Small caps: The great divide

Forget the ‘magnificent seven’, it’s the magnificent gap investors need to be watching out for

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The ‘magnificent seven’ drove equity markets last year with supercharged returns, and their market capitalisations grew considerably as a result. This small handful of stocks now dwarfs the rest of the market, opening a unique opportunity for investors, according to some.

On the back of strong performance in 2023, these seven companies alone are worth $13.6trn (£10.7trn), accounting for 29.4% of the S&P 500’s total value of $46.3trn. They outpaced the rest of the market by a considerable distance, leaving a sizable gap between themselves and their peers.

See also: Does the ‘magnificent seven’ tech wobble signal a turning point?

“Investors should focus more on the magnificent gap rather than the magnificent seven,” says Jonas Edholm, lead manager of the Skagen Focus fund. “That might be the more interesting opportunity if you look two to three years out from here. And this gap is only becoming wider as money is drawn into these large mega-cap companies of the world.”

As the magnificent seven swelled in size, the gap between their market caps and the rest of the market has become “wider than it has ever been at any point in time”. But how did the equity market become so top heavy? Edholm credits passive products.

Is bigger better?

Index trackers base their allocations on market capitalisation – the bigger a company is, the bigger a stake it has of a fund’s overall exposure. The MSCI World index tracks the largest 1,479 listed companies in the developed world, yet these seven stocks account for over a fifth (21.8%) of the entire index.

“This concentration risk has yet to unravel,” Edholm explains. “These passive mandates which have become so popular are only investing in companies according to their size. That is the only consideration, so valuation and fundamentals do not have any merit or analysis – there is no analysis.”

“Nonsensical” environmental, social and governance (ESG) screenings used in passive funds have also played a key role in warping market capitalisations. Edholm says the surface-level factors they monitor do not give a pragmatic result, ignoring alarming ESG issues and awarding high ratings to bad companies.

“They own companies that are seemingly ESG stars, but some of these companies are not good from an ESG perspective,” he continues. “Just look at Meta or Apple – many of these companies make our planet a worse place to live.

“We think there are more green transition winners in global small and mid-caps. They can make a real change. You won’t make the world a better place by owning Meta, that’s for sure, even if these ESG databases tell you otherwise.”

Read the rest of this article in the April issue of Portfolio Adviser magazine