A wise investment rule of thumb and fundamental investment maxim is “A great company is not necessarily a great stock.” While the investment community is acutely aware of this, the same behaviour tends to repeat itself – and it doesn’t necessarily end well.
Let’s just look at what is going on right now with the US’s S&P 500. Its top stocks are dominated by the Magnificent 7 – a group of all but one mega tech-led businesses that include Alphabet, Apple and Microsoft. With asset managers everywhere investing in these industry giants, due to their strong, sustained performance, currently (which is the operative word), there is a possible risk of a bubble due to the extreme concentration in these stocks which are beginning to look very much like of the ‘hey day’ of the 1960’s “buy and hold” Nifty Fifties.
The Nifty Fifty group of companies included stocks like Avon, Disney, McDonald’s, Polaroid, and Xerox, and institutional investors were infatuated by them. At its heart, holding the Nifty Fifty in a portfolio meant that investors would never sell but always buy, regardless of price. This led to the fundamental question: is a company’s stock worth any price, no matter how high? At that time investors’ answers were a resounding yes.
Then the markets crashed. While the Nifty Fifty held up for some time, they also fell like lead weights, and from their 1972–1973 highs to their 1974 lows, Xerox fell 71%, Avon 86%, and Polaroid 91%.
There’s a lesson in this, the Magnificent 7’s rally has a historic analogue. While the S&P 500 has hit recent record highs, thanks to the almighty “7”, the tech sector has its highest weight since August 2020. There’s no denying the performance of these companies.
To put this in context the “7” jumped by 10% year to date, while Meta Platforms Inc. added a huge US$197 billion in market cap in one day alone. However, it’s our responsibility as investment custodians to ask whether the concentration risk is too high. In our view, what we are seeing now exposes investors to similar risks in the Nifty Fifty era, investors may be overwhelmed by the hype and might start losing their resolve. But at what cost?
Over-concentration in one segment of the global market, and to make it even more accurate, just 7 companies, does not make sense over the long-term. Diversification away from this group is, in our view, a better strategy as it protects investors from a possible bubble and fall in stock prices. Instead, investors should we looking at a mix of stocks that align with their long-term objectives. While they may not enjoy watching the 7 run, taking a diversified approach reduces the risk of something going wrong.
Diversification is a term that is thrown around loosely in investment circles. Everyone knows a diversified strategy is paramount, but a truly diversified portfolio ensures that portfolios do not have excessive concentrations. To mitigate this we ensure that our portfolios are exposed to all sorts of things, and that each selection is fundamentally different to every other within that same basket.
At Lodestar we don’t have subjective views on this stock or that market. Instead, our tech-led process ensures that our mathematically-based investment strategy provides us with consistent exposure to a wide range of assets without following fads.
To further confirm our views, we test our portfolio selections through a robust check-list to ultimately ensure that we have a portfolio construction that has exposure across the investment universe, and that is sound, stable, resilient and unlikely to be influenced as much by market shocks……which could happen if the Magnificent 7 reverses course.
While we can’t predict the near term performance of the Magnificent 7, there is a distinct possibility that history repeats itself and another Nifty Fifty scenario plays out. In this case investors should ideally be less exposed to this risk and instead have their basket of assets broadly diversified across stocks and geographies to mitigate losses.
Lodestar Fund Managers (Pty) Ltd is an authorised financial services provider, FSP 49808. Disclaimers available on the Lodestar website.