By Doug Sandler, CFA, RiverFront Investment Group
Since 2010, the S&P 500 has been driven in large part by a small number of companies in just a handful of industries like social media, Internet retailing, artificial intelligence, electric vehicles, and mobile communications.
Narrow market leadership by only a handful of ‘Wall Street Darlings’ can frustrate even the most experienced investors and often encourages radical responses that do not adhere to the fundamental cornerstones of successful long-term investing, in our view.
For example, some investors may be lured into allocating too much to the ‘Darlings’, violating a basic principle of investing; diversification; while other investors avoid or even bet against these ‘Darlings’ under the belief that they have risen ‘too far too fast’.
RiverFront’s investment teams are familiar with these types of markets and believe that neither a radical nor emotional strategy is appropriate. Instead, the team has developed and implemented processes designed to allow us to ‘participate’ in a narrow leadership market while aiming to ‘protect’ investors from the risk of a shift in market preferences. This week we outline the rationale for our approach and its implications to our portfolios.
1. Participate: Participating can mean owning some or all of the ‘Darlings’ or owning their secondary beneficiaries. We believe participation is important because the market may know something we do not and the decision to not participate may undermine an investor’s willingness to adhere to their long-term investment plan.
- The Market is not efficient but it is not stupid either: James Surowiecki addressed the subject of ‘market knowledge’ in his 2004 book The Wisdom of Crowds. After many years of research, Surowiecki concluded that the collective wisdom of a large group nearly always trumped the knowledge of any single ‘expert’. In the investment world, the best way to access the ‘crowd’s wisdom’ is by analyzing stock prices, which reflect the insight of millions who purchase and sell stocks every day. Therefore, it is not surprising that a number of former Wall Street Darlings have proved the crowd ‘right’ and the experts ‘wrong’.
- Not participating can undermine an investment plan: One of the goals of investment management is to discourage an investor from abandoning their long-term investment plan. Therefore, a second reason to participate is that it can be too painful not to participate, and painful investment periods often lead to an investor making short-term, sub-optimal choices that put their long-term goals at risk. From this perspective, the challenge facing a portfolio manager is similar to that facing a dietitian… i.e.: A healthy meal has to be palatable, or their patient’s won’t eat it.
- Participation through secondary beneficiaries: While the pure-play companies in today’s hot industries garner most of the market’s attention and thus the higher valuations, a number of companies and industries stand to benefit from the ‘darlings’ success and are often more stable and valued more reasonably. Two alternative ways to participate include the ‘suppliers’, and the ‘customers’. The suppliers are those companies that make the tools that enable innovation. For example electric car companies ultimately rely on the electric utilities to generate and distribute the fuel to power their vehicles while social media could not exist without semiconductors and massive amounts of storage hardware. The ‘customer’s’ companies are those companies that do not make the innovations, but ultimately benefit from them through increased sales or enhanced profit margins. The travel and leisure industry, for example, has experienced growth in sales from social media users craving unique content to enhance their on-line personas. Similarly, we believe advances in artificial intelligence (AI) can be expected to meaningfully improve productivity and lower costs in more mundane industries with historically high staffing costs like health care services and banking.
Our portfolios ‘participate’ in the following ways: RiverFront’s security selection process, which is built on the cornerstones of value, quality & momentum, is designed to encourage participation when appropriate.
- Our ‘value’ methodology is unique and concludes that not all the ‘Darlings’ are expensive. There are two ways we depart from the traditional valuation analysis used by many investors. First, we believe value comparisons are most relevant if they are intra-sector and use sector appropriate metrics. For example, we do not believe tech stocks should be compared to energy stocks, nor do we believe that all valuation metrics, such as price-to-book value, are equally effective in all sectors. Second, we believe it is important to consider the value of a stock within the context of its’ unique historical relative range. We believe that stocks that have historically carried premium valuations to their peers will likely carry premium valuations in the future. When using the appropriate valuation metric and after adjusting for historical sector and stock biases, we do not conclude that all Wall Street Darlings are universally expensive, as some critics claim. In fact, we find a number of the darlings ‘cheap’ or ‘fairly valued’ and as a result maintain exposure to them in our portfolios.
- The ‘Darlings’ have the wind at their back: The old Wall Street adage, ‘a market can remain irrational longer than one can remain solvent’ reminds us of the power of momentum and is the reason that it is one of the cornerstones of our security selection process. When momentum is strong and our other two cornerstones (value and quality) are reasonable, we will likely view some of the Wall Street Darlings as attractive investments for our portfolios.
- Structural guidelines used to maintain diversification: We build our equity portfolios to be relatively sector and beta neutral which can give our portfolios exposure to the ‘suppliers’ and ‘customers’ of the darlings that might benefit from ‘ripples’ caused by today’s popular investment themes.
2. Protect: Protecting our portfolios from the Wall Street Darlings is important, because the market can be fickle and today’s ‘darlings’ can quickly become tomorrow’s ‘dogs’. Having managed portfolios through other periods of narrow market leadership, we have made the following observations:
- Narrow markets bring out investor’s worst behaviors: Some of the characteristics that have created today’s darlings are those same characteristics that behavioral finance professionals caution investors about. A few examples include strong near-term performance (recency bias), excessive media attention (confirmation bias), widely-held (herding bias) and ‘home run’ potential (swing for the fence bias). These biases have been classified by behaviorists as ‘unhealthy’ because they have the tendency to interfere with sound decision making.
- Trees cannot grow to the sky: Generally, by the time a stock becomes a ‘darling’, it has already risen to a lofty level, making further advances more difficult especially in innovative industries where leadership is typically short-lived. As an example, consider that the combined market capitalization of the top-5 US companies, all of which are in the Technology sector, is nearly $3 trillion as of year-end, which according to the World Bank is larger than the 2016 market values of the entire French ($2.2 trillion) or German ($1.7 trillion) stock market.
- Losers can be easier to identify than winners: Identifying the next ‘hot’ social media company is tremendously difficult, especially given that many are looking for it. In our opinion, it is often easier to determine the potential victims and avoid them. Just like in sports, a good defense can be a good offense. At fair or full valuations retail stores and traditional media companies are good examples of what we see as ‘obvious losers’ that have suffered from the success of the Internet retail and social media industries.
We ‘protect’ our portfolios in the following ways: While no money manager can fully participate and fully protect a portfolio, we aim to minimize our portfolio’s exposure from a ‘bad outcome’ for the ‘darlings in the following ways.
- Implement processes to protect our portfolios from ‘bad behavior’: RiverFront uses processes designed to minimize the impact of emotions on investment decisions. The first process occurs within equity selection, where we limit the degree that our portfolios can overweight or underweight a sector and a stock. The second process involves our robust risk management process used to help identify and address poorly performing securities before they become significant problems.
- Recognize that trees can’t grow to the sky: RiverFront’s value process starts with our Price Matters asset allocation methodology. This methodology is designed to move our portfolios away from asset classes that are expensive and toward asset classes that we believe are cheap or undervalued. Today, our asset allocation portfolios are roughly 5-15% underweight US equities reflecting their slightly above average valuations.
- Use quality and momentum tools to help identify losers early: Secular underperformers typically show themselves well before it is too late. This is one of the reasons we rely on ‘quality’ and ‘momentum’ metrics to drive two cornerstones of our equity security selection process. Our research has shown that many secular losers can be detected early through the deterioration of stock’s quality or momentum scores. For example, a company facing stiff structural headwinds tends to borrow more, hold less cash and report earnings that are less ‘clean’.
Important Disclosure Information:
The comments above refer to generally to financial markets and not RiverFront portfolios or any related performance.
RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.