Large Cap Domestic Stock Asset Class

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When it comes to investing, most people think of this as “The Market” – the market they talk about on the financial news. This market, the Large Cap Stock market, is the most common asset class people invest in. We talk a lot about diversifying away from “The Market” since it can be like a roller coaster, but we still think every portfolio should have included the Large Cap Asset Class. Investing in large-cap stocks is an essential part of a well-diversified investment strategy. The companies in this asset class are often well-established and have a track record of stability and consistent performance.

The S&P 500 index, on which many index funds are based, is “capitalization” weighted. In other words, a stock representation within the Index is based on the total outstanding value of all the shares of that company calculated as follows:

Market Capitalization = Outstanding Shares x Stock Price

Example:   5,000,000         x     $20           = $100,000,000 (size of the company)

Though a moving target since these numbers change right now, the definition of large-cap stocks is as follows:

  • mega-cap: market value of $200 billion or more;
  • large-cap: market value between $10 billion and $200 billion;
  • mid-cap: market value between $2 billion and $10 billion;
  • small-cap: market value between $250 million and $2 billion;
  • micro-cap: market value of less than $250 million.

The large-cap asset class is indeed an essential component of a diversified portfolio. Large-cap stocks represent shares of well-established, financially stable companies with a significant market capitalization. Including large-cap stocks in a portfolio can offer several advantages:

  • Stability: Large-cap companies tend to be more stable and less volatile than smaller companies, which can help reduce overall portfolio risk.
  • Dividend Income: Many large-cap companies pay regular dividends, providing investors with a potential income source.
  • Liquidity: Large-cap stocks are often more liquid, making buying and selling shares easier without significant price fluctuations.
  • Market Leadership: These companies often have a leading position in their industries, which can translate into long-term growth potential.
  • Diversification: Adding large-cap stocks to a portfolio can diversify risk by complementing other asset classes like small-cap and mid-cap stocks, bonds, and alternative investments.

Unfortunately, indices based on market capitalization have two issues:

  • They can become overweighted to a small number of giant companies
  • The large companies within the Index can become richly valued.

We prefer well-diversified indices and those that lean towards companies not priced so high (value) for those two reasons. Here are the holdings we use:

Exposure to US Large Cap Stock

RSP – Equal Weight S&P 500: The Invesco S&P 500® Equal Weight ETF (Fund) is based on the S&P 500® Equal Weight Index (Index). The Fund will invest at least 90% of its total assets in securities that comprise the Index. The Index equally weights the stocks in the S&P 500® Index. The Fund and the Index are rebalanced quarterly.

RWL — The Invesco S&P 500 Revenue ETF (Fund) is based on the S&P 500® Revenue-Weighted Index (Index). The Fund will invest at least 90% of its total assets in securities that comprise the Index. The Index is constructed using a rules-based approach that re-weights securities of the S&P 500® Index according to the revenue earned by the companies, with a maximum of 5% per company weighting. The Fund and Index are rebalanced quarterly.

COWZ – Pacer US Cash Cows 100: A strategy-driven exchange-traded fund that aims to provide capital appreciation over time by screening the Russell 1000 for the top 100 companies based on free cash flow yield. Free cash flow is the cash remaining after a company has paid expenses, interest, taxes, and long-term investments. It can be used to buy back stock, pay dividends, or participate in mergers and acquisitions.

SDY —  The SPDR® S&P® Dividend ETF seeks to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P® High Yield Dividend AristocratsTM Index (the “Index”). The Index screens for companies that have consistently increased their dividend for at least 20 consecutive years and weight the stocks by yield. Due to the index screen for 20 years of consecutively raising dividends, stocks included in the Index have both capital growth and dividend income characteristics, as opposed to stocks that are pure yield.

SPY – The S&P 500 is a market-capitalization-weighted index. Larger companies have a more substantial influence on the Index’s performance. Companies with higher market capitalizations carry more weight regardless of their financial health or performance.

We lean towards value and broad diversification instead of the high concentration within the S&P 500 index.

The chart below shows how concentrated the S&P 500 index is in comparison to the ETFs we use for this asset class:

Over 30% of the S&P 500 index is in 10 stocks. Because those ten stocks are so richly valued, the price-to-earnings ratio (P/E Ratio) for the S&P 500 index is also elevated, as shown below:

Our holdings have lower average P/E ratios because they are not as highly concentrated towards those ten wildly overvalued stocks, and our holdings lean towards value. In other words, they seek to weigh their portfolios more heavily towards companies that are not richly valued. They generate a lot of cash in relation to their book value or the total value of all their tangible (real estate, etc.) and intangible (patents, intellectual property) assets. One of our holdings, the Pacer US Cash Cows 100 ETF, only includes the top 100 companies for free cash flow compared to their “intrinsic” value, which includes tangible and intangible assets.

What Is Free Cash Flow (FCF)?

Free cash flow (FCF) represents a company’s cash generated after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.

The chart below shows our holdings’ average price of the stock they own compared to free cash flow:

Why do We Lean Towards Value?

Historically, Value stocks have provided returns higher than growth stocks. The chart below shows the performance of value vs. growth stocks over history.

Though the large-cap asset class is an integral part of a balanced portfolio, it’s essential to remember that the specific allocation to large-cap stocks should align with your overall financial goals, risk tolerance, and time horizon. Diversification across various asset classes is crucial in building a well-rounded and balanced investment portfolio. Please ask if you have more detailed questions or need guidance on portfolio allocation.