7 min2023 Redux
Guy Wagner On the stock markets, 2024 so far strongly resembles 2023: outperformance by a limited number of large companies expected to benefit from structural trends, and underperformance by companies with smaller market capitalizations. In local currency terms, the Japanese market is outperforming its US and European counterparts, but the weak yen almost halves its performance for a euro investor.
The Magnificent 7 continue to pull the S&P 500 higher, even though two of its members, Apple and especially Tesla, are down since the start of the year. (As far as Tesla is concerned, however, it's worth noting that it never had its place in this celebrated group. While the latter are able to self-finance through the cash flow they generate, Tesla is not. This is reflected in the number of shares outstanding: whereas Apple, for example, has regularly been able to buy back its own shares, so that the number of shares outstanding has fallen by some 40% over 10 years, Tesla has regularly had to carry out capital increases, so that the number of shares outstanding has almost doubled since 2012. As a result, Tesla's profit, however small, now has to be spread over twice as many shares). In Europe, Novo Nordisk's share price has already risen by 20%, following a 50% increase last year. At the other extreme, the Chinese market continues to suffer.
Big differences in performance
With regard to US indices in particular, we now find ourselves in the somewhat incongruous situation where, over 1 year, the Magnificent 7 index has risen by 84%, the S&P 500 index (with some 30% in these 7 stocks), by 29%, the S&P 500 equal-weighted index (with the same 500 stocks but weighted identically) by 12% and the Russell 2000 index (made up of smaller companies) by 9%. A huge difference also illustrated by a few examples:
- The market capitalization of the 5 largest companies in the S&P 500 is more than three times that of the 2,000 stocks making up the Russell 2000;
- The market capitalization of the 16 largest US companies is greater than that of the 16 largest stock markets in Europe;
- Microsoft's market capitalization in the S&P 500 is double that of the energy sector, which generates twice as much free cash flow as Microsoft.
- The 27 largest semiconductor companies are trading at nearly 10 times sales. In 2002, after the dot-com bubble burst, the former head of Sun Microsystems went back over the fact that investors had been prepared to pay 10 times his company's sales during the bubble and said: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?“ (Scott McNealy, Business Week, 2002)
Chart 1: Performance over 1 year
Source: Macrobond/Bloomberg
The rise of index-based management, with the popularization of ETFs, has clearly altered market dynamics. The segments that are currently driving up equity markets are expensive. In the case of the big technology stocks, one could always argue that they are in tune with the major structural themes (Digitalisation, Artificial Intelligence, ...), have very strong balance sheets, are buying back their shares and are generally managed by competent people. Some investors also believe that the massive digital investments made by these companies, which will only bear fruit in the future, are currently weighing on their results, somewhat artificially inflating their valuations. All these elements are valid. They were also valid at the end of 2021, but that didn't stop the share prices of the Magnificent 7 falling by 45% in 2022.
A winner takes all environment
Fundamentals, and especially valuation, are becoming less important. As long as there is a narrative behind a company that captures investors’ imagination, investors seem willing to pay any price. Diversification also loses its meaning in a 'winner takes all' environment. Why invest in anything other than the US market, and more specifically the technology sector? It's important to note that this wasn't always the case. In the first decade of this century, the European and, especially, Asian markets outperformed, while the US market lagged behind. It wasn't until 2014 that the latter, driven by the technology sector, took off.
It's worth noting that the narrative driving a company’s stock price can change. Companies like Roche and Nestlé are currently feeling the pinch. In the case of the former, the potential of its pipeline and the productivity of its R&D department in general are now being called into question, following disappointments with one or another molecule under development. In the case of the latter, various endogenous factors (notably organic sales growth below expectations) and exogenous factors (rising bond yields) are worrying the market. For a short-term investor, these are reasons to get out of these two companies. This explains the decline in their stock price, which not even the increase in their dividend (a good indicator of a company's fundamental health and management's confidence in the future) has been able to prevent. Roche's share price has lost 40% over 2 years, and is now back where it was in 2016. Nestlé's share price has fallen by 30% over 2 years and is now close to the low reached during the pandemic. For a long-term investor, Roche and Nestlé remain high-quality companies, however, and the weakness of their stock price might be a buying opportunity. The former will continue to benefit from the collaboration between its industry-leading diagnostics and its drug-development divisions, and from its strong positions in biotechnology and oncology. The latter remains a well-diversified food company that has successfully restructured its portfolio towards the sector's most attractive categories: coffee, pet food and confectionery products with well-established brands.
Ignore equity valuations?
All this obviously makes life very difficult for an active manager. Investing his clients' money in an extremely limited number of stocks is contrary to his fiduciary duty, but diversifying risks penalizing him in terms of performance. Similarly, ignoring valuations means exposing clients' portfolios to very high potential losses, but placing too much emphasis on valuations means incurring a significant risk of underperformance.
Chart 2: Number of stocks underperforming
Source: Gavekal Research/Macrobond
To a large extent, indexation comes down to momentum investing: you buy the stocks that have risen the most, with the idea that they will continue to rise. Financial history shows that after long periods when momentum buying prevails over fundamental investing, markets tend to go down very sharply. The same history also shows that when markets are characterized by a very high degree of concentration, they become very vulnerable. For an active manager, however, the problem is that, to quote Keynes, "markets can stay irrational longer than you can stay solvent". And so, to repeat the conclusion of my article “A portfolio manager’s dilemma”: What strategy should a professional portfolio manager adopt in such an environment? Play the relative-performance game by buying expensive stocks favoured by investors, with the risk of not getting out in time? Respect fundamentals and try to find neglected assets that are attractively valued, but with the risk that they will continue to underperform? A manager opting for the first strategy risks losing his clients a lot of money. A manager opting for the latter risks losing his clients before the markets finally prove him right. This is the eternal dilemma of the professional manager.
If the momentum approach continues to prevail over the fundamental approach, there will inevitably come a time when the manager's dilemma will become his clients' dilemma. By continuously having to explain why he is underperforming, the active manager will begin to sound like a broken record. It will then be up to his clients to decide whether they want to continue on their way with him, or whether they prefer to invest with another manager. From experience, I know that it's impossible to ask a manager convinced by fundamental analysis to suddenly ignore fundamentals and base his decisions on other factors (and if he does, he'll risk doing stupid things). The article “About a boy, dilemmas and convictions” by Steve Glod, manager of the BL Equities Japan fund, showed that focusing on quality companies, often market leaders in their field, bought not for the sake of short-term performance, but with a thoughtful long-term approach, is the basis of our methodology here at BLI - Banque de Luxembourg Investments.
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