I have been investing for almost 40 years. There has never been such a strong trend, driven by the fundamentals of innovation and disruption, running in tandem with a huge technical trend, such as the rise of passive investing. These two monster trends support each other and create a memorable investment period that has seen the S&P 500 return 13% compound over the last 10 years.
Passive investors have ridden the wave of innovation, and that ride has been easy. However, in our view, we are at or close to a peak in the trend that will make it very hard to achieve a satisfactory return in equity markets through passive investing alone. The case for increasing active strategies is compelling.
In fact, Goldman Sachs recently cited market concentration, record margins and valuation as key reasons why returns going forward will be harder to achieve. They forecast that the S&P 500 will only return a compound rate of 3% a year over the next 10 years. If true, this will not be sufficient for investors, and truly actively derived (higher) returns will become necessary.
Examining these three factors individually, concentration risk is at the highest level in a century. The last time we experienced such concentration was during the early disruptive phase of the Industrial Revolution.
Market cap of the largest stock relative to the 75th percentile stock
Source: Compustat, Kenneth R. French, Goldman Sachs Global Investment Research as at 14.03.24.
In the late 1920s, U.S. Steel dominated the market with a market capitalisation that accounted for 8% of the country's GDP at the time. However, it was not U.S. Steel that yielded the best returns for investors as the Industrial Revolution unfolded. Instead, opportunities shifted from 'enablers' to businesses built on the existing infrastructure.
Often, in investing, we observe that a sound thesis can be supported by poor investment choices. We refer to this phenomenon as having the right thesis but the wrong valuation. A similar situation occurred in 1999 and 2000 during the expansion of the Internet. Cisco became a favoured stock in this Internet boom, representing the right thesis (the Internet) but at an incorrect valuation. Cisco's stock rose by 3.5 times during that period, only to lose all those gains later. Twenty-five years later, its shares have yet to return to the levels of 2000.
US market cap weightings (super sectors)
Source: Topdown charts, LSEG, December 2023.
A golden period for stock picking comes at the same time as concentration risk is maxed out. The chart above shows the opposite side of tech and quasi-tech concentration; it leaves cyclical and defensive sectors at near multi-year lows in terms of index representation.
It is also worth noting that big companies rarely dominate the market for long. In fact, as the chart below shows, there are only 18 companies that have been in the US index top three by market capitalisation and of those 17, only seven have manged to hold a top spot for five consecutive years or more. This is a very small pool in which to find longer term winners.
Top 3 US by market capitalisation
Source: Factset and Counterpoint Global, September 2024. Note: Market capitalizations reflect calendar year-end; some of these companies have varied their names over time; GM = General Motors; P&G Procter & Gamble; Exxon = ExxonMobil; IBM = International Business Machines; GE = General Electric; Altria was previously known as Philip Morris. All use of company logos, images or trademarks in this presentation are for reference purposes only
Passive investing has reinforced this concentration trend, and it is important to realise that passive investing is the antithesis of active. As Benjamin Graham said, in the short run, the market is a voting machine, but in the long run it is a weighing machine. Passive investing is voting – it pays absolutely no attention to valuation. Passive is voting while active is weighing. There is no regard for the price an investor pays in passive investing.
Daily trading volumes on the US stock market are dominated by passive flows (about one third), by retail trading (about 20%) and by the huge surge in daily option trading. This all adds to the valuation agnostic nature of markets today. No wonder so many fundamental investors say the market is broken – in a traditional sense it is.
But here is the rub. If equity returns are going to be harder to achieve at the index level, then passive flows have to become more active, either through active ETFs or through traditional active management.
I firmly believe this will create a golden period for active investors, reversing the flows into easy money passive index funds and back into a better balance of active and passive as the scales of valuation and broadening of opportunity navigate investors away from the concentration risk.
KEY RISKS
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.
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