A Quick Peek at the Russell Large Cap Growth Index

Understandably smitten with low fees and a long bull market, index fund promoters appear to have the data on their side.  A collection of financial heretics, the authors of this investment newsletter have highlighted what we believe are the defects endemic to index funds today.  In the interest of simplicity, we have used single factors to highlight just how these popular and heavily promoted products are ripe for disaster.

In our piece Tesla PS Ratio & the Coming Tax on Index Fund Owners, we explained the nonsense in large cap core funds. In Vanguard Small Cap Index Fund: The Myth of Low Cost Indexing, we highlighted how investors were exposing themselves to needless financial losses.  Both pieces relied entirely on empirical evidence.

The conclusions were drawn from historical evidence and not predicated on forecasts.  We are in the moneyball business, not the crystal ball business.  You don’t need a Ph.D. to understand the problems we highlighted.

Contrary to what you may have heard: there are numerous providers of low-cost, tax efficient, and high-quality active managers who can help you avoid the empirical failures that have, in our view, taken index funds too far.

So, today’s task is to tackle the Russell 1000 Growth Index Fund complex.  This will be one of the most simple, straightforward, and empirically obvious things you’ve read this week.  Here it is in one chart:

The top 30 names in Russell Large Cap Growth Index Funds make up ~65% of the index weight.

Index Weight of the Largest 30 Firms in the R1000G
How simple is this?  Those 30 stocks have been driving the bus since 2011.  Big getting bigger.                                   Let’s review the problem with growth stock index funds in a few bullets:

  • When you buy an R1000G index fund, you are putting nearly 2/3rd of your money into just 30 stocks
  • It is very tough for that index to make you money if those 30 stocks don’t keep going up
  • In theory, the 30 largest names could just keep getting bigger and drive the R1000G higher
  • When you buy a passive large-cap growth index fund that is effectively the “bet” you are making
  • KCR believes the historical data is clear: that is not a bet you want to make

Investors have shown some newfound interest in large-cap growth stocks.  Understandable.  They’ve sold off.

But how much?  The chart below divides the market cap of the 30 largest growth stocks by GDP.  These companies have indeed fallen….to where they were at the peak of the dot.com bubble.  That is sheer madness.

Does it make sense to have 30 stocks in the United States valued at half the country’s GDP?  It has never made sense before.  Maybe it is different this time, but we doubt it.

Market Cap to GDP of the Largest 30 Firms 

Note: we have faced intermittent pushback on the Buffett market cap to GDP metric.  Please see our notes at the bottom for more information on why we believe the method is so powerful.

Summarily:

  • The large-cap growth indexes have concentration levels in the top 30 weighted stocks last seen at the peak of the dot.com bubble
  • The last time we got here, the weight of those supersized firms would subsequently implode
  • Despite recent declines, the 30 largest stocks are at the same valuation that the 30 largest stocks were at the peak of the dot.com bubble when scaled by GDP

SO, WHAT DOES HISTORY TELL US?

The prior peak in concentration was on March 31, 2001.  We looked at the performance of the 30 largest stocks over the next six years.  The chart below shows the results.

Nearly 80% of the top 30 experienced losses on an absolute basis over six years.  Only one stock, Cisco, was able to generate returns of ~10% a year (right-most bar, +60% over 6 years).   Ask yourself: do you want to play this game?

6 Year Forward Absolute Returns From Last Concentration Peak

KCR understands the importance of diversification, index funds, and avoiding trying to time markets.  An allocation to a large-cap growth fund is a component of any portfolio.  But like our work on small-cap and large-cap core index funds, this quick study of the Russell 1000 Growth index exposes a massive flaw in portfolio construction.

Fortunately, this flaw can be easily remedied by a low-cost, evidence-based active manager with a lick of common sense. The table below compares the largest 30 growth stocks in the index to the top 30 ranked growth stocks in our Large Cap ranking model.

What’s remarkable comparing the two rows is that despite trading at a significant discount to the 30 largest stocks, our growth picks offer identical net profit margins, a 2% kicker on total yield (6% vs. 4%), and faster earnings growth.  Pay less. Get more.  

For a list of our top picks, please see at the bottom of this page or login below.

NOTES on Market Cap to GDP:

That pushback flies in the face of the statistical evidence and requires a belief that it is “different this time.”  We wholeheartedly respect that people will hold opinions that conflict with our own.

To see the statistical data that supports the metric’s validity, we encourage you to read The Buffett Valuation Metric, The Costliest Stocks: A Lifetime Earnings Analysis, or the ultra-brief Warren Buffett’s Market Cap to GDP piece.

Our work, Economic Cycles and Means Reversion, explains why globalization and the highest margins in 100 years have done nothing to diminish the importance of this metric.  If you’d like to hop on the phone and discuss, please let us know.

KCR Top 30 Ranked Growth Stocks

R1000G fundamental panel

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for a simple, concentrated, low turnover, and hard-hitting GARP investing strategy, we would like to talk with you.  Similarly, if you are looking for a model portfolio of the most proven and durable dividend payers that is simple to implement, please let us know.  KCR also offers a wide range of easy-to-use but sophisticated tools like our Equity Duration product, which allows you to estimate a given portfolio’s interest rate and inflation risk. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.

Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seek independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling, or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as a result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

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November 4, 2022 |

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