The gaps in performance between different sectors, and the companies within those sectors, increased last year. A major reason is a small group of outperformers that already had massive stock valuations before the COVID-19 crisis and have pulled further ahead since. In this episode of the Inside the Strategy Room podcast, coauthors of a recent article discuss what the performance of capital markets during the pandemic indicates about future economic and investment trends. Tim Koller is a leader in McKinsey’s Strategy & Corporate Finance Practice and the author of the best-selling book, Valuation. Peter Stumpner leads the corporate performance analytics group within the Strategy & Corporate Finance Practice. He is the coauthor of another article on which this podcast is based, “The impact of COVID-19 on capital markets, one year in.” This is an edited transcript of the discussion.
Sean Brown: Peter, in your article you describe the capital markets going through four acts during the first year of the pandemic. Can you walk us through that?
Peter Stumpner: If you go back to 2019, the markets went up significantly and that momentum continued into 2020. The markets peaked on February 19, 2020, when investors started to realize that the pandemic would have a significant impact and the markets started to drop—first gradually, and then rapidly. All sectors sharply declined in the early days of the pandemic (Exhibit 1). A couple of days in early March of last year saw declines of over 10 percent.
In mid to late March, we hit a turning point. After March 23, the markets started to rebound and by June some sectors had recovered and turned positive. Others, however, such as the aerospace and defense industry and the air and travel sectors, continued to be significantly affected by the travel bans and lockdowns. By October, that differentiation became more pronounced. Some sectors declined further between June and October while others had not only recovered but turned significantly positive. A steep decline across the board at the beginning of a crisis is fairly normal, but the recovery was faster than in some previous crises. Also, while most sectors had recovered a year in, the difference between the top- and bottom-performing sectors did not shrink but rather has continued to grow. The difference in performance between consumer durables and aerospace, for example, was bigger this past February than it was at any point before.
Sean Brown: Tim, you have analyzed capital market movements over many decades. Do you see anything else distinctive about the stock market patterns during this crisis?
A steep stock market decline across the board at the beginning of a crisis is fairly normal, but the recovery was faster than in some previous crises.
Tim Koller: We saw a similar pattern in 2008 and 2009, and also in the early 2000s. Bad news about the economy leads retail investors to panic and sell a lot of stocks, but then institutional investors realize that some sectors are undervalued, they start to buy, and the markets come back. The comebacks tend to vary by sector based on how the market expects the crisis to affect each sector. This is why you saw such big differences in sector performance last year.
Sean Brown: Did interest rates have much of an impact on how capital markets reacted? The rates have been exceptionally low and central banks were signaling that they would not raise them in the near term.
Tim Koller: We have been studying the impact of interest rates on valuations and the cost of equity for well over 20 years now. While interest rates obviously affect the cost of corporate borrowing, we have found that they do not affect the cost of equity. Investors demand the same returns regardless of what is happening to interest rates. We saw that during the Great Recession and we see it now. As interest rates go up or down, corporate valuations do not change much. That makes sense because if you are an investor, you don’t want to assume that interest rates will stay low—they could rebound and that would affect valuations. We have a model that reverse engineers share prices and we consistently come up with about 7 percent for the “real” cost of equity. The nominal cost of equity, assuming approximately 2 percent inflation, is about 9 percent.
Sean Brown: Typically, one would talk about the cost of capital as the risk-free rate plus a risk premium. Is that different now because the risk-free rate is going down?
Tim Koller: We used to say that the return on long-term government bonds was the risk-free rate. Now, there is a question about whether the market’s perception of the risk-free rate is the same as the current yield on government bonds because central banks have begun to manipulate those rates.
They have been buying a lot of both government and corporate bonds and pursuing quantitative easing. You also have risk-averse investors moving into government bonds, pushing up prices and lowering rates. We have found that the most logical way to address this is to construct a synthetic risk-free rate based on long-term trends in the risk-free rate, an approach a number of banks and academics use as well. From this, we come to the conclusion that the typical cost of capital for a large company is about 7 percent in real terms. That is why there is a disconnect between the government bond rate and what we used to think of as the risk-free rate.
Sean Brown: What about the effect of surplus cash? There was a lot of cash in the market last year, especially with consumer savings rates rising in many countries.
Tim Koller: That cash is spread among a lot of people, not all of whom are investors. It will be interesting to see what consumers spend that money on and whether they keep it as savings. This does not, however, appear to have affected the stock markets directly. What really matters is companies’ ability to generate cash. If investors believe that consumers will spend more of that cash on certain types of companies, their shares will go up. For example, the travel and leisure sector still has not recovered because consumers may hesitate to spend money on travel for a while.
Sean Brown: Peter, you mentioned there are growing differences in the performance of various industries. Have the gaps widened between companies as well?
Peter Stumpner: Across all industries, we see significant differences between companies on the lower end of the spectrum in terms of shareholder returns and those at the higher end, with the differences being more pronounced in some industries. The reason is that some companies were much more negatively affected by the pandemic than others in their sectors. Entertainment, for example, includes online gaming as well as theme parks or casinos. While online gaming did well last year, casinos and parks did not because of travel bans and lockdowns. The variance is largely due to companies at the top of the distribution pulling ahead. There is a group of companies with very high shareholder returns, which widens the distribution more than particularly low shareholder returns for companies at the bottom.
Sean Brown: In your article, you call the group of companies with extremely high shareholder returns the Mega 25. How did you define them?
Peter Stumpner: When we were doing the research, we realized that a small number of companies accounted for a significant share of the total market capitalization. Our sample included 5,000 companies, which covers most of the market, but 25 of them accounted for 40 percent of the total market cap added between February 19, 2020, and February 19, 2021 (Exhibit 2). So it was important to take them out of the overall sample and treat them with a separate lens.
Sean Brown: Is the performance of these companies a major reason why the stock market did so well last year?
Tim Koller: Yes. There is a disconnect there and part of the reason is the valuation of these Mega 25 companies.
Peter Stumpner: There are some clear patterns in the type of companies included in that group. Almost half of the total market cap was added by North American technology companies. The group with the second-biggest market-cap growth are Chinese and other Asian technology companies, which benefited from similar trends around working from home, digital payments, and online shopping and entertainment. The third-biggest are electric-vehicle companies, followed by the semiconductor industry. Finally, there are a couple of Chinese consumer-goods companies that did very well last year. The Chinese market is slightly different because its recovery from the pandemic happened much faster and sooner. One important point is that we saw trends which were already there accelerate during this crisis and companies that did well before the pandemic did particularly well during the pandemic.
Sean Brown: Given the market capitalization of the Mega 25, should investors worry that those companies may be in a bubble?
Tim Koller: A bubble is when share prices of a company or a sector—and sometimes an entire market—rise to a level out of line with economic fundamentals. Ultimately, all bubbles burst, so you can recognize a bubble after the fact when the share prices come back down. We saw that the 1999 tech boom was a bubble. We have seen bubbles in utility stocks in the US and in biotech. Bubbles usually don’t last more than a couple of years. The question about the Mega 25 is whether the economics can sustain their valuations. If a company is worth $1 trillion or $750 billion, what would you have to believe about its future performance to justify that valuation? Businesses eventually mature and their valuations always come into line with their economics—at least that has always been the case.
Another thing to assess when you are looking for bubbles is who is driving up the share price. Is it retail investors or institutional investors? If it is retail investors, that is more likely to indicate a bubble because it suggests that more sophisticated investors think those stocks are overvalued. That creates bubbles because the markets are not perfectly liquid. If you think a stock is overvalued, it is difficult to bet against that stock. You can short it, but that is very risky because the share price could continue going up for a while, even if you are right. This happened in 1999 and 2000 in tech and it happened in 2008 in the real-estate market. Many people went bankrupt because they could not provide enough capital to maintain their positions long enough to be proven right.
To see what is driving the market, one thing to look at is the weighted average price-earnings [PE] ratio. In the US market, average PE weighted by the market capitalizations of the companies is extremely high now, at a multiple of 23. Interestingly, the median is much lower, at 16. Over time, ignoring some unusual years like 2008, the median has been fairly constant, with the typical large US company trading at a multiple of 13 to 16. Over the past two years, the weighted average deviated substantially from the median, which means that a handful of very large companies are distorting that number. If the cost of equity had gone down, you would expect the median company to be trading at a 25 multiple or higher. This is further evidence that the cost of equity has not changed.
Sean Brown: Considering what you just explained, Tim, does that suggest to you that the Mega 25 have entered bubble territory?
Tim Koller: We have done some back-of-the-envelope calculations on Mega 25 companies and for some, it is hard to imagine them achieving a level of performance far beyond what it is today on a sustainable basis. For example, some of those companies rely primarily on advertising for their revenues and there is a limit to how much an economy can spend on advertising. You either have to believe that advertising as a percentage of the economy will increase, which is highly unlikely, or that these companies will find new sources of revenue. Their valuations are unlikely to be justified by their current core businesses in the future, so you have to believe that they will enter new businesses that will create massive amounts of value. You typically do not see that. In the past, most companies that were very successful in a particular market rarely created as much value in the second or third market they entered. To put it in a nutshell, I am skeptical about the sustainability of these companies’ share prices.
Sean Brown: Unlike past bubbles, these companies are not just speculative investments—they have real earnings and cash flows. Do the winner-take-all scenarios that are emerging in the digital economy play a role in these companies’ valuations?
Tim Koller: Yes, the winner-take-all phenomenon does exist but only in specific markets, such as advertising. Online advertising is becoming a bigger part of total advertising, for example, and it shifts to certain players. But there is a limit to how big the advertising business can be. Secondly, it is not clear that the other businesses these companies will get into will have the same winner-take-all characteristics. Many companies are entering into electric vehicles, but if you look at the history of the automotive industry, it does not have the characteristics of a winner-take-all business. Consumers are willing to switch brands and companies catch up on innovations quickly. Over time, almost all of the value that has been created from innovation in the car industry has flowed to consumers and you would expect that to be the case going forward. If ten or 15 global automobile companies continue to compete vigorously in electric vehicles to the benefit of the consumer, the profit margins can only go so high.
Sean Brown: As central bank easing continues and government bonds potentially become overvalued, is it possible that institutional investors are viewing the Mega 25 as less risky and more attractive from an asset allocation perspective?
Tim Koller: That is conceivable. But if you are an institutional investor, you will be very cautious about a company that is valued so highly, because what matters is what the value is in five years, not what it is now. Chasing trends can be dangerous because you are often behind and you have to be smart enough to know when to get out. I don’t think that is a big driver. I think the Mega 25 are being driven up by retail investors and the institutions are sitting on the sidelines.
Sean Brown: You mentioned earlier the disconnect between the capital markets and the broader economy. Are there reasons other than the Mega 25 that explain why the markets have performed so well even though the economy has been in a deep downturn?
It is hard to imagine the Mega 25 companies achieving a level of performance far beyond what it is today on a sustainable basis.
Tim Koller: Another reason is that the economy and the stock market have different characteristics. The real economy has a lot of activity in sectors with few publicly listed companies. In the US, the real estate and construction sectors for the most part are not made up of public companies. Professional and technical services are the same; so are healthcare services and doctors’ offices. When you look at employment, restaurants and hospitality play a major role, but there are few publicly listed companies in those sectors.
Public companies tend to be concentrated in technology, pharmaceuticals, medical devices, finance, and insurance, and the technology and pharmaceutical companies have done particularly well recently. Additionally, many US technology and pharma companies are effectively exporters: they earn a lot of their profits abroad, which does not directly contribute to US employment, but it does affect their stock market value. The disconnect is not as extreme in other markets.
Sean Brown: Given that stock market composition is different around the world, how have capital markets’ performance varied across regions?
Tim Koller: China is up 40 percent, North America is up 22 percent, Asian markets excluding China have risen 20 percent. Much of this has to do with different compositions of the regional economies and different presence of the Mega 25 companies. For the North American market, the Mega 25 accounted for 8 percent of the total returns to shareholders. Europe does not have many of those high-flying companies and that took 7 percent off their returns last year.
Sean Brown: Institutional investors increasingly focus on environmental, social, and corporate governance [ESG] issues. To what extent do you see ESG affecting the market performance of different sectors and companies in the future?
Tim Koller: Yes, there is an enormous increase in focus on ESG among both institutional and retail investors, but it is not clear yet that they are willing to sacrifice returns and pay a higher price for the shares of companies with high ESG ratings. Right now, there is no empirical evidence linking ESG performance and stock market performance. A lot of studies are very short term oriented and do not adjust for industry.
Part of the problem is that companies with the highest ESG scores tend to be in industries that have been performing strongly, such as tech and pharma. Those sectors also do not have much emissions and tend to be more forward thinking on social issues, so there is more of a correlation than a causation. Oil and gas has gone down in price with the economic decline, but it is hard to tease out the ESG element there. The other problem is that a lot of ESG ratings are contradictory. A company may have a high rating in one company’s index and a low one in another. That said, there are plenty of opportunities to do better from an ESG perspective while also creating value for shareholders.