In this interview with Capital Compounders, Francois Rochon explains how a few dominant companies, such as Amazon, Apple, Microsoft, and Nvidia, have driven the S&P 500’s performance in recent years. Their strong growth increases their weight in the index, leading more investors to favor indexing, which amplifies their dominance.
However, Rochon warns of the risks of overpaying for even the best companies, citing the early 2000s tech bubble as a cautionary example. He highlights Cisco Systems, whose high P/E ratio in 2000 limited long-term returns despite solid earnings growth. Rochon highlights the challenges of sustaining high growth rates for large-cap companies due to the law of large numbers.
Here’s an excerpt from the interview:
Rochon: It’s the second time I’ve experienced that mostly as an observer, and, uh, it’s really what happens is, um, a few big holdings in the S&P 500 do very well—let’s say Amazon, Apple, Microsoft, and Nvidia more recently—and they do very, very well for good reasons.
But at some point, it gets a little pricey. Yet they continue to do well and become large weights in the index. All the managers that don’t have those securities in the portfolio, they’ll underperform.
By underperforming, they’ll lose some clients that will want to favor the index, which has beaten most managers in recent years. And they’ll continue by just going into indexing. They’ll continue to purchase a large weight in the index.
And here is the waltz: the more they buy the index, the more the large weight goes up. And the more it goes up, the, uh, many more managers underperform and lose clients to indexing.
So, it can last quite a long while—and, uh, it has in the last few years. It really resembles the early 2000s. There were different names back then, like Cisco Systems or General Electric. But, uh, it’s similar in the way that the process is going on.
And if you go back to 2000—I mean, Cisco Systems was an extraordinary company, and we owned it for a while, I think from ’97 to ’99. And, um, at some point—I think the height of 2000—the stock traded at 80 times earnings.
If you look at the stock today, I’m not sure it’s even gone back to the peak of 2000 because, today, the P/E ratio is probably 14 or 15 times. It’s been a great company.
Cisco is an outstanding company, and they probably grew earnings by, I don’t know, 9 or 10% a year—which is very good over 20 odd years. But the P/E ratio was so high that it limited the upside.
And in this case, uh, it turned out that it was, uh, you know, low return for many decades. So there’s a danger of overpaying for even the greatest companies.
The law of large numbers makes it, at some point, much harder to compound at 15% per year. You need another trillion of market cap addition in the next five years to justify 15% growth.
So, when it trades at 30, 35, 40 times earnings, I mean, the street expects high growth rates. And at some point, it’s going to be just impossible to continue at those high rates. But so far, they’ve been incredible performers.
So, the waltz has continued.
You can watch the entire interview here:
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
