To outperform markets over the long term, you need to be positioned differently. True diversification can be hard to find, and investors need to look outside the areas of biggest concentration and across geographies and sectors. Fiona Jeffery, Investment Counsellor at Orbis, explains.
To outperform over the very long term you need to be positioned differently: if you are invested in the market, you are never going to beat the market.
Today, markets and investors are as concentrated as ever. Investors in passive and index funds tracking a global index may find that their investments are less diversified than expected. The areas of greatest concentration also look expensive. This could leave investors exposed if trends shift, which is why we think it is as important as ever to be different.
To assess just how concentrated stockmarkets are, we can rank and plot companies into the framework in the chart above based on their characteristics. Cheaper stocks appear on the left, more expensive ones on the right, defensive stocks on the bottom, and more cyclical ones at the top. This leaves us with four quadrants, which we’ve termed “Value defensive”, “Value cyclical”, “Growth cyclical”, and “Growth defensive”. In the top left quadrant (Value cyclical), for example, would sit an automobile company like BMW.
In the chart, each dot represents one company – and there are more than 2500 of them in the FTSE World Index. The picture looks fairly diversified, with companies scattered across all four quadrants. This is what you might expect when you buy a passive or index fund tracking an index like the FTSE World. But there is one crucial piece of information missing – the weight of each of these stocks in the Index.
If we adjust the size of the dots to account for the stock’s weight in the Index, a very different picture emerges. This is a much better visualisation of what investors in passive and index funds are really buying.
The chart above shows that the Index is heavily skewed to the bottom right, “Growth defensive” quadrant. At the end of June 2024, “Growth defensive” stocks represented a staggering 62% of the FTSE World Index – close to the highest level since the late 90s. This is fascinating, because investors tend to buy passive funds to gain diversified equity exposure, however this is hardly true diversification.
And it is not only passive funds that are crowding into already concentrated areas. Some of the largest stocks in the FTSE World Index – mainly “Growth defensive” names – are also widely held by active managers.
Concentration doesn’t have to be a bad thing. If investors are concentrated in attractive parts of the market, it can be great for returns. In the chart below, we have used expected returns as a proxy for assessing the attractiveness of different parts of the market – a higher expected return implies that part of the market is more attractive. But as shown by the blue line in the chart below, “Growth defensive” stocks – the area of greatest concentration in the market – have lower expected returns than at any point in the last 25 years.
The yellow line shows the expected return for the rest of the FTSE World Index, or the other quadrants. The gap between the two lines is very wide versus history, implying the stocks in the rest of the Index are more attractive relative to “Growth defensive” stocks than usual.
With the most concentrated parts of the market looking expensive, it could be very painful for investors if trends shift. The problem is that it can be very hard to imagine what market change might look like. We have seen growth shares beat value shares, technology shares beat the rest of the market, stocks beat cash and low inflation rates for so long, that many investors have forgotten – or haven’t even seen – what a different market environment could look like. It is tempting to assume that the current winners will keep on winning, but history has shown that is rarely the case. When market cycles turn, it can happen quickly, so it is good to be prepared.
One step investors can take is to ensure their portfolios are properly diversified by looking for opportunities to invest differently. The good news is that we think there are opportunities to invest in a variety of very different companies at attractive prices.
Take the example of the Magnificent Seven – a group of shares1 which represent over 20% of market capitalisation of the FTSE World Index. These are great companies with excellent fundamentals, but they only contribute 11% of the combined profits of the companies in the FTSE World Index2.
In contrast, there are almost 950 stocks in the seven biggest stockmarkets outside the US. Perhaps we should call these the “Mundane Seven”? The Mundane Seven are also around 20% of the market capitalisation of the FTSE World Index but represent almost 30% of the profits. That’s almost triple the Magnificent Seven today. And the potential earnings are much more diversified, across a wide range of sectors and geographies.
I know which of the two groups I’d rather be hunting in.
1 Alphabet, Amazon, Apple, Microsoft, Meta Platforms, Nvidia, Tesla
2 As calculated by their contribution to FTSE World Index consensus net income estimates for the current fiscal year.
