You can learn a lot about a large-cap value product just by looking at the average market cap of the portfolio. While the category may be called large-cap value, there is an inherent conflict in trying to be both large-cap and value. Few of the largest stocks are cheap, and the cheapest stocks mostly fall toward the smaller end of the large-cap universe. So, if a large-cap value product has an average market cap over $50 or $100 billion, it is likely compromising value for the sake of market cap.
Indices are typically capitalization weighted, and thus for a large-cap manager there is a strong incentive to own the largest stocks that have the highest weights in the benchmark. The problem is that as a large-cap value manager, there is not a lot of value among the largest stocks.
Our investment universe is the top 1,000 U.S. stocks. Within that universe, the top 100 largest stocks are only 10% of the constituents, but make up a disproportionate 64% of the market cap.
As of September 30, 2024, the largest stock in our universe was Apple, with a market cap of over $3.5 trillion. NVDIA and Microsoft were also above the $3 trillion mark. Amazon was around $2 trillion, and Meta and Alphabet were over $1 trillion. While very large in capitalization, none of these appear to be value stocks. The forward P/E of this group averaged 28.5x with a range of Alphabet at 20.5x to NVDIA at 36.3x.
As we go further down the market cap range and look at the rest of the top 100 stocks, we find that value remains scarce. In fact, only nine stocks in the top 100 ranked in the cheapest quintile of the full 1,000 stock universe. Three were giant banks (Bank of America, Wells Fargo, and Citigroup), three were communication utilities (Verizon, Comcast and AT&T), two were pharma giants (Pfizer and Bristol-Myers), and one was a memory chip producer (Micron). All appear to be either complex and opaque or low growth, or both. If you favor quality growth and analyzability, as we do at Lyrical, these are not the value stocks you want to own.
Furthermore, the market cap of the 100th largest stock was just under $100 billion. Therefore, if you want your portfolio to have a very large average market cap like $50 or $100 billion, you really need to own stocks in the top 100. But, as we just covered, there are few value stocks in the top 100 to choose from, and they are of questionable attractiveness. There are no solutions to being very large cap and value, only tradeoffs.
The tradeoff between market cap and value extends beyond the top 100. We have divided our universe of the top 1,000 U.S. stocks into five quintiles by forward P/E and calculated the average market cap of each. When we do this, the connection between cheaper valuation and smaller market cap is obvious.
The cheapest valuation quintile includes stocks with a forward P/E of 12.6x or less. These 200 stocks have an average market cap of $25 billion, which is dramatically smaller than the average market cap of most of the other valuation quintiles, and less than half the $55 billion average market cap of the top 1,000 stocks.
As you sacrifice value and move to pricier stocks, the average market cap increases dramatically. The second cheapest quintile, which includes stocks with a forward P/E between 12.6x and 18.5x, has an average market cap of $43 billion, which is 68% larger than the cheapest quintile.
Moving out of the cheap quintiles into the median quintile increases the average market cap even more. The median quintile includes stocks with a forward P/E between 18.5x and 25.0x. These stocks have an average market cap of $58 billion, about in line with the average market cap of the universe and 131% larger than the cheapest quintile.
Pricey stocks have an even greater average market cap. The second priciest quintile includes stocks with a forward P/E between 25.0x and 36.5x, and has an average market cap of $114 billion, which is more than double the average of the universe and 353% larger than the cheapest quintile.
The priciest quintile breaks the trend of higher P/E stocks having larger average market caps. Note that this quintile includes stocks with a forward P/E over 36.5x and the stocks with negative earnings. Thus, it is a mix of both expensive growth stocks and deep value stocks with severely depressed earnings. This mixture may explain its lower average market cap. Still, the average for this quintile is $37 billion, which is 46% larger than the cheapest quintile.
You can own the cheapest stocks, or you can own the largest, but there is not much opportunity to do both. You must choose to prioritize one or the other.
For us, the decision is clear. We believe that value drives long-term returns, while market cap does not, and therefore we prioritize value. Other products in the value category do not necessarily share our priorities, and they are easy to spot. If you see a value product with a very large average market cap, you can be pretty sure that valuation is not their top priority.