Week 21 Day 2: Large Caps: The Compounding Machines

Large-cap stocks (companies worth over $10 billion) are the blue chips of the market. They dominate their industries, generate enormous cash flows, and have survived multiple recessions. They grow more slowly than small caps but with far more consistency. The S&P 500 is overwhelmingly large-cap stocks.

The case for large-cap dominance: (1) Network effects and moats: Google handles 90% of searches. Visa processes 65% of card transactions. These monopolistic positions create durable competitive advantages that compound over decades. (2) Global diversification: S&P 500 companies derive approximately 40% of revenue from outside the U.S. -- buying U.S. large caps gives you built-in international exposure. (3) Financial resilience: large companies have access to capital markets, cash reserves, and credit lines that help them survive downturns. In 2020, while small businesses closed, Amazon hired 400,000 workers. (4) Consistent returns with lower volatility: the S&P 500's standard deviation is about 15% annually versus 20% for small caps. Same direction, smoother ride. Since 2010, large caps have dominated partly due to the rise of mega-cap technology companies. The top 10 S&P 500 stocks (Magnificent Seven plus Berkshire Hathaway, UnitedHealth, and Eli Lilly) represent about 35% of the index. This concentration is unusual but reflects the genuine economic dominance of these companies.

The concentration of the S&P 500 in mega-cap technology stocks has reignited the debate about cap-weighted versus equal-weighted indices. The Herfindahl-Hirschman Index (HHI) of the S&P 500 reached levels in 2024 last seen during the Nifty Fifty era (early 1970s), which preceded a decade of underperformance for the largest stocks. However, today's mega-caps are fundamentally different: Apple, Microsoft, Google, and Amazon have profit margins of 25-40%, massive free cash flow generation, low debt, and genuine global competitive moats. The Nifty Fifty included companies like Polaroid and Xerox whose moats proved temporary. Research by Bessembinder (2018) showed that just 4% of publicly traded stocks account for ALL net stock market wealth creation since 1926. The remaining 96% collectively matched Treasury bills. This extreme positive skew means that owning all stocks (including the rare mega-winners) is critical, and concentration in genuine compounding machines may be less dangerous than historical analogy suggests. The counter-evidence: Arnott, Kalesnik, and Tindall (2013) showed that 'yesterday's winners' (the largest stocks by market cap) subsequently underperform equal-weighted portfolios by approximately 2% annually, suggesting mean reversion in relative size. The optimal approach likely involves holding the market-cap-weighted index as a core (capturing mega-cap compounders) with a modest tilt toward small-cap value (capturing the factor premium).