So its been a really interesting earnings season thus far. Coupled with that there is also an interesting chart which has been doing the rounds online, courtesy of Bianco Research. The chart below shows how the concentration of the five largest stocks in the S&P 500 has risen to just shy of 25%! This is the highest level since the 1970’s. Many an unaccustomed reader may say, ‘so what’, so here’s the point.

Source: Bianco Research

We have been told that diversification in portfolio management is the key to managing risks and sustainable long-term returns. There is an alternative school of thought which says you should back your winners and run concentrated positions. Let duke it out.

Passive aggressive

Many passive investors believe that buying the index is the ultimate diversifier. You get 500 different stocks, etc. And there is merit in the argument, provided that the index itself is diversified. However, when looking at market capitalization weighted indices, like the S&P500, the larger stocks will always carry a higher weight in the index. That’s normal. What’s not normal is when the ‘mega-caps’ literally run away from the rest of the index resulting in a situation much like what we find today.

Now there are two ways of looking at this. One is that by riding the index, you continue to ride the success of the mega-caps. That’s a good thing as long as they outperform. If you held anything ‘more diversified’ like an equally weighted basket, you would have massively underperformed the index. This is the whole ‘back your winners’ strategy, the antithesis of diversification. And lets be frank. The top 5 stocks are all tech heavyweights (MSFT, AAPL, AMZN, GOOG, TSLA) meaning that your investment thesis had better align to the fate of big tech, warts and all.

The alternative hypothesis is that concentrated positions increase portfolio risk. For example, any regulation which impacts big tech specifically will hurt the concentrated tech (now S&P500) investor disproportionately more. As such, the ‘don’t put all your eggs into one (S&P) basket’ would resonate.

So which approach is correct?

This is the beauty of markets and portfolio management. There is no ‘one size fits all’ approach. There is an approach which suits every temperament and every investor. Perhaps in recent years, the ‘active investor’ has fallen out of favor as it has become harder to ‘beat the index’ in the face of the rampant bull run and YOLO trading on meme-stocks and crypto. It’s wild out there.

My approach has always been one of diversification and conservatism. I’m not in this for the get rich quick (heck that would be nice though) rather than ensuring financial sustainability over the long term and through the cycle. It’s the harder road to travel especially when faced with FOMO and the new found riches of the post 2020 trader. But there’s something to be said for sticking to one’s knitting especially if one knows how that knitting has turned out through not only 2020, but 2008 too.

Betting on the right horse?

This leads me to the comment on the current earnings season. For this, I would like to highlight the following charts, courtesy of Factset. Now these are about a week out of date, but the overall picture and message remain.

The revenue growth (blended) in the current quarter just north of 17% (depending on how the earnings season closes) will be the second highest since 2008. Now, lets be realistic here. Q2 and Q3 last year were the pandemic slump and so there is A LOT of base effect in this number. But even if we smooth that all out and take the average over the last 2 years, revenue growth has been remarkably strong and above the 5 and 10 year growth rates of 5.8% and 3.5% respectively! These buoyant revenue numbers has translated into strong profit margins and margin expectations in the current and next quarter and have provided the underpin to the overall rally in markets.

Source: FactSet

This is where it gets interesting. Markets are cyclical. Let’s take a look at what has been driving the recent revenue and margin on a sector level. From the charts below, we can see that Energy is a large feature. Again, not surprising, given that over little more than 18 months, we have seen oil move from ‘negative’ on the near future to over $80/bbl.

Source: FactSet

Does anyone remember how the sector languished over the preceding few years, cutting back on capex to ensure they survived? Returning cash to shareholders? Interestingly and on the other end of the spectrum is consumer discretionary. I’ll leave the charts above for you to look through, but the point I would like to land on is that there are always winners and losers and that the winners of today are not necessarily the winners of tomorrow. This is why it is so important to look to the underlying companies one is buying into.

If you are interested in the underlying thesis behind different stocks from both a trading and investing perspective, you MUST check out Magic Markets Premium where I discuss my views, both fundamental and technical on specific global stocks. The Finance Ghost and I do a proper analysis of the financials and provide a write up and podcast each week behind the paywall.

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Trading vs. Investing

In this era, too many people are just ‘buying a ticker’ on the screen. When IPO’s of untested companies who haven’t sold a product yet, dwarf the market cap of established industry players, we have to question the sanity of markets. And that is starting to show. Rivian, listed with a larger market cap than VW, Ford and GM. But the post IPO slump is bound to leave a few crying punters in its wake.

That’s why, at the risk of being ‘old fashioned’ and being called a boomer (I’m not btw 😊) I prefer to look at valuations, understanding the drivers of the businesses I invest in. Do I take a punt every now and then? Sure, but I keep those ring fenced. It’s spicy, fun and also not likely sustainable and that part of my portfolio is very different to real investing!

That’s why I am clear about what I put in my ‘trading portfolio’ and what I am ‘Investing’ in. These are distinct in their approach, ideology and ethos. And understanding that is just as key as getting to understand yourself and how you will navigate, survive and thrive through different market cycles.

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