As the market reached historic highs in the First Quarter and has since retreated somewhat, we are reminded of diversification’s value during uncertain times.
At Hanke & Co., we endeavor to sidestep likely duds and speculative bubbles — but without the heartbreak of market timing. As we are not deer-in-the-headlight, passive investors, we’d like to reveal some of our pro-active investment alchemy while drawing from lessons of economic history.
The orthodox view holds that bubbles and spikes are seen only in a rearview mirror. Nonetheless, segments of the markets-asset classes-demand special handling when valuations move far above or below their historical averages. This is key to our asset allocation discipline.
Comparative valuations further guide us in selecting fund managers who execute day-to-day stock trades behind the scenes. Managers also decide which industries to emphasize or not.
Harsh History
For a moment, let’s go back to the Dot-Com Crash of 2000 when “irrational exuberance" met with reality. In retrospect, everyone should have seen a bubble about to burst. This was presaged by the Newsweek cover story, “The Whine of ’99 — Everyone’s Getting Rich But Me.” So it goes, or went.
After “dot bomb,” the tech-heavy NASDAQ index would not return to its prior high for 15 years. For the S&P 500, it took 10 years. Along the way 9/11, the Iraq War, and the Great Recession contributed to epic market morass.
Today we have concerns about the so-called “Magnificent Seven” — mega companies whose combined value now represents one-fourth of all S&P 500 stocks. Valuations for the Seven are high but nowhere as nutty as dotcom stocks had been. The painful lessons of the “dot bomb” era still endure to a great extent. Nonetheless, a century of market data suggests the Seven are fated to log increasingly sub-par returns.
Concentrated among tech companies (beware!), the Seven are Microsoft, Apple, Nvidia, Alphabet/Google, Amazon, Meta/Facebook, and, as of this week, Tesla. Sure, these behemoths are swell outfits, but at what price?
Before the iPhone
Statistically speaking, Apple stock may have seen better days. Hit with a steady stream of antitrust suits, right-to-repair controversies, and the loss of legal tax stunts, Apple cannot innovate its way forward on the same scale as it had over past decades. Nor should it maintain the same profit margins as competitors chip away at its premium branding and mimic more of its proprietary features. Free enterprise can be costly.
Before the iPhone, there was the Blackberry. Remember? Former highflyers like IBM, General Electric, AT&T, and Xerox also suggest Apple could one day become one more sleepy blue chip stock — but with a cult following. Just sayin’.
Curse of the Cool Kids’ Table
In the lead-up to joining the Top Ten, companies have historically registered eye-popping returns. For the three years prior to joining, Top Ten stocks averaged returns that were 27% above and beyond the market as a whole. That’s definitely an “outperform” (source: Dimensional Fund Advisors; data set, 1927-2023).
But once seated at the Cool Kids’ Table, the Top Ten soon begin to underperform the overall market by 1.5% annually over the next 10 years. Future results will vary, but schadenfreude is here to stay.
Shifting Sands of Commerce
Below, we observe a tale of constant change in the Top Ten lineup since 1984, the year our firm started. Note the rankings of specific companies (e.g., Sears, IBM, General Motors) and domination by various industries (e.g., oil, communications, retail). The rankings are shorthand for 40 years of economic history, the arrival of the Information Age:
Top Ten S&P 500 companies as measured by market capitalization:
Buy straw hats in January
Okay, Warren Buffet coined that expression, not us. We’ll use his metaphor for value investing — seeking opportunity and reducing volatility — as illustrated below.
One metric to sizing up the value of a stock is price/earnings ratio (P/E), the stock price divided by the company’s annual earnings per share. Today’s Top Ten — which includes the Magnificent Seven — presently trades at an average P/E of 28, well above a historical average of 20. (source: JPMorgan, data set 1996-2023).
In contrast, the “Bottom 490” stocks are trading at a P/E of 18, slightly above an average of 16. Which of the two — the Top Ten or the Bottom 490 — has greater upside potential? Greater downside risk? From this simplified example, you might be thinking about that straw hat you’ve always wanted.
This newsletter, intended for investor education, highlights aspects of our methodology. It should not be construed as making a specific investment recommendation.