The S&P 500 has had a strong run in 2023 but its performance is heavily skewed by seven mega-cap companies. Investing outside of mega-caps and other high-flying stocks could be a hedge against a possible reversal of fortune for these companies.
In 2023, the fortunes of the S&P 500 have become heavily influenced by the performance of a relatively small number of large, predominantly technology-focused companies: Apple, Alphabet Inc., Microsoft, Meta, Amazon, Nvidia and Tesla. Together these seven companies (eight stocks, incorporating both Alphabet share classes) comprise more than 30% of the index weight as of July 31, 2023, despite representing roughly 1.5% of the total number of companies in the index.
Because the S&P 500 is a market-cap-weighted index, when these seven companies do well the index does well. This has been the case in the first half of 2023: As of July 31, 2023, the S&P 500 was up nearly 21% year-to-date, but without these seven companies it would have been up only about 9%.
That should set some alarm bells ringing. Any problems affecting one of these influential stocks could have a material impact on many investor portfolios. While economic indicators have improved in recent months, interest rates are still higher than at any time in the last 15 years and may remain that way until at least 2025. That could be bad news for the stocks that dominate the S&P 500 and may lead to significant volatility and potential losses.
The value at risk is enormous: According to S&P’s most recent Annual Survey of Assets, an estimated $11.4 trillion is indexed or benchmarked to the S&P 500.1 Though investing to mirror an index can provide diversification, that diversification is limited by seven companies accounting for more than 30% of the index.
The Russell Midcap index doesn’t have this problem. As of July 31, 2023, the top eight names accounted for only 3.5% of the weight of the Russell Midcap, versus 30% for the S&P 500. Russell’s annual rebalancing of its indexes also helps prevent individual stocks from skewing the overall index performance.
At Jensen, our mantra is: “focus on the company, not the stock.” This keeps our eyes on businesses that we believe consistently create value for shareholders. For those investors who do pay close attention to companies, we believe that this could be a good time to consider mid-caps.
Generally, “mid-cap” refers to companies with a market capitalization of approximately $2 billion to $10 billion. The Russell Midcap Index comprises approximately the 800 smallest companies in the Russell 1000 (an index of the 1,000 largest companies by market cap), representing about 27% of the market cap of the Russell 1000 companies (as of July 31, 2023). While the Russell Midcap does include companies with a market cap of more than $10 billion (the largest is $55.8 billion as of July 31, 2023), the annual rebalance helps ensure that it won’t be overly influenced by a small set of companies.
The chart below demonstrates the growth of $100 starting in 1978, showing that the Russell Midcap index outperformed its small-cap, large-cap and mega-cap counterparts over that extended period of time.
Chart 1 – Russell Indexes Growth of $100
Source: Refinitiv Datastream. Data as of 7/31/2023.
Chart 1
Russell Indexes Growth of $100
Source: Refinitiv Datastream. Data as of 07/31/2023.
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Russell Midcap vs. S&P 500
Chart 2 – Index Cumulative Return, Year-to-Date
Source: Refinitiv Datastream. Data as of 7/31/2023.
Chart 2
Index Cumulative Return, Year-to-Date
Source: Refinitiv Datastream. Data as of 07/31/2023.
While it is true that the S&P 500 has outperformed the Russell Midcap year-to-date, this is almost entirely attributable to the seven mega-cap companies listed earlier. The Russell Midcap has delivered 13% year-to-date through July 31, even without this boost from the mega-caps, compared to 21% for the S&P 500.
Primarily, the Russell Midcap underperformed the S&P 500 due to its lower weight in Information Technology companies, as defined by the MSCI GICS Economic Sectors. For the seven months ended July 31, the S&P 500 had an average tech weight of 27%, versus 15% for the Russell Midcap. The Midcap is more diversified by sector weight than the S&P 500 on average in the year-to-date, as shown in the graph below.
Chart 3 – Average Sector Weights, Year-to-Date
Source: Refinitiv Datastream. Data as of 7/31/2023.
Chart 3
Average Sector Weights, Year-to-Date
Source: Refinitiv Datastream. Data as of 07/31/2023.
Quality Shines Through
This is where a focus on “quality” can make a real difference. At Jensen, a stock is considered part of our quality universe if it has consistently delivered at least a 15% return on equity each year for 10 consecutive years. There is no perfect standard for measuring quality, but companies with an S&P Earnings and Dividend Quality Rating of A- or above are as good a proxy as we have found. Screening the Russell Midcap index this way reveals an interesting picture.
Not including 2023, quality mid-cap companies (those rated A- or above) generally kept pace with the broad S&P 500 index over the previous 10 years — and in some cases outperformed the S&P. In 2022, quality mid-caps lost 10.6%, compared to an 18.1% loss for the S&P 500. Over three-, five- and 10-year horizons (to the end of 2022) the results have been mixed, but quality mid-caps were consistently comparable, with positive returns of 7.8%, 9.6% and 12.2%, respectively, compared to 7.7%, 9.4% and 12.6% for the S&P 500.
Admittedly, in 2023 even quality mid-caps have struggled versus their quality large-cap counterparts. Through July 2023, quality mid-caps have returned 11%, while their quality counterparts in the S&P 500 (stocks rated A- or above) delivered 14% and the broader S&P delivered nearly 21%. Again, this was largely attributable to the seven companies disproportionately influencing the S&P 500. We view this as a potential opportunity for mid-cap stocks based on historical comparable performance.
The case for investing in mid-caps can be a difficult one to make with investors who may be drawn to the familiarity and liquidity offered by the larger names. But with the S&P 500 skewed by the fortunes of a small number of mega-cap stocks, we believe investors would be wise to think about increasing their diversification and consider investing in quality mid-cap stocks.
Jensen has offered a mid-cap strategy since 2010. Explore our Quality Value Strategy here.
1 https://www.spglobal.com/spdji/en/documents/index-news-and-announcements/spdji-indexed-asset-survey-2022.pdf. Indexed assets represent assets in institutional funds, ETFs, retail mutual funds and other investable products that seek to replicate or match the performance of the respective index. Benchmarked assets represent assets in actively managed funds where the performance of the active manager is measured against the respective index.
Click here to view a list of the Jensen Quality Value Strategy’s current holdings.
The company discussions in this article are solely intended to illustrate the application of our investment approach and is not to be considered a recommendation by Jensen. Our views expressed herein are subject to change and should not be construed as a recommendation or offer to buy or sell any security and are not designed or intended as a basis or determination for making any investment decision for any security. Our discussions should not be construed as an indication that an investment in a security has been or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of any security discussed herein.
Generally, small- and mid-capitalization companies, and less-seasoned companies, have more potential growth than large-capitalization companies. They also often involve greater risk than large-capitalization companies. Small- and mid-cap companies may not have the management experience, financial resources, product diversification and competitive strengths of large-cap companies. Therefore, their securities tend to be more volatile than the securities of larger, more established companies, making them less liquid than other securities.
Past performance is no guarantee of future results. The information contained herein represents management’s current expectation of how the Jensen Quality Value Strategy will continue to be operated in the near term; however, management’s plans and policies in this respect may change in the future. In particular, (i) policies and approaches to portfolio monitoring, risk management, and asset allocation may change in the future without notice and (ii) economic, market and other conditions could cause the strategy and accounts invested in the strategy to deviate from stated investment objectives, guidelines, and conclusions stated herein.
Certain information contained in this material represents or is based upon forward-looking statements, which can be identified by the use of terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of a client account may differ materially from those reflected or contemplated in such forward-looking statements. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions.
Jensen Investment Management, Inc., is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Although taken from reliable sources, Jensen cannot guarantee the accuracy of the information received from third parties. Indexes are unmanaged. You cannot directly invest in an index.
© 2023 Jensen Investment Management.
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In the current investment climate, the case for quality mid-caps is compelling. We believe high returns on capital, robust balance sheets and profitability are indicative of companies poised for success. Jensen’s Quality Value Strategy offers a path to explore these quality mid-caps.
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