A look at the shrinking U.S. large cap universe

[Bill Nygren] What we are finding today is that many large businesses are being classified as mid cap stocks and that reduces the opportunity that investors have to add value from stock selection. We want to talk about how we've confronted that at Oakmark, what we think the challenges are for the rest of the industry. So, let's get into it.

What is a large cap stock?

For the mutual fund side of our business, Morningstar is probably the most important arbiter of style, and that includes both value versus growth, and also what size companies people invest in. And we think Morningstar’s approach is a very logical sensible approach to how to define the universe, and we want to make sure that this isn't viewed as any criticism of their methodology.

But what Morningstar does is they start with the largest cap stocks and then move down the list until they get to forty percent of a country's total market capitalization. Today in the U.S., that means you start with companies like Apple and NVIDIA, you go down to a company like Netflix, which is the twentieth largest, and in those 20 companies, you've got 40 percent of the market cap. Then you take the next 30 percent, and that would be called large. 

That, that incorporates another 137 companies. So, we've got roughly 157 companies that are called either large or giant, and then they have further breakdowns for mid-caps, small-cap, and micro-cap, and when you look at all of them together, that addresses the Russell 3000.

Because of the very strong performance of mega caps, we've seen a radical increase in the cutoffs between these market capitalizations. 

So, the green line represents giant cap stocks, and to be giant four years ago, or 2022, you had to be about 150 billion dollars. Today, that number is almost 400 billion. Five years ago, the cutoff for a large cap was 22 billion. Today it's 68. 

And, we think people haven't thought through the repercussions of what this does to portfolios and portfolio construction. I mean, most of us just don't think of a 10 billion dollar company today as a small-cap stock, but that's how it's defined by Morningstar.

We're looking at - through the life of the Oakmark Fund - how the large cap universe, the size of the large cap universe has changed. When we started, there were about 250 companies that qualified as large cap, and that went up to a little over 300, and, in fact, over the 30-some years that Oakmark has been an existence, the average in the large cap universe has been 265. 

We were above that level as recently as 2021, but you can see that number has now fallen to 167. And that matches where we were at the peak of the internet bubble in the year 2000. Now somebody submitted a question that is probably worth addressing here saying, “Isn't this just what's going on across the whole public investment space? Haven't we seen a significant decline in just the total number of public equities?” And while that's true, you know, 25 years ago, there were about 8,000 public companies in the US. Now, there are a little over 4,000.

So you could say the entire investable universe has been cut in half. Our focus is just on the Russell 3000 here. So, what you've really seen is a very large reduction in micro-cap stocks that has nothing to do with what we're looking at today of the changing mix between giant, large, mid cap, and small cap.

If we look into the various style boxes, what does it actually mean to see such a big reduction in large caps? So, in the large cap value space, there are 68 names today. Sixty-two in blend and only 22 in large growth.

So what does that mean to a portfolio manager who's trying to stay with stay in their lane in the large growth category for Morningstar? If that manager today has 54 stocks on average in their portfolio, which is more than two and a half times the number that are actually classified as large growth. Forty percent of the stocks in their portfolio today could be classified as large growth if they owned all of them, and that's not even giving them room to say they want to exclude some stocks they think are less attractive from their portfolios. 

The problem isn't quite as dire in the large blend or large value categories, but in both those categories, the average portfolio has more holdings than there are names in the style box. And you see what that's doing to active share. It makes it much harder to construct a portfolio today that's different than the style, and that's why you see so many advisors today moving to value factors or growth factors in the large space, rather than using active managers. The large growth active share, relative to large growth style, is down to about a 50 percent ratio. So that means the active management fee you're paying really only applies to half the portfolio. So, managers have to do something different today than they were doing five years ago.

Either they're running a riskier portfolio because it's more concentrated, they're delivering less active share because the opportunity set isn't there, or they're buying more names outside of their style boxes. 

[Bill Nygren] You know, in 2000, twenty-five years ago, names that we owned were getting crowded out of the large cap universe because of what we thought was insanely high value valuations on smaller technology companies. That's different than the problem we face today.

Today, our holdings are getting crowded out because of the very high success that mega-cap companies have had. It's not so much that the valuations are crazy, but their share of corporate earnings has just grown dramatically. And we're not sounding an alarm bell on the valuation levels for these companies. But what the risk that we do want to point out is just how much more concentrated the index has become, the large value space, and even the large growth space has become, because big businesses are getting crowded out of the large cap universe. And I'll hand it off to Mike to talk about what that means to us at Harris Oakmark.

[Mike Nicolas] Thanks Bill. It's important to make the distinction between a fundamentally big business and a big market value as Bill mentioned, and when we think of defining large at Oakmark, we really are thinking about fundamental characteristics that, that help us kind of quantify or measure the actual size of the underlying company. 

And for reasons as we, that we discussed earlier is that, you know, investors prefer mutual funds that focus on larger companies as they perceive them to be less risky investments. And there's a reason for that, you know, larger businesses tend to benefit from being large, from their scale, from their market leadership, certainly relative to smaller competitors. They can be better positioned to absorb down cycles and tend to have a higher capacity to invest in their business. They usually have better access to capital and balance sheet strength. They tend to have really long track records that we can study to know how they're performed throughout various business cycles, which really helps us inform our own view views and build conviction into our own future projections of these companies. 

You know, sometimes we'll encounter a young, small underlying business that will have an enormous market cap due to the expectation that a younger company will grow at a super normal rate for far into the future. In other words, they trade for very big multiples today, but they don't have a very big earnings space. And you know, this type of business has a much, much different risk profile than is typically associated with a large underlying company, which is really what we're, we're trying to focus on. 

Bill referenced our experience during the two timeframes when several small businesses with big market caps crowded out our large company holdings that it created the appearance that that we were a mid-cap fund, even though we weren't doing anything differently. 

We saw shades of this during Covid as well, and even wrote about some of the excessive optimism we saw in areas like video conferencing where the perceived market leader once had a hundred- and seventy-billion-dollar market cap on a base business that was generating under a billion dollars of operating profit. So we really tried to avoid that risk by focusing on large U.S.-based businesses as measured by fundamental metrics, not market value. 

Now, so what are some of these, some of these criteria that we use to define a large business? You know, we're primarily focused on businesses that rank within the top 250 or more of revenue operating income or shareholders equity or book value.

With just a few exceptions today, the names in the Oakmark Fund, qualify on at least one of these measures. And if you look at the Venn diagram on this slide, you can see there are 383 companies that qualify on at least one of these metrics in the U.S. And for us, that's our opportunity set for the Oakmark Fund.

There are 137 of these names that meet all three criteria, and most of the names meet at least two, you know, big businesses tend to be big across the spectrum. So instead of exclusively fishing for new ideas in a specific style box like, like large cap value, we have a very different definition of our opportunity set and as a result, a much broader universe from which to choose from. And, you know, although our funds may look less large cap today, similar to what happened during Covid and even during the 2000 timeframe, we're doing the same thing we did during those periods. And every year since, we're buying big businesses at what we believe to be bargain prices.