Heavyweights dominate index performance
In our latest investment report, we addressed the question of whether the technology sector is overvalued and concluded that this is not fundamentally the case. Looking back at the first half of the year, it is tempting to examine this issue from a different perspective.
In particular, the large technology companies, after another strong rise, are not only highly weighted in the benchmark indices but also responsible for a large part of this year’s performance. This is most pronounced in the Nasdaq technology index, where the 10 largest companies have a weight of 52% and are responsible for 94% of this year’s performance. In the more broadly diversified MSCI World Index, the 10 largest companies make up 25% of the index and have contributed 62% to the performance.
Economic growth is low, interest rates are high, and the outlook is uncertain. At the same time, we are experiencing euphoria in the field of artificial intelligence, and in the middle of it are the largest corporations, which have the financial means to invest in the data centers that produce the necessary computing power. Even without earnings from artificial intelligence applications, the earnings growth of these large corporations is already considerable. The combination of these factors has raised investor expectations, and as a result, the 10 largest companies are now twice as expensive as the overall market. At the same time, the weighting in the indices has risen sharply. As recent as 2018, the 10 largest companies in the MSCI World had a weighting of 12%, compared to 25% today.
Analysis of the valuation dynamics
Meanwhile, there are countless indices that weight all stocks in the index equally to achieve a broader distribution of invested capital. Interestingly, these indices outperform cap-weighted indices in the long term. However, the phases in which cap-weighted indices generate excess returns are often long. This can possibly be explained by the fact that fundamental earnings drivers first justify the price increase of dominant companies, but are then replaced by exaggerated expectations, which consequently lead to a valuation correction. It has yet to be definitively assessed which phase we are currently in. The potential of artificial intelligence appears promising, the possible changes are far-reaching. But the risks are also multifaceted, from technological disruption to new competitors to government intervention.
A high index weighting and valuation premium do not necessarily mean that these companies are overvalued. They may be fairly valued in view of the potential scope of artificial intelligence. However, fairly valued also means that a positive scenario for earnings growth is already discounted in the price. If the priced-in scenario proves to be realistic, the future price increase will be driven more by actual earnings growth than by a further widening of the valuation premium. Therefore, the probability of a renewed development on the scale of the past few years is significantly lower. The risk/return ratio, which is essential for investing, has deteriorated accordingly.
This poses various risks for investors. Passive investors are disproportionately invested in highly valued large caps. Active investors are often measured against benchmark indices whose weightings are based on the market capitalization of companies. If the performance of these benchmark indices, as is currently the case, is driven by a few stocks that additionally and because of their strong price performance have a high media presence, the pressure increases to weight them in a similar way to the benchmark indices.
Added value through active asset management
As a Swiss investor, one is well aware of the downside of index dependence. Nestlé, Roche, Novartis, and UBS make up more than half of the SMI Index and are partly responsible for the fact that the index has not been able to keep up with the performance of the MSCI World Index for years. The fact that large corporations have a dominant weighting in indices is not unusual globally and in historical context. However, the fact that they outperform the overall market in the long term is. Away from the media attention and expectations of trend investors, a multitude of companies are generating attractive profit growth without having to pay a valuation premium for it.
Active asset management can again become crucial in the near future if one takes an independent path away from benchmark indices and can withstand the occasional strong pressure to neglect diversification and valuation criteria. We at Valvest Partners do not consider the current time to be opportune to weight the large companies analogously to the benchmark indices. For this reason, we have made reallocations and reinvested in companies where we see a more attractive risk/return ratio.
Zurich, end of June 2024
With the euphoria surrounding the topic of artificial intelligence and the strong performance of the technology sector since the end of 2022, concerns have grown that the sector may now be too expensive. The issue in assessing this question is multifaceted. The technology sector consists of the three sub-sectors: software, hardware, and semiconductors. Each of these three sub-sectors has different demand dynamics, margin profiles, growth rates, and valuations. Both the sector and the sub-sectors are dominated by Apple, Microsoft, and NVIDIA, which together make up about half of the technology sector with market capitalizations of several trillion USD each. Since 2018, large technology companies like Alphabet (formerly Google) and Meta (formerly Facebook) have also been allocated to the communication sector rather than the technology sector. Broad overall assessments at the level of an overarching sector do not do justice to these circumstances.
The same can also be said for regional evaluations. A statement like ‘Europe is attractively valued compared to the USA’ is not meaningful without considering the different composition of the sectors. While in Europe the finance and industrial sectors each account for about 15% of the total, in the USA the technology sector, with around one-third, is by far the most significant sector. It is undisputed that the financial sector, especially since the financial crisis, does not have the best track record, while the technology sector continues to gain importance. From the trend towards smartphones, cloud computing, and most recently artificial intelligence, no consumer and no company can escape digitization. Accordingly, their share of economic output has increased, which is rightly reflected in market capitalization.
For a specific assessment of valuation, the widely used price/earnings ratio falls short. The price reflects not only the current earnings but also their growth prospects. The entire technology sector shows a significant growth premium compared to the overall market. Especially in economically challenging environments, this is valuable and essential to at least keep pace with inflation. Thus, a valuation premium based on current earnings compared to the overall market is justified.
Additionally, important is that profit growth can be achieved both through revenue increases and efficiency gains. The latter, due to scalability, leads to above-average high margins in the technology sector. According to our assessment, these could be even higher, especially for the large technology companies, since efficiency was not a priority until recently due to strong growth.
Considering all the above-mentioned circumstances, the valuation of the technology sector has indeed become more demanding compared to the overall market. At the same time, the excess growth has accentuated in the current environment. Occasionally, future expectations regarding artificial intelligence may have led to valuations that have somewhat outrun earnings development. Overall, we consider the valuation to be in an appropriate relation to the growth.
As active investors, we have the privilege of not having to buy the entire sector. Our focus is exclusively on finding companies where the earnings prospects are in an attractive relation to the valuation.
Zurich, end of March 2024
Review
Even though the end of the year is arbitrary, it is a good opportunity to reflect on the past and learn for the future. In the past year, we were once again able to see how much the consensus can lead us astray on complex issues. The majority of market participants and economists predicted a negative economic development for 2023. Even our assessment, in hindsight, was not positive enough to do justice to the strong market development. A variety of challenges shaped the economic landscape. The extraordinarily high inflation forced central banks to raise interest rates sharply and pursue a restrictive monetary policy. After a long period of low interest rates, companies, consumers and states were suddenly confronted with rising interest rates and their diverse effects.
Meanwhile, the global supply chain bottlenecks have largely normalized. This has mitigated a major driver of inflationary pressure and allowed central banks to pause interest rate hikes in the second half of the year and adopt a wait-and-see stance. Therefore, an important factor of uncertainty has stabilized, which benefits the valuation of the financial markets. The risk premium of equities over fixed-income government bonds, a measure to judge the attractiveness of equities vs bonds, has therefore remained at a low level despite all the uncertainties. The strong stock market increases reflect, on the one hand, the declining long-term interest rates and the anticipated interest rate cuts by central banks for 2024. On the other hand, corporate earnings for the overall market have continued to grow and have already reached new highs, unlike the stock market. These two factors have made valuations both absolutely and relatively more attractive and have accordingly made the surprisingly positive performance possible. Most companies were able to pass on price increases to their customers and increase sales despite a weakening economy and partly declining sales volumes. A less impressive picture emerges when purchasing power is considered, but nominal growth feels better than nominal stagnation nonetheless.
Statistical context
As active investors, our goal is to invest in the world’s best companies, which not only preserve purchasing power, but also generate a long-term excess return compared to the market. We take into account the comprehensive earning power, which includes earnings growth, dividends, share buybacks and debt. Based on these factors, we regularly scrutinize all listed companies that are eligible for investment. We are always fascinated by how successful many companies generate added value for both customers and owners through innovation and efficiency. When we underpin these fundamental impressions with historical data, we do find it difficult not to look positively into the future. A statistic that supports this feeling is the number of years it takes on average for a portfolio to reach new highs. The graph below shows that balanced mandates reach a new valuation high every three years on average. Especially after strong corrections, it is worthwhile to keep this in mind.
A lower equity exposure further shortens this duration, but at the expense of long-term returns. A variety of dangers, whether inflation, geopolitical events or fundamental economic changes, are not unusual in the historical context and are represented in this data set. For evolutionary reasons, we tend to overestimate dangers, because this was essential for survival. However, equally natural is the desire of all market participants to maneuver the current environment as best as possible. Accordingly, the best companies emerge stronger from difficult phases.
Outlook
What can we expect for 2024? The current economic indicators continue to paint a bleak picture and the long awaited recession remains possible. With certainty we know, that 2024 will be a record year for politics. In more than 50 countries, a new government will be elected. Election years not only provide ample controversial topics for discussion but are also, at least in the short term, a positive driver for the economy. Several studies indicate that governments tend to increase spending in election years. As a result, government debt is expected to increase due to higher expenditures, possibly accompanied by measures from central banks. These measures, including interest rate cuts, may contribute to an expansion of the central banks’ balance sheets. As always, there are therefore sufficient reasons to justify both a positive and negative assessment. The decisive factor is how the actual development differs from the expectations embedded in the market prices. In this regard, we observe that market participants while less pessimistic compared to a year ago, show no signs of widespread euphoria. This is also reflected in the valuation differences of the various equity sectors. Specifically, the valuation in the technology sector already factors in substantial anticipated growth rates, whereas significant portions of the markets anticipate declining profits instead. This provides us with the chance to benefit from relative valuation differences and make corresponding adjustments in the portfolio. In view of the dynamic market conditions, we remain committed to our strategy of generating long-term value for our investors through careful analysis and selective investments.
Zurich, end of December 2023
An important parameter for assessing the market valuation is the risk premium, which represents the difference between the yield of corporate earnings and risk-free government bonds. As interest rates remain elevated, equity markets approach previous highs and have risen disproportionally to corporate earnings. As a result, the risk premium is low despite the difficult market environment.
At present, inflation poses a significant source of uncertainty. However, the growth in corporate earnings demonstrates that companies have successfully tackled this challenge and have managed to partially offset the impact of inflation. On the other hand, fixed rate government bonds lack this characteristic, which justifies a lower risk premium for equities. To truly understand the risk-premium of stocks, it is important to consider the corporate earnings yield in relation to the inflation-adjusted real yield of government bonds. This perspective provides a more balanced view of the real risk premium and offers a more concise assessment of the current valuation of the stock market.
However, there are significant variations in the risk premiums among different sectors and individual stocks, reflecting investors’ expectations regarding their ability to thrive in the current environment. Companies are continuously striving to enhance efficiency and achieve economies of scale through increased sales volumes.
This serves as a partial offset to the impact of low inflation rates. During periods of elevated short-term inflation, as we have recently experienced, companies are compelled to pass on higher costs (such as materials, labor, and energy) directly to end customers in order to protect their profitability. Companies that are well-positioned and have high-demand products are more successful in this endeavor compared to those offering easily substitutable products. However, even some companies with weaker positioning have managed to achieve growth in sales and profits, as price increases have more than compensated for declining sales volumes.
The latter impressively illustrates the distorted perception that can arise from high nominal growth rates. Short-term wage increases, although initially positive for consumer sentiment, also contribute to this phenomenon. The concept of money illusion highlights the tendency for people to concentrate on nominal figures while paying insufficient attention to inflation. As a result, the effective loss of purchasing power is often neglected or recognized with a delay. Consequently, nominal economic growth of 5% with 7% inflation feels better than 0% growth with 2% inflation.
Higher interest rates have undeniably made the current environment more challenging. Expensive valuations must be consistently justified with profit growth, as any disappointments are swiftly penalized by the market. This was evident in parts of the health sector, which had benefited greatly from the effects of the Covid-19 pandemic but has since struggled to sustain the previous growth and has underperformed the market as a consequence. Nonetheless, the first half of the year demonstrated that economic prospects were overly pessimistic, and the anticipated slowdown was premature.
It takes time for the effects of higher interest rates to fully unfold. It is important to note that higher interest rates do not necessarily indicate rates that are too high for sustainable economic growth. Currently, the various economic indicators present an inconsistent picture. Central banks are likely to maintain higher interest rates until inflation appears to be firmly under control. The trajectory of inflation plays a vital role in determining real interest rates. As interest rates stabilize, the risk premium benefits from reduced uncertainty, enabling a stronger emphasis on profit growth.
The economic and investment landscape remains challenging, demanding thorough and nimble analysis of assets to be well-prepared for various scenarios. By exclusively investing in direct investments, we closely monitor the progress of all companies held in our portfolio and can promptly respond when needed. Additionally, we prioritize a balanced distribution of company characteristics to ensure the resilience of our portfolio. The past year highlighted the importance of not solely relying on growth but also considering valuations for sustainable long-term performance. A relative valuation discount to the market and comparable companies provides a margin of safety to better withstand unpredictability. In the current environment, we do not compromise on quality and valuation.
Despite the presence of various risks, adhering to our long-term strategy, maintaining disciplined ownership of the best companies in our portfolio, and trusting in their ongoing pursuit of growth and efficiency, regardless of the market conditions, has once again proven successful. We capitalized on the divergent performance of individual positions by realizing profits from volatile cyclical stocks and reinvesting them in attractively valued, more defensive opportunities.
Zurich, end of June 2023.
Review
A balanced investment profile aims to offset various influencing factors and stabilize the return. An investor in bonds provides debt capital to companies and is usually compensated with a fixed interest rate. An investor in equities is a co-owner and thus participates in the profits or losses of a company. If the economy grows, corporate profits tend to rise and equities yield a higher return than fixed-interest bonds. In uncertain times, on the other hand, investors seek the safe returns of bonds. Typically, bonds gain in value when stocks perform badly.
Not so this year. Balanced investment portfolios had one of the worst years on record. The reason for this was that the market’s perception changed within a very short period from persistently too low inflation to fear of lasting high inflation. In this context, the very low interest rates of the recent past lost their justification, which caused a strong correction of fixed-interest bonds. Consequently, equities also faltered, because their valuation or earnings yields, are in direct competition with bond yields.
Development of global equities vs. bond yields
The trend of falling interest rates lasted 40 years, peaked with negative nominal yields in some currencies last year and now experienced a dramatic reversal. Accordingly, previous beneficiaries of this trend suffered the most, especially long-dated bonds, expensively valued defensive quality and growth stocks.
Outlook
Now that the U.S. Federal Reserve has raised interest rates at an unprecedented pace, and other central banks around the world have followed suit, the question is how well this interest rate level can be absorbed by consumers, companies and governments. On the one hand, higher interest rates and the increased prices of many goods are straining the budget. On the other hand, the labor market continues to be very robust, wage negotiations are promising, and demand is stagnating at a high level. With China now also easing covid measures, the full impact on demand is difficult to assess at present.
In case the economy weakens, interest rates should stabilize, which would have a supportive effect on equity valuations. However, the development of corporate profits is then likely to be less positive. The various interdependencies between growth, inflation, interest rates and valuations make the current situation challenging. In contrast to the starting position one year ago, bond yields are once again contributing to portfolio returns. The valuation of the stock market reflects the higher interest rate level and, at least partially, the economic slowdown expected by most economists next year.
Conclusion
It is advisable to be prepared for various scenarios and to take a long-term perspective. Current interest rates offer a stable source of income, which is why we have increased the bond allocation and extended our maturities slightly. Due to the sharp rise in interest rates and the resulting changes and risks for the market and the economy, we consider a neutral equity weight to be appropriate at present. Nevertheless, valuations are less demanding and offer good entry points for long-term investors. We expect uncertainties to persist and market developments to remain challenging. However, times like these always offer good opportunities to identify new investments that are at a valuation discount due to the current environment. The resilience of our portfolios remains the upmost priority.
Zurich, end of December 2022
Review
Record-low interest rates coupled with record-high inflation are leading to deeply negative real interest rates. To correct this situation, either interest rates must rise or inflation rates must fall. Since inflation has turned out to be less “transitory” than central banks had hoped, they now see themselves forced to raise interest rates substantially.
Whereas valuations in recent years were justified by low, and in some cases negative, interest rates, this valuation correction based on sharply rising interest rates is also justified. Capital is always looking for the most attractive return in relation to the given risks. Thus, if the yields of reliable and steady bonds increase, this also requires an increase in the yield of equities in order to keep the risk premium over bonds constant. This can be done either by increasing the yields or by correcting the valuation.
The current problem is that interest rates have risen very quickly and corporate earnings growth has not kept pace. There is also the problem of the base effect. Because of low interest rates, small increases in interest rates are large increases in percentage terms. The same applies to company valuations: the more expensive a company is, the higher the earnings growth must be to compensate for the rise in interest rates and maintain the risk premium compared with fixed-interest investments. As higher interest rates also have a slowing effect on economic development, companies’ earnings growth tends to slow down. Ongoing cost pressure due to strained supply chains and labor shortages further exacerbates this problem.
The risk premium on equities is therefore under pressure on both sides. Higher interest rates combined with presumably lower earnings. Particularly hard hit by this situation are companies with demanding valuations, which have to grow disproportionately in order to correct their own valuation. These are precisely the companies that have benefited in recent years from steadily lower interest rates and positive economic development and have received a lot of attention from the media and trend investors.
Outlook
Whereas historically central banks could be relied upon to counter an economic slowdown with interest rate cuts, this time the starting position is reversed. Central banks are forced to raise interest rates due to high inflation rates and to accept an economic slowdown. Depending on the intensity of the growth slowdown, the current high inflation rates should fall and bring about a stabilization of interest rates. It cannot be ruled out that the current investments by companies to eliminate the supply shortage could even lead to a supply surplus and renewed deflationary tendencies as the economy weakens.
Much depends on the further development of inflation rates and the resulting interest rates. On the positive side, after a long wait, investors in fixed-income investments are once again receiving a return, even if this is not yet keeping pace with inflation. In the event of a return to lower inflation rates, the current interest rates could prove to be an attractive opportunity. The money in the account, on the other hand, is fully exposed to the high inflation rates, but allows at least temporarily to benefit from better opportunities to buy assets.
The challenging initial situation makes it necessary to focus on proven features in the stocks, which help to survive a more difficult situation. A leading market positioning secures earnings despite rising costs. Structural growth areas cushion the economic cycle somewhat, and an attractive valuation makes it easier to compensate for any interest rate rises. Temporary profiteers such as commodity companies do not meet our quality requirements in the long term any more than overpriced growth companies did before the correction began this year. Short- to medium-term market dislocations, on the other hand, are a part of investing and offer attractive opportunities to profit from valuation deviations in the long run.
Zurich, end of June 2022