Imagine you’re a gardener. You spend a weekend building a few raised beds, planting sunflowers and corn, etc. It’s a nice little hobby. Your first summer gardening ends up successful and fulfilling.
You come back for Year 2 with vigor! You want to expand. You spend a month preparing your beds and double the size of your garden. You plant new veggies and a few flowers, and all goes well.
You rinse and repeat for a few more years. Not only is your garden blooming, but its size is blooming. After years of doubling in size, it occupies a couple acres in your side field (we’re putting you in the countryside).
Eventually, you grow so big that an annual doubling size is no longer feasible. You don’t have the time or equipment to build twice as many new beds. You don’t have the resources to water and fertilize the full area. You don’t have the patience to weed the weeds and scare away the hungry deer and rabbits.
Growth, in other words, cannot be exponential forever. Eventually, size becomes the enemy of growth. Growth is easy when you’re small. It’s much harder when you’re big.
We see similar “rules” all over the natural world. Small children grow and learn unbelievably quickly in their early years. They “grow like a weed” – how punny. But eventually, that child becomes a “full-grown” adult who, if they’re learning at all, certainly is no longer learning at an exponential pace.
While the governing rules might differ (Mother Nature vs. something economic), a similar phenomenon applies to the business world and thus to the stock market: growth can’t be exponential forever, and growth becomes harder the bigger you are.
Forward Growth, Backward Growth
Let’s go back to the garden.
Imagine I have a bed of fully grown sunflowers —10 feet tall, giant heads, full of seeds.
Next to that, I have a bed of corn. The corn is only halfway grown—3 feet tall, barely a sign of any “ears” yet.
If I wanted to see which crop has the best growing potential, how should I measure it?
The natural tact to measure backward and say, “It’s the sunflowers – look, they’re huge! They’ve grown like crazy this past month!”
But I could also measure forward and say, “The sunflowers are ‘exhausted’ – fully grown! The corn, though, still has a huge potential in front of it.”
The same idea applies to the stock market.
If we measure backward, the best-performing stocks of the past 5 years are the biggest stocks right now (kind of like our sunflowers). Ben Carlson shared this idea and data in a recent post. The right-most columns below show that today’s largest stocks are also the best performers of the past 5 years:
The biggest stocks (on the right) have also had the best recent performance.
But as investors, is it good for us to “measure the sunflowers” after they’re fully grown?!
The wise skeptic would retort, “Jesse – you don’t know if those large stocks are fully grown or not.” It’s true. For all we know, those “sunflowers” could double in size again. We’ll come back to this idea later.
Still, I think it makes more sense to measure from the beginning and ask, “Which stocks will grow most in the future?” The problem is that we don’t have crystal balls. We don’t know what the future will hold.
The middle ground, then, is to combine the past and the present. For example: what if we took the stock market’s values from 2019, ranked the size of those companies at that time, and then tracked their performance from 2019 until today?
That’s exactly what this chart shows:
If we measure forward instead of backward, we see that smaller companies have been the best performers of the past five years (not that large companies performed all that poorly).
Here’s another terrific way of visualizing that idea. I’ve been using the following chart with some clients recently, especially when they ask questions about Apple, Microsoft, or NVIDIA, etc.
The data examines companies when they reach the Top 10 largest companies in the U.S. stock market. The left side of the graphic shows companies before they reach the Top 10, and the right side shows companies after they reach the Top 10. The left shows “future world-record sunflowers as they’re growing” and the right shows “world-record sunflowers once they’ve set those records.”
The chart pulls together our various ideas today.
It’s hard to grow forever. Instead, growth has an upper limit. Once a company has become “one of the largest companies in the US, or even the world,” odds are that its growth is tapped out.
While investing in “full-grown sunflowers” might be appealing – after all, look how tall they are! – the smart money knows investors don’t make money on past growth. They make it on future growth.
I’m not guaranteeing it. The future might be different than the past. Maybe NVIDIA will continue taking over the world. But get this:
In the five years from July 2019 to July 2024, NVIDIA’s market cap grew from $100 billion to $3 trillion, a 30x increase.
If NVIDIA did the same thing from now until July 2029, its then-$90 trillion market cap would be:
as large as every other publically traded company in the world, all combined.
about 2x the rest of the entire U.S. stock market, combined.
about 3x the annual GDP of the U.S.
and roughly ~$90 trillion more than my personal net worth. Ouch.
Uncle Warren, Cousin Rubin
In 1995, Uncle Warren Buffett wrote to his investors:
The giant disadvantage we face is size: In the early years, we needed only good ideas, but now we need good big ideas. Unfortunately, the difficulty of finding these grows in direct proportion to our financial success, a problem that increasingly erodes our strengths.
When you have one garden bed, it’s easy to double in size. Just build one more bed. It’s not so easy when you’re running an entire farm.
Buffett’s company, Berkshire Hathaway, is in the business of buying other companies – great companies, ideally, at fair prices.
But Berkshire is worth $900 billion dollars. They can’t afford to buy a $1 million company that they think will double to $2 million – it’s a tiny drop compared to their $900 billion value. Instead, Berkshire is looking to acquire multi-billion dollar companies. But those companies aren’t flying under the radar. They’re well-known and accurately priced. The opportunity for large investment gains simply isn’t there.
A similar idea comes from Rubin Miller, writing about Nvidia. Rubin said:
The stock market has averaged ~ 10%/year over the last 100 years, so if that continued while NVIDIA averaged 32% (which it has since its IPO in 1999)….
In 10 years, NVIDIA would be ~ 27% of the U.S. stock market.
In 15 years, NVIDIA would be ~ 68% of the U.S. stock market.
In 25 years, NVIDIA would be ~ 420% of the U.S. stock market.
But nothing can be more than 100% of something that it’s a part of.
That’s the impossibility (meaning if anything like this remotely occurred in reality, the entire market’s return would of course be pulled higher than 10%, simply by NVIDIA’s weight and return).
But this is the rub. You cannot compound returns at high rates forever.
On an infinite timeline, anything compounding at a higher rate than something else will eventually completely subsume it.
Rubin Miller
Eventually, in other words, NVIDIA would be so big and the rest of the market so small (comparatively) that “market returns” wouldn’t tell us anything about “the market” – they would only tell us about NVIDIA!
This is not poo-poo’ing on NVIDIA. It can still be a great company. But that’s different than being a great investment. You can be a good company, but a bad stock..
Or, back to our sunflower analogy, here’s a fact: a sunflower grows 100x in height over ~70 days. Then it withers and dies. But if it didn’t die and instead continued 100x’ing its height every 70 days, that sunflower would reach the Moon in just over 1 year.
You tell me. Maybe we’ll soon see a sunflower reach the moon.
But I’m not betting the farm on it.
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-Jesse
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