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**A discussion on index concentration and valuations**

A topic which has gained prominence within fund management circles recently is the ever-rising concentration of the S&P500 index in a “few big winners” and, equally, the extent of divergence of valuations between the market capitalization weighted index and its equally weighted peer. This is shown in the chart below, which shows a 10-year time series of the forward P/E multiple of the two and highlights how a persistently large gap in forward multiples has emerged in the second five-year period. Furthermore, it appears the gap is getting wider too. The key question for investors is: does this have information value, and does it highlight greater riskiness for the headline index?

**Figure 1: SPY ETF forward P/E vs RSP (equal-weighted S&P500) forward P/E**

The above divergence in valuations has also resulted in dramatic underperformance of the equally weighted index versus the cap weighted S&P500 index, with the relative performance now at levels last seen during the 2008 global financial crisis. Does this pose an opportunity (or risk, depending on one’s perspective)?

**Figure 2: S&P equal weighted index (RSP) relative to S&P500 (SPY) – price performance **

Firstly, the disparity in valuations essentially means that the largest weighted stocks in the index must, in aggregate, have a forward multiple that is persistently higher than the average of the index constituents in question.

To begin, below is a list of the 15 largest index constituents of the S&P500 (SPY ETF) today, together with their respective estimated forward P/E multiples:

**Figure 2: Top 15 largest index constituents: S&P500 **

Note: we count Alphabet as one company, despite it having two inclusions in the index (GOOG & GOOGL) collectively comprising a 4.4% index weight. Data as at 10^{th} July 2024.

The key points from the above table are:

- The top 15 companies in the S&P500 today account for
**43% of the index market cap**. - The
**weighted average forward P/E of the top 15 companies is 31x.**

The remaining 485 companies in the index collectively trade at a weighted average forward P/E of 18.5x.

So, it is clearly this top cohort of stocks that contributes disproportionately to the large gap between the equal weighted S&P500 and the cap weighted index’s valuation multiples.

In the chart below, we show a 10-year time series of the forward P/E multiple of some of the more notable companies in the current top 15, and can make some general observations:

- Tesla was not an S&P500 constituent prior to 2020, having joined in late December 2020 at an initial index weighting of <0.3%. Today, it accounts for 1.5% of the S&P500. While a relatively small weighting, its forward multiple is high at 94x and has consistently traded at a substantial premium to the overall index since its inclusion. Thus, it is now an accretive contributor to the cap weighted index’s forward P/E.
- For most of the 5 years prior to 2020,
**Apple traded at a substantial***discount***to the S&P500**, while today it trades at a c.35% premium on a 12-month forward basis. This explains a meaningful proportion of the index’s cap-weighted premium vs. equal weighted which has opened up in the past few years. **Nvidia is the single largest contributor to the S&P500’s cap weighted premium rating versus the equal weighted counterpart**, with the stock both: 1) very highly rated at a forward 46x P/E; 2) a very large index component at 7%. Notably, Nvidia has typically been a much higher rated stock than the aggregate index, but it wasn’t always such a large index component, so the influence was limited.**Meta & Alphabet’s***relative***ratings have shrunk over the past five years**(i.e. lower premium versus the S&P500 vs pre-2020) and they have long been fairly important index components. As a result, they wouldn’t be responsible for the large gap that has opened in the cap weighted index valuation versus the equal weighted index.

**Figure 3: 12-month forward P/E histories of the “heavy weights” versus S&P500**

In the table below, we distill the impact of excluding each stock discussed above and, for each instance, recalculate what the index’s forward P/E would be if that stock’s weighting was reallocated proportionately to the remaining index constituents. In so doing, we can isolate the impact on the index forward P/E from each company. As shown below, if we excluded these companies, the remaining companies, if treated as an index, would trade at a forward 20x P/E versus the 22.5x of the S&P500.

**Figure 4: Five companies account for roughly half the gap between the S&P500 cap weighted forward P/E and equal weighted forward P/E**

It is clear from the above, however, that it’s not just about the top tier of companies which are skewing the index valuation higher versus its equally weighted peer – this upward “size vs. multiple” bias extends further down the index food chain. In the table below, we’ve stratified the S&P500 (or SPY ETF as proxy) into 1) the top 10 companies by market value and 2) each respective next 100 largest companies, together with the bottom cohort of companies. For each cohort, we show the *simple average* of revenue and EPS growth rates on a two-year forward estimated basis (per Koyfin consensus), as well as the averages of forward P/Es for each cohort. Note that due to index construction methodologies, readers should not equate the average earnings growth rates with that of index-level earnings growth. What is notable is that there is a direct relationship between size of index constituent and growth, as well as valuation.

What an equal-weighted index would be doing is allocating the same proportionate weight to the 38% of the cap weighted index with companies averaging 29% earnings growth to the remaining companies with growth rates in the teens. **It is perhaps no wonder that a valuation gap has opened up: the largest businesses in the world happen to be the fastest growing ones too!**

**Figure 5: S&P500 index: average revenue and profit growth, 12-month forward P/Es by size cohort**

*Source: Koyfin data, Omba calculations*

**Conclusion**

The valuation gap between the S&P500 and its equally weighted peer is historically high today, and is a function of its largest components, in aggregate, delivering the strongest anticipated earnings growth. As a result, they are afforded a – arguably well-justified – premium rating. Nvidia is the poster-child of this phenomenon for this cycle: when last did we have a $3 trillion company delivering year on year EPS growth of >400% year on year? Never.

By choosing to invest in the equal weighted S&P500 over its cap weighted peer today is to effectively short earnings momentum and the size factor, in favour of a relative value argument. Implicit in this trade would be an embedded assumption that the growth *differential* which these companies are enjoying versus their smaller index peers will not persist for long. Thus, the risk to staying long the cap-weighted index, is that the forward estimated earnings of these larger companies disappoint and the tail of smaller ones, which have less growth priced in, surprise to the upside.

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