The underappreciated concentration risks of indices
Co-Authored by Adrian Warner, Chief Investment Officer and Sam Morris, Senior Investment Specialist. The following article featured on Investor Daily, November 3, 2020 and Morningstar, October 29, 2020.
Compared to active investing, passive strategies have enjoyed the sunshine of late, but the increasingly crowded nature of the indices – predominately in US technology – will make it hard to duplicate that success over the next five years.
As a result, savvy investors should turn to active value investing to help uncover undervalued businesses that are increasingly neglected by a market too focused on a shrinking concentrated list of US tech names.
Investors with a truly long-term perspective should not let themselves be enticed into taking risks in order to keep up with a benchmark, nor to chase increasingly expensive and risky investment opportunities. Irrespective of how one defines and calculates value, we believe these principles are common sense.
Our job as active equity investors is to plot a course through an uncertain world by assembling a portfolio of high-quality businesses that offer a margin of safety between the price paid and the fundamental value of the business, the prospect of attractive returns and a diversified and controlled set of investment risks.
Robust, well-capitalised, undervalued businesses that can grow intrinsic value are out there and the increased concentration of benchmark-aware capital into fewer and fewer mega-cap tech stocks means these opportunities are multiplying.
Increasing index concentration
In January 2020, before the full impact of the coronavirus was felt, the top five companies made up 17.4 per cent of the total market capitalisation of the S&P 500. This level of market concentration was already equivalent to that seen prior to the dot com crash in 2000.
The market fortunes of the five firms have improved further, making up 21.7 per cent of the SPX, with their market share increasing 25 per cent in the first six months of this year. Since March 2017, their market share has increased 67 per cent.
For the past 25 years, Bank of America has surveyed fund managers on their portfolio positioning. The latest survey found nearly three-quarters of fund managers agreed holding big US tech stocks was the “most crowded” trade in the market, the survey’s strongest-ever consensus. Buying tech stocks is now the “longest ‘long’ of all-time”. Many passive index investors (or investors in benchmark-focused funds) do not fully realise how much their fortunes rest on these five companies.
There is no question these are admirable names with strong growth prospects, but they are not undiscovered and they do not come without risks, such as valuation. The big five have seen their market capitalisation increase 44 per cent, on average, over the past 12 months while their consensus expected earnings for fiscal 2021 have fallen, on average, 8 per cent over the same period.
These companies have done a remarkable job of lifting the index over the past five years, indeed, over the past 10 years since the global financial crisis, but it is optimistic to think they can do it again.
For these companies to increase in value by 10 per cent per annum for the next five years they would have to add an incremental US$4 trillion to their combined market capitalisation. This is the equivalent of adding the entire current market capitalisation of the next 13 companies in the SPX today. Alternatively, you could add the bottom 288 companies in the index to make up the same amount. Not impossible, but also not a slam dunk. Therefore, we think focusing on investment efforts outside of this domain makes sense.
In a broader sense, passive and benchmark-aware investors are not getting the diversification they think they are. For example, in the Vanguard International Shares Index Fund, the top 100 stocks are only 6 per cent of the 1,500-plus total holdings, they account for nearly 50 per cent of the net assets held. Those top 100 holdings are also less than 30 per cent weighted in IT and communication services (e.g. Google and Facebook) and +80 per cent in the US.
Index investing in Australia is widely understood to be heavily concentrated in bank stocks and resources, in the same way global index investing is a very heavy sector and geographic bet on the US tech sector.
Making investment decisions guided by a firm understanding of the intrinsic, cash-generative value of companies over the long term is like gravity – you may be able to resist it for a while, but it will always bring you back to earth eventually.
The type of businesses our private equity-influenced approach seeks to invest into are high-quality but appropriately valued as opposed to companies priced for perfection in the current uncertain environment. We believe value-oriented investors don’t have to simply buy “cheap”.
Periods of volatility are a sweet spot for patient investors, as it allows them to continually improve their margin of safety by reallocating capital from companies with a higher price-to-value ratio to those with a lower price-to-value ratio. By doing so, one can substantially reduce risk and increase the prospective returns for their portfolio over time. This is not rocket science, but such discipline is still hard to adhere to in an increasingly impatient and low-rate world.
A private equity-influenced investment approach means every purchase is viewed as if buying the whole company. This keeps focus on the quality of the underlying business, its long-term prospects and the price one is being asked to pay, rather than trying to speculate as to what the market or individual company prices may do over the short-term.
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