As published in The Globe and Mail on September 26, 2024 (for subscribers only).
Use low sentiment to your advantage
Rush hour traffic is no one’s idea of fun. Studies show idling on crowded roads negatively affects our health and lowers satisfaction with work and life. Likewise, crowded trades are no picnic for advisors who must decide whether to jump in. Very popular stocks, like yesteryear’s General Electric and today’s Nvidia, pull focus and capital which drives their share prices up, sometimes away from business fundamentals. In a recent poll, 40 per cent of fund managers considered the Magnificent 7 a hugely crowded trade and the frenzy for all things AI decidedly in bubbly territory. Research on stock data going back 75 years shows market concentration in a few stocks is not sustainable over the long term.
Following market momentum leaves little room for error or surprise. Expanding exposure to include more reasonably priced companies gives the advisor more flexibility. It also offers a much larger opportunity set and greater portfolio diversification, which is a proven risk management tool. Investing in companies and sectors currently experiencing low sentiment means investment dollars go further. Market concentration in the US, measured as the market capitalization of the top 10 companies relative to total capitalization from 1950 to 2023, has varied between a low of 12% in 1993 to a high of 30% in 1963. In the decade ended in 2023, concentration of the US stock market nearly doubled from 14% to 27% and has since expanded further in 2024. The rate of increase in market concentration over the last decade, the most rapid since 1950, is disconcerting to many investors. A return to more normal market concentration would necessitate broadening of market returns.
Festina Lente: Make haste slowly
Sometimes a little patience goes a long way. On February 5, 1999, Nvidia’s share price was four cents. Since inception, the share price has risen over 262,000%. Apple debuted on the Nasdaq in 1980 at $22 per share. (As a sidebar, on a split-adjusted basis the initial stock price was 10 cents.) By 1997 the company was practically left for dead and on the verge of bankruptcy. Yet in 2022, it became the world’s first trillion-dollar company. These are dramatic examples but they remind us that stock prices rise and fall—sometimes a lot. Good or even great businesses occasionally stumble but usually right themselves over the long term. Advisors who react to the market’s gyrations can potentially miss out on impressive turnarounds. Patience is in low supply today. In the 1960s, investors held stock positions for an average of 8 years. Today, the average is closer to 6 months. This makes an advisor who practices patience more valuable than ever to their clients because patient capital is a source of outperformance. Being willing and able to hold on to high-quality assets during periods of market turbulence is the not-so-secret weapon of the successful advisor.
Know your circle of competence
Warren Buffett has often spoken about staying within his circle of competence focusing on those companies and sectors where he believes he understands them better than the average investor. The size of that circle is of less importance, he has said, that knowing its boundaries. An advisor must have the courage to occasionally say, « I don’t know » when clients ask about company X or sector Y. Staying within the perimeter of one’s competence is a prudent use of both time and of capital. Not only does it reduce the risk of loss, it keeps us humble which, along with patience, is a valuable trait for investors. Acknowledging that we don’t know everything about everything is a great incentive to remain vigilant about our decisions and to seek continual improvement to serve our clients better.
These concepts are simple, but their application takes regular practice. Advisors who do make the effort are likely to be rewarded with better long-term outcomes for their clients.
