” ‘Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” —Don Quixote, Miguel de Cervantes, 1615
When the stock market stopped its dizzying plunge and averages began to climb again in March, we all breathed a sigh of relief as our holdings regained much of their previous value.
But the picture is more complex than a simple reversal in market direction. The recovery of the well-known market indices was largely led by a handful of stars. These companies have dominated the market indices more than often realized. Some might wonder, with such outstanding players on stage, why bother with a supporting cast of other, less spectacular performers in our portfolios? We believe that now, more than ever, is the time for spreading risk and smoothing volatility through a well-diversified portfolio of investments.
The Standard & Poor’s 500, probably the index most commonly used to gauge performance, has become less and less diversified. The S&P 500 consists of 500 of the largest US companies based on market capitalization (number of outstanding shares multiplied by the price of those shares). The larger the company’s market capitalization, the larger the percentage share that company holds in the index. Currently, Facebook, Amazon, Apple, Netflix, Google (Alphabet), and Microsoft (FAANGM) make up close to 25% of the S&P 500.
As the viral pandemic swept across the world, these companies were better positioned than most to survive—and even thrive—in the new environment as people socially distanced and connected online. Their stock performances reflect this. FAANGM returned 26.8% from January 1, 2020, through June 30, 2020, while the S&P 500 (494 companies plus FAANGM) returned -3.08%. Since the pandemic lows in March, FAANGM returned slightly over 50% versus the S&P’s 35%. The FAANGM powerhouse stocks together outperformed an equal-weighted S&P portfolio, as well as mid-cap and small-cap stock indices.
The strong performance of the six FAANGM companies can mask some market realities. One sign of a healthy market is “wide market breadth,” meaning that many companies across different sectors are doing well, causing the market to rise. Alternatively, “narrow market breadth” means that a few companies account for the majority of returns in the market. Today we have “narrow market breadth.” As a handful of large companies are doing very well, the remaining companies are struggling.
Unquestionably, Facebook, Amazon, Apple, Netflix, Google, and Microsoft are well-respected, high-achieving companies. They generate revenue from market segments ranging from advertising, retail, cloud services, devices, and social networking sites, among others. I use their products and services almost daily. While writing this article, I tried to think of another company that I use as often as the FAANGM companies. Why bother investing in other companies if I only need these six to get me consistently high returns?
Well, there are several reasons, as it turns out. One of them occurred to me as I ran our dishwasher at home. Our family has used Cascade, one of Procter & Gamble’s many products, for as long as I can remember. I even ate a handful of Cascade when I was a toddler, causing my panic-stricken mother to call 911. We still used Cascade after that incident.
There is a Procter & Gamble product in our shopping cart practically every time we shop for groceries. The company’s instantly-recognizable brands include Tide, Crest, Pampers, Bounty, Charmin, Ivory, and Dawn.
Crucially, there is a difference between a wonderful company and a wonderful investment. Contrast Procter & Gamble with a once-popular growth company like Yahoo. In mid-May of 1999, Yahoo’s P/E ratio (price-to-earnings) was around 1,062. That means an investor was willing to pay $1,062 for every $1 of Yahoo’s earnings. Using trailing 12-month earnings, the average P/E for the S&P 500 over the last twenty years is about 24. A review of Yahoo’s financial statements at the time could have revealed that despite the company’s successes, there were some red flags signaling that it was in fact highly overvalued at that price. Yahoo’s market value peaked in 1999 at $125 Billion. When the tech bubble burst and the market finally bottomed in 2002, Yahoo’s market cap had declined by 92% to $10 billion and fourteen years later Yahoo was purchased by Verizon for only $4.8 Billion. In contrast, Procter & Gamble, a boring soap maker, reached a price of $58 at the peak of the tech bubble, declined to a low of $28 in 2002 but is still trucking along and recently closed above $130 per share.
In the case of Yahoo, an exciting, pioneering company reached a point where it was not a wonderful investment. As Warren Buffet once said, “Price is what you pay. Value is what you get.” Determining whether a company is a wonderful investment requires a deep dive into the company’s financial records. One goal is to review its fundamentals and business prospects to determine its true value, and then compare that to its current stock price.
Yahoo may have been a wonderful company in 1999 as it pioneered the internet, but Procter & Gamble was a far better investment. So-called value companies may not be as flashy or in the news as much as growth companies, and that’s okay. Procter & Gamble will still make the Cascade we use to clean our dishes for years to come. Honeywell will continue to make thermostats and bar-code scanners. Johnson & Johnson will produce Band-Aids, hip replacement devices, and pharmaceutical treatments for diseases. Value stocks such as these may not soar with the high-flyers, but they tend to produce steady income streams that help cushion them a bit from market downturns. As a bonus, many pay regular dividends, boosting their total return to investors.
In reviewing a prospective investment, it’s crucial to review the company’s risk, assets, business prospects and future income streams. Suppose I made a deal with you. I will give you $215 billion, and you will buy either Netflix or Disney, both currently value at about $215 billion. You will be buying the company’s earnings, assets, debts, labor force, patents, and culture. If you buy Netflix, you will own the top streaming service in the world. If you buy Disney, you will own all the parks, cruise ships, Disney+, ABC, ESPN, the Marvel franchise, the Star Wars franchise, the Avatar franchise, the Simpsons, the majority of Hulu, and all the merchandise that goes along with the iconic Disney stores. Both are wonderful companies. Which is the wonderful investment? Which one would you buy? In our view, Disney represents a better value, including less risk, for our money.
At Bragg, we currently own and buy Facebook, Apple, Amazon, Google, and Microsoft. These companies have demonstrated the ability to generate repeatable profits, maintain manageable levels of debt, and showcase the high quality of their management. The decision to add a company to our portfolio requires time and research. Our investment committee diligently and regularly reviews each of these companies, and all the companies we own, to determine whether or not they are still suitable and appropriately valued for inclusion in our portfolio.
A key element of our strategy is to remain diversified throughout all market segments. Diversification lowers risk and volatility. Technology companies like FAANGM are trading at all-time highs today. However, another Mark Zuckerberg, Bill Gates, or Jeff Bezos could be sitting in his garage right now working on a product or service that could change the habits of millions the way FAANGM has. Companies with multiple products in more than one industry typically carry less risk. There’s a reason that the saying about not putting all your eggs in one basket has survived for centuries.
At Bragg, we do not believe in speculating. We do not make predictions about the market. We believe that a portfolio with a tilt toward value stocks will have better risk-adjusted returns over the long term. We believe that diversification including value and growth companies across various sectors will produce better results than attempting to pick a few market winners. Furthermore, we believe that having a disciplined, unemotional and repeatable rebalancing process (selling bonds and buying stocks, or vice versa to maintain allocation targets) during market declines and market run-ups will produce better risk-adjusted returns over time.
The only constant in life is change. At Bragg, our goal is to help our clients feel comfortable that while things around us change, their daily lives and future goals do not have to.