The S&P 500 Index (S&P 500) is often cited as the benchmark measure of U.S. equity market performance. At its lowest point this year on March 23, it had declined nearly 30%. However, the index has since recovered much of that drop and is now down approximately 10% for 2020. The S&P 500 is a market capitalization-weighted (cap-weighted) index and its largest constituents — Microsoft, Apple and Amazon — have performed well during the COVID-19 pandemic. Intuitively, this makes sense as these types of companies are large, well-capitalized global operators that are viewed as safe havens by investors. The total index weighting of the three aforementioned corporations has risen by 3.1 percentage points thus far in 2020. To put that in perspective, their index weight gain this year is greater than three entire sectors of the index: Energy, Real Estate and Materials. The combined weighting of the top five holdings in the S&P 500 is at its highest level since the late 1970s. At the time of this writing, the five largest stocks comprise the same index weighting (18.7%) as the bottom 338 stocks.
When one looks at the same portfolio of companies, but as equal-weighted this time, the picture changes. The equal-weighted S&P 500 lost over 38% of its value at the 2020 low and is now down 17% for the year. As illustrated in the chart, the cap-size comparison shows a current bias toward companies with the largest market capitalizations - something we have not seen in the past 10 years. A reasonable conclusion is that size is being perceived as a synonym for safety. Valuation, when measured by price-to-earnings ratio, also demonstrates the premium being placed on the top of the index, with the cap-weighted index trading at 19.6x and the equal-weighted index trading at 14.3x. With performance and valuation evidence heavily on their side, does this mean mega-cap companies are the only stocks worth owning?
Over the long term, I’d argue not. In a narrow recovery, the opportunity exists in the stocks that have not participated to the same extent. For income investors, there are many dividend-paying stocks up and down the capitalization range. Some of the companies are well capitalized, while others are not. Some have demonstrated sustainable high levels of return on capital over an economic cycle, and others have not. Some can maintain (or grow) their dividend, while others will reduce or have eliminated it. The point is, with the recovery this year being so exclusive, there are many opportunities to pick and choose non-mega-cap, high-quality dividend-paying companies with solid financial strength that are worth owning now and in the future.
Though the market has recovered much of its 2020 decline, the recovery is top heavy. Opportunities still exist to take advantage of this year’s price decreases. Income investors willing to conduct extensive due diligence can sift through dividend-paying stocks and uncover some high-quality companies at reasonable long-term valuations.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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