Feature – Equities
tries or sectors, vary over time. But what we are seeing in the recent period is that the top stocks have outperformed the mar- ket, which is quite an unusual thing because usually the top 10 stocks would face headwinds of regulation from above and competition from below. So effectively overtime you tend to see quite a lot of turnover at the top 10 stocks. “What we’ve seen recently is the top 10 stocks outperform the index, and that applies especially to the top five stocks in the S&P500, the FAANG stocks, this year they have outperformed the other 495 stocks by around a third. So that has driven an increase in concentration in the US,” Booth argues. The reasons for the dominance of tech stocks are complex, he says. “Partly that is due to the regulatory environment catching up on the evolving tech sector and also some of the competitive behaviours and acquisition activity of some tech companies. You do get periodic concentration in stock market indices over- time (Japan accounted for almost 50% of the world index in 1980s) and we have seen that particularly in 2020, as the Covid related market environment is hitting some sectors (such as hospitality and travel) and benefiting companies with an online presence. So, a trend that was already in place has been accel- erated by the Covid crisis,” Booth explains.
Potential for a turnaround So far, the gamble has paid off for many equity investors, with FAANG stocks recouping most of their losses from earlier this year. But as stock market volatility and warnings of a tech bub- ble are mounting, could it be time for pension schemes to think outside the box? At its recent peak valuation, Apple’s market cap exceeded that of the FTSE, while Tesla’s market value grew bigger than all other car manufacturers combined. Booth acknowledges that valuations have reached extreme lev- els. “The relative valuations of growth versus value are quite extreme today. When we look at the beginning of the year, according to Research Affiliates, we were at the 95th per- centile and that means the ratio of more expensive growth stocks to cheaper value stocks, was more expensive than 95% of the history, and we’re now at a 100%. So, the divergence between the expensive stocks and the cheap stocks is at record levels. That is partly because of the Covid market environment that has benefited online large-cap tech companies and been disadvantageous for cyclical, leveraged value sectors,” he warns.
Structural changes to stock markets have made it increasingly challenging to put an accurate price tag on a company’s shares. Popular methods such as the Shiller PE struggle to capture the potential effect of the Covid pandemic on future earnings. Meanwhile, negative interest rates on bonds have posed a seri- ous challenge to the discounted cash-flow model, as portfolio institutional explored in our previous issue.
46 | portfolio institutional October 2020 | issue 97
Added to that is the gradual decline of analyst coverage for individual stocks, partly as an unintended side effect of Mifid II. Since the introduction of the new rules unbundling research and trading costs, investment banks have cut back on their research departments. Over the past year alone, analyst cover- age of UK-listed firms has dropped by 52%, according to Citi- gate Dewe Rogerson. Across Europe, analyst coverage fell by 38%. One consequence of this decline in research output could be that high-quality SME companies might fall off the radar for institutional investors, the firms warns. Most schemes might be reluctant to describe themselves as contrarian investors and are careful to avoid the impression of banking on short-term, tactical trades. But neither do they wish to stand accused of simply replicating what everybody else does. As valuations of a handful of stocks have reached increas- ingly extreme levels, could a move away from indices start to become a more prudent approach?
Thinking outside the box
There are, of course, multiple ways of doing so, from allocating a growing proportion of assets into actively-managed strategies to implementing a factor tilt across portfolios. Or, at the most fundamental level, being comfortable with having a relatively higher active share compared to benchmark indices. Less mature final salary schemes with an in-house investment
As CIO or asset manager, you need to be an inde- pendent thinker, which means you should not always follow the herd or be a contrarian
Craig Heron, Railways Pension Scheme
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