The Importance of Diversifying U.S. Equities Through an Uneven Recovery Copy
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Nick Schommer, CFA
Portfolio Manager
The Importance of Diversifying U.S. Equities Through an Uneven Recovery Copy
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Nick Schommer, CFA
Portfolio Manager
Given fluctuating markets and changing leadership as the economic recovery progresses, Portfolio Manager Nick Schommer discusses how it may be prudent to sharpen the focus on sources of risk and return within one’s portfolio and seek to ensure these are not overly correlated.
Key Takeaways
- The recovery to date has been highlighted by distinct swings in leadership ‒ between value and growth, smaller- and larger-capitalizations and cyclical and secular growth stocks.
- Given fluctuating markets and changing leadership it may now be prudent to sharpen the focus on sources of risk and return within one’s portfolio and seek to ensure these are not overly correlated.
- A portfolio not dependent on specific market capitalizations, styles or sectors, but rather, focused on quality business models, may benefit from uncorrelated sources of risk and return with the potential to perform across multiple market scenarios.
In our view, the shifting nature of the COVID economic recovery has brought into focus the potential value of owning diversifying equity assets. A blend of holdings that do not look like the S&P 500® Index, are not dependent on specific market capitalizations, styles or sectors, but rather exhibiting the attributes of durable business models with the potential to perform in different market scenarios, may prove beneficial at this stage in the cycle.
The COVID Recovery has been Swift, but Uneven
While COVID initially created a severe economic contraction – akin to a natural disaster – we believed for some time that a health care solution to the pandemic would enable a similarly swift rebound. As the vaccination effort has steadily progressed in the U.S., consumers eager to re-engage with the physical economy have released substantial pent-up demand, and GDP growth has accelerated significantly. Powerful fiscal and monetary stimulus, strong capital market performance and a robust housing market have likewise positioned both individuals and corporations to reinforce an already widening economic recovery. Recently, though, the Delta variant has raised fears of slowing consumer demand. At the same time, supply chain bottlenecks and raw material and labor shortages have stoked inflation concerns and the potential for stormier weather ahead from an interest rate and economic data standpoint.
So, we have witnessed an ongoing push-pull in markets, and the recovery to date has been highlighted by distinct swings in leadership ‒ between value and growth, smaller- and larger-capitalizations and cyclical and secular growth stocks. At the end of last year and earlier this year, cyclical, more value-oriented stocks assumed market leadership. These were companies positioned to benefit from a reopening and a normalization of the economy in industries like travel where consumers directed pent-up demand and savings. Cyclical companies ‒ which tend to have a greater degree of operating leverage and perform better during periods of higher GDP growth – in general, rebounded strongly as the market gained confidence in a v-shaped recovery.
Diversifying Away from Big Tech
This is a stark reversal of the theme that saw the digital economy continue to thrive while the physical economy stalled at the onset of the pandemic, when a handful of large technology companies benefitted directly from the COVID environment. As with any crisis, the pandemic created a set of economic challenges that exposed weakness in certain business models and created opportunity for others. As businesses and consumers became increasingly dependent on ‒ and comfortable with ‒ digital technology during widespread lockdowns, big tech companies’ prominence in the economy grew.
As it stood in August, the information technology and communication services sectors made up 39% of the S&P 500 Index (as of 8/16/21). Out of eleven economic sectors, information technology alone was larger than six sectors combined (energy, utilities, materials, real estate, consumer staples and industrials). What’s more, the largest five stocks represented nearly 22% of the index, a level of concentration not seen even in the 2000 dot-com bubble (as of 6/30/21).
Chart 1: S&P 500 Index – sector weightings (%)
Chart 2: S&P 500 Index
| Top Holdings | Weight (%) |
| Apple, Inc. | 5.91 |
| Microsoft | 5.65 |
| Amazon.com, Inc. | 4.06 |
| Alphabet, Inc. | 3.99 |
| Facebook, Inc. | 2.29 |
Many investors’ primary exposure to U.S. equities is associated with the S&P 500 Index, which represents approximately 80% of the total value of the U.S. market.1 However, as illustrated above, the S&P 500 has become ‒ perhaps unwittingly to many ‒ an index increasingly concentrated in a handful of large-cap technology stocks ‒ a development that is certainly not without risk. This is not to say these stocks are not worth owning or bad companies. On the contrary, they have seen strong growth in recent years. As illustrated in the table below, over the trailing three years through to the end of September 2020, the S&P 500 (which is market capitalization weighted, giving greater influence to the largest stocks) outperformed the equal-weighted S&P 500, due largely to the strong performance of the mega-cap tech stocks. But, particularly as the economic recovery has broadened, we have witnessed a substantial leadership change, as illustrated in the period since September last year during which the equal weighted index has significantly outperformed.
Chart 3: Index returns (%)
Given the fluctuating nature of the recovery, this demonstrates to us the potential benefits of owning diversifying equities in other market sectors or wholly outside of the highly tech-concentrated S&P 500.
Differentiation by Redefining Value
To be clear, we do not advocate looking different from an index just for the sake of being different, nor do we suggest trying to time which market segment will be the next to outperform. Rather, taking an independent and thoughtful approach may lead investors to attractive opportunities that can provide diversified sources of return.
For instance, we believe that investors can uncover value in the market not by focusing on traditional measures, like price-to-book and price-to-earnings ratios, but by identifying companies with durable business models that have the ability to create value independent of macroeconomic conditions or market trends. This can be the case when the market misunderstands the potential profitability of a business or its growth capacity. There may also be opportunity in undervalued businesses where, over time, the market becomes willing to pay more for that business after company, industry or market events have created short-term dislocations in value.
Thus, it is our belief that by building a knowledge base of specific companies, one can assemble holdings with different sources of value and the ability to move independently to potentially create uncorrelated sources of risk and return. Likewise, we think it is particularly important in this environment to better understand changes to company business models and differences in pre- and post-COVID financials to home in on investment opportunities.
Deeper Analysis Required
We also think analysis that extends beyond the norm is particularly important in periods such as this. One such example that we believe can be extremely valuable for fundamental research ‒ but that is rarely applied in equity management ‒ is a knowledge of a company’s entire capital structure: both its bonds and its equity.
This analysis can be critical in identifying an inflection point in a company’s financial lifecycle. For example, when a company deleverages, at a certain level, equity investors may begin to see real returns in the form of stock buybacks and gain more confidence in that company’s ability to invest for future growth. Additionally, with more highly levered businesses, there tend to be a greater proportion of hedge fund investors, who often have shorter investment time frames and are more comfortable with the increased volatility that high leverage entails. Again, as a company deleverages and strengthens its balance sheet, more cash can be given to shareholders, and a new base of equity investors may become potential investors in that company, opening up the potential for a keen observer to arbitrage these different investor bases’ appetites for leverage and risk. Thus, while fixed income investors tend to focus on the appeal of a company’s bonds and equity investors study the value of its stock, at the end of the day, the ability to analyze the total capital structure can offer an advantage.
Navigating an Unpredictable Recovery
Thus far, we have seen fluctuation in the markets and changing leadership as the economic recovery progresses. We expect this to continue and it may therefore be prudent to sharpen the focus on sources of risk and return within one’s portfolio and seek to ensure these are not overly correlated. This could be through holding stocks of different market cap and sectors, or bringing in companies with diverse sources of value, uncovered through differentiated research. With more twists and turns likely ahead, a portfolio that is less dependent on the economic cycle and that avoids unintended concentration risks may well be welcome.
1Source: S&P Dow Jones Indices, as of 7/31/21.