How advisers and active managers respond to concentration risk
The Magnificent Seven technology shares have continued to lift global equities higher through 2024, shrugging off concerns over earnings momentum, and all but ignoring the growing cohort of analysts who caution over their high valuations. These seven United States (US) listed shares, up an average 47% year-to-date 7 November 2024, have helped the MSCI World index around 20% higher over the same period.
Super stocks, worthy of their moniker
Alphabet (+19.4%); Amazon (+24%); Apple (+21.2%); Meta (+63.3%); Microsoft (+13.4%); NVIDIA (+183.8%); and Tesla (+5.7%) have mostly powered ahead, adding to their staggering 111% average gain over the whole of 2023. For context, the Magnificent Seven constitute approximately a fifth (or 21.92%) of the MSCI World Index by market capitalisation, giving them a substantial influence on the performance of global equity markets and portfolios with exposure thereto.
In his recent presentation to an Allan Gray Fund Update webinar, Steven Skinner, a portfolio manager at Orbis, hinted at the difficulty this basket of shares was causing for active portfolio managers. “The 2024 year-to-date global equity performance has been driven by a concentrated basket of stocks; our global equity strategy has been under-weight these stocks, creating a drag on performance of around 2.5%,” he said. His observation underscores the challenge active managers face when benchmarks become too concentrated.
As a small number of large-cap stocks dominate the index, active portfolio managers find it increasingly difficult to maintain a diversified strategy while outperforming their benchmarks. Active managers must either risk underperforming the index by sensibly diversifying away from the concentration, or take on more risk by being overweight in any of the dominant stocks. Their passive manager peers, meanwhile, benefit from the automatic inclusion of these high-performing stocks, allowing them to capture the market’s gains without having to make difficult allocation decisions.
Concentration and currency risks erode returns
“We had a further drag on performance due to our currency selections,” Skinner admitted, explaining how being overweight the Japanese yen and underweight the US dollar had eroded a further 1% of performance. The good news for investors is that the manager’s idiosyncratic stock selections helped to offset the concentration- and currency-related headwinds. Stock selection added around 4.5% in performance, allowing the fund to exceed its benchmark after fees, returning just over 19% in US dollars.
It is difficult to predict what financial markets will do over the coming 12-months. According to Skinner, stock pickers were facing some unusual dynamics presently, including that the proportion of stocks in the MSCI World Index that had managed to outperform the overall market return over given periods was at historic lows. “You would expect to see the market success ratio at around 50% across the market, so half the stocks outperform, and half underperform in any given period,” he explained. “In the last few years, the success ratio of the market has declined steeply falling to a low of about 35% in 2023 and maintaining that level into 2024.”
The portfolio manager added that while Orbis’ ‘in fund’ stock selection success ratio remained significantly higher than that of the index, some slippage was inevitable. “We are picking stocks much more accurately than are represented in the market success ratio; however, because the market success ratio is so low, our success ratio has dropped below 50% in the last couple of years too,” he said. A key reason for optimism among bottom-up investing houses is the inevitable alpha ‘lift’ that should accompany a reversion to trend of the market success ratio over time.
Advice lessons from active asset managers
Financial planners and your clients can learn an excellent lesson from the active manager’s response to financial market adversity and short-term performance hiccups. “Managers without robust processes, and without some level of fortitude to endure the pressure, must resist changing their approach at just the time when that approach is likely to bear fruit,” Skinner said. This does not mean you should not work on your investment strategy over time, but rather that any tweaks be proactive rather than reactive.
Turning to financial markets, the portfolio manager shared a composite graph of 12 ‘global market valuation’ indicators. “We are not in the business of predicting market returns; but we can observe when things are getting towards an extreme,” he said, noting that this valuation measure placed global equities quite near the most expensive the market has ever been. Orbis’ internal valuation metrics show that only 14% of the market presents attractive value. And on its analysis, the asset manager expects fairly low returns from global equities over the coming periods, especially compared to what is on offer from cash.
There were plenty of encouraging snippets shared throughout the presentation. In this case, the negative of only 14% of stocks offering fair (or better) valuations was countered by there still being 753 stocks to choose from, boasting a combined market cap of around USD12 trillion. “So, while the majority of the market, especially on a capitalisation weighted basis, is quite expensive and unattractive, we do think there is a pocket of value which gives us plenty of opportunity set to find interesting ideas for our clients in the coming years,” Skinner said.
No longer ‘big in Japan’
Over the past few months, the asset manager has reduced its exposure to Japan (from 14% to just 3%). This shift was largely driven by a move out of certain Japanese financial sector investments that had “appreciated towards [the asset manager’s] estimate of intrinsic value.” Some of the capital freed up through this action was redeployed to South Korea, taking exposure to that region from 8% to 12%. There are some promising early indications that Korea-listed firms could set off on the path walked by their Japanese peers over the past decade.
“In terms of sector changes, we have seen a couple of shifts this year; our weighting in financials has gone from 36% to 28% which although still high is less extreme than it was,” Skinner said. The asset manager has also positioned for specific, strategic opportunities in healthcare and industrials. “These are quite idiosyncratic situations; by being able to go deeper into these sectors, we have found some opportunities that are quite different from the overall sector dynamics, and therefore offer very attractive long term return prospects,” he said.
The top 10 holdings in the Orbis Global Equity Fund include KB Financial Group and Shinhan Financial Group, which are in the Korean financials sector; QXO (IT); and GXO Logistics and RXO (both industrials). The XO companies are a family of companies born from the entrepreneurial activities of Brad Jacobs, an entrepreneur and very successful business builder, who the fund has followed for several years.
Nothing like the world index
In closing, the presenter restated the key difference between his active fund and the passive MSCI World Index. If you compare the top names in his fund to those in the MSCI World Index, you will only find one overlap: Alphabet. The fund’s unique mix of hand-picked shares also comes with an attractive valuation at just 16 price-to-earnings (PE) across its top 10 versus 30 times in the MSCI.
“There are some very good companies in the world index, especially among the large stocks; but we think that the difference in quality is far less than is implied by double the valuation,” concluded Skinner. “We are optimistic on the relative returns of our largest stocks, and quite excited about that in the future.” Finally, three clear messages for financial planners and your clients.
First, the risk reward profile of the market has changed, meaning you must be mindful of your future asset allocations. Second, the world index is unlikely to repeat its 2023 and 2024 returns over the next few periods. And finally, there are pockets of value for sensible, value-based investment methodologies to pick up on.
Writer’s Thoughts:
Active managers cannot replicate Magnificent Seven returns without taking on excessive risk. How can financial advisers guide clients through periods when sensible active strategies may lead to short-term underperformance? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
