There are a couple of different philosophies about salary construction in sports. One side believes in the star model, having a small number of highly compensated star players mixed with less expensive players. The other option is a balanced roster of more evenly paid players. HarvardSportsAnalysis.org examined payrolls of MLB and NBA teams and compared wins against the concentration of the payroll, using the Herfindahl-Hirschman Index (HHI). As one might expect, they found that the nature of the sport affects which philosophy works best. The star model was superior in the NBA, where the team can put the ball in the star’s hand every possession. In baseball, where players only bat four or five times per game and starting pitchers only throw once every five days, the more balanced roster construction is better.
There have been many stories written about the “Magnificent Seven” technology stocks (NVDA, FB, TSLA, AMZN, AAPL, GOOG, & MSFT), largely on the promise of artificial intelligence, being responsible for three-quarters of the gain in the S&P 500 this year. The star model has dominated equity returns this year.
The chart, using the same HHI method that the researchers used for sports payrolls, shows that the S&P 500 is now more concentrated than it has been in decades. It also shows that S&P 500 Equal Weight, a proxy for overweighting smaller companies over larger companies, has historically outperformed the S&P 500 following periods of high stock index concentration.
The unanswerable question is, “Going forward, does the stock market more resemble the NBA star model or MLB balanced model?” Stated another way, have the largest technology stocks constructed such large barriers to entry through capital investment in technology infrastructure, network effects, and R&D that their market leadership is more justifiable than it was for dominant companies of prior cycles? We think the answer is somewhere in the middle. It would be incredibly difficult for competitors to displace these companies, but the prices of the star stocks may have gotten too far ahead of the broad market. Better diversified portfolios are likely to outperform if stock market concentration returns to more normal levels.
Sources: S&P & Harvardsportsanalysis.org: Pay to Play: An Analysis of Payroll and Performance in MLB and NBA, February 2, 2023