Theme and Background
This chapter examines whether large-cap stocks are truly less risky than small-cap stocks. The report points out that the current composition of large-cap stocks (the 250 stocks with the highest market capitalization) is undergoing structural changes: many companies with relatively small business scales are entering the large-cap category due to high valuations, while genuinely large enterprises are being pushed out. This phenomenon distorts the traditional perception that "large-cap equals low risk."
Core Argument
The author's central thesis is: The risk level of large-cap stocks should not be determined by market capitalization, but rather by their business scale (sales, net profit, shareholders' equity). The current market classifies small companies with high valuations as large-cap stocks, which actually amplifies risk—the inherent uncertainty of small businesses is compounded by the fragility of high valuations. The counterintuitive conclusion is: Many traditional large enterprises with market caps below $100 billion (e.g., Wells Fargo) are safer and offer higher expected returns than high-valuation stocks like Zoom, which have market caps exceeding $100 billion.
Key Arguments and Data
1. Changes in Large-Cap Composition:
- Over the past year, the median sales of the 40 newly added large-cap stocks were only $2.4 billion, while the median sales of the stocks that exited were $14 billion (only 2 exiting companies had sales below $2.4 billion).
- The median price-to-sales ratio of newly added large-cap stocks was as high as 13x, compared to just 1.4x for exiting stocks.
- Companies pushed out of the large-cap category include: Schlumberger, Phillips 66, Southwest Airlines, Dollar Tree; new entrants include: Square, Splunk, Snap.
2. Zoom vs. Wells Fargo Comparison:
- Zoom has a market cap of $134 billion, a price-to-sales ratio of nearly 100x, and sales of only $1 billion, facing fierce competition from giants like Cisco Webex, Microsoft Teams, and Google Meet.
- Wells Fargo has a market cap below $100 billion (about three-quarters of Zoom's), but as one of the three largest retail banks in the U.S. (alongside Bank of America and JPMorgan), its business demand is tied to GDP growth, and its market share has been expanding over the past decade.
- Historical tangible return on equity (ROTE) for bank stocks is in the low to mid-teens, and both Wells Fargo and Bank of America currently trade at single-digit P/E ratios (7-8x pre-pandemic earnings). The author believes their fair P/E ratios should be at least 50% higher (reverting to long-term averages).
3. Historical Comparison of Valuation Extremes:
- Empirical Research data shows that over the past 70 years (excluding the 1999 internet bubble), the P/E ratio of high-growth stocks was typically 2-3 times that of the lowest-P/E stocks.
- In 1999, this ratio surged to 9x, and it is now approaching 10x again, an extreme level.
- Of the 40 stocks pushed out of the large-cap category over the past year, 35 met the criteria for "large enterprises" (based on sales, profit, or book value); among the 40 new entrants, only 9 met the criteria.
| Metric |
New Large-Cap Stocks |
Exiting Large-Cap Stocks |
| Median Sales |
$2.4 billion |
$14 billion |
| Median Price-to-Sales Ratio |
13x |
1.4x |
| Proportion Meeting "Large Enterprise" Criteria |
22.5% (9/40) |
87.5% (35/40) |
Companies/Assets Involved
- Zoom Video Communications: Bearish. Market cap of $134 billion but small business scale ($1 billion in sales), intense competition, and extremely high future uncertainty.
- Wells Fargo: Bullish. Market cap below $100 billion, but as one of the three largest U.S. retail banks, its business is highly predictable. Currently trading at a single-digit P/E ratio, with expected returns higher than high-valuation large-cap stocks.
- Bank of America: Bullish (also held by Oakmark). Same logic as Wells Fargo, benefiting from economies of scale and expectations of rising interest rates.
- AIG International, EOG Resources, Hilton Worldwide: Mentioned as holdings in the Oakmark Select Fund that transitioned from mid-cap to large-cap due to declining market caps, but no explicit bullish/bearish stance is stated.
Investment Implications
- Beware of "Pseudo Large-Cap Stocks": Investors should distinguish between market capitalization and business scale. Currently, high-valuation small-cap stocks (e.g., Zoom) are classified as large-cap, amplifying risk (small business risk + high valuation risk) and should be avoided.
- Focus on Undervalued Traditional Large Enterprises: Low-valuation, large-scale companies like banks (e.g., Wells Fargo, Bank of America) currently trade at P/E ratios of only 7-8x, far below historical averages. Rising interest rates will further boost earnings. The author believes these stocks carry lower risk and offer higher expected returns.
- Capitalize on Valuation Extremes: The current P/E ratio of high-growth stocks relative to low-valuation stocks (approximately 10x) is near the level seen during the 1999 internet bubble. Mean reversion could lead to a revaluation of value stocks. When buying, the Oakmark fund places greater emphasis on business scale (sales, profit, book value) rather than market cap. Of the 10 stocks it bought over the past year, only 5 were large-cap at the time of purchase.
Theme and Background
This chapter reviews Oakmark’s judgment at the peak of the 2000 internet bubble and draws an analogy to the current market environment. The author points out a fundamental divergence in how the market defines “large-cap stocks”: Oakmark judges based on business scale (sales, net profit, etc.), while institutions like Morningstar judge based on market capitalization. Currently, many stocks pushed to high market capitalizations actually have very small business scales, causing funds classified as “large-cap” to potentially fail to deliver the low risk investors expect.
Core Thesis
The author’s core investment argument is: Investors should not be misled by market-cap classifications but should focus on the true business scale of enterprises. In the current market environment, a large number of companies with small business scales are classified as “large-cap” due to high valuations, carrying far greater risk than traditional large companies. Oakmark would rather be reclassified by Morningstar as a “mid-cap value” fund than abandon its commitment to buying undervalued stocks with large business scales. The author believes this logic is consistent with the behavior during the 2000 bubble—maintaining rationality when the market prices irrationally.
Key Arguments and Data
- Historical Analogy: During the 2000 internet bubble, Oakmark was reclassified by Morningstar from “large-cap value” to “mid-cap value” precisely because it insisted on buying stocks with large business scales rather than large market capitalizations. The author believes the current situation is highly similar.
- Current Threshold Changes: As of the reporting period, there were 250 companies with market capitalizations exceeding $260 billion, but Morningstar set the “large-cap” threshold at approximately $350 billion (based on the 70th percentile of total market capitalization). This means many large enterprises Oakmark analysts are researching (with market caps below $350 billion) will be classified as mid-cap.
- Risk Mismatch: The author notes that last year, many small companies (mainly tech stocks) were pushed into the large-cap category due to surging stock prices. The number of such “small-company large-caps” is five times that of a decade ago. These stocks carry far higher risk than traditional large-cap stocks.
- Portfolio Structure: In Oakmark’s fund, many companies with large business scales (e.g., Wells Fargo, Bank of America) have market capitalizations below $350 billion, while holdings in high-valuation tech stocks (e.g., Zoom, Snap, Square) are 0%.
Companies/Assets Involved
| Company |
Role |
Key Data |
View |
| Wells Fargo |
Holding |
Market cap under $100 billion, but one of the three largest retail banks in the U.S. |
Bullish: Large business scale, predictable demand, undervalued |
| Bank of America |
Holding |
Accounts for 3.0% of Oakmark’s net assets |
Bullish: Large business scale, reasonable valuation |
| Alphabet (Google) |
Holding |
Accounts for 3.8% of Oakmark’s net assets |
Bullish: Large business scale, undervalued |
| Zoom Video Communications |
Not held |
Market cap of $134 billion, price-to-sales ratio near 100x |
Bearish: Small business scale, facing intense competition, high risk |
| Snap, Square, Splunk |
Not held |
Holdings at 0% |
Bearish: High-valuation small companies, do not meet Oakmark’s criteria |
Investment Implications
- Beware of the Market-Cap Classification Trap: Investors should not assume a fund is low-risk simply because it is classified as “large-cap” by institutions like Morningstar. They should look beyond the market-cap label and examine the actual business scale (e.g., sales, net profit) of the fund’s holdings.
- Focus on the Alignment of Valuation and Business Scale: In the current market environment, the phenomenon of high-valuation small companies being classified as large-cap has increased significantly (the number is five times that of a decade ago). Such stocks combine the high risk of small companies with high valuation risk, and investors should avoid blindly chasing them.
- Adhere to Value Investing Discipline: Oakmark’s approach shows that when the market prices irrationally, actively choosing undervalued large-business-scale companies (even if their market caps are classified as mid-cap) may be more effective over the long term than passively following market-cap classifications. Investors should focus on whether a fund adheres to its investment philosophy, rather than short-term classification changes.