reasonable as it appears to be. In fact, it was so unsuccessful that most managers underperformed the S&P 500, which is the reason that indexation has become the dominant strategy.
See full “Horizon Kinetics: What is a Large Cap Stock?” in PDF format here.