Beyond The Headlines
Poor Market Breadth is a Contrarian Opportunity
I recently returned from France, where local colleagues pointed out how a few high-capitalization (market value) names were disrupting the performance game for French money managers. Popular luxury-oriented companies– which had already outperformed the CAC 40 index for several years thanks to superior operating performances – have further accelerated recently with signs of recovery in China’s consumer spending.
Several of these companies are included in the relatively narrow CAC 40 French stock index. Since they had already sold at much higher price/earnings ratios (and thus market capitalization) than the majority of French shares, they now have a disproportionate influence on the behavior of the index. For example, the following three companies account for nearly 35% of the CAC 40’s total capitalization, which makes it difficult for a portfolio to outperform without owning them:
Company Capitalization % CAC 40 Price/Earnings Ratio
LVMH 17.3% 30x
HERMES 8.4% 61x
L’OREAL 9.1% 39x
Total / Average 34.8% 43x (*)
(*) vs. 23x for the CAC 40 as a whole
Lack of breadth is not just a French phenomenon. According to Forbes Magazine (6/2/2023), the ten largest stocks in America’s S&P 500 are responsible for nearly 90% of the index’s return this year. That represents the highest percentage in history. The five largest companies in the S&P — Apple. Microsoft, Amazon, Nvidia, and Alphabet (Google) now comprise almost a quarter (24%) of the index’s market capitalization. Apple alone exceeds the combined value of all stocks in the Russell 2000 Small Cap index.
The focus of enthusiasm or speculative activity differs by market. At the moment, for instance, luxury dominates in France and artificial intelligence in the United States. Nevertheless, the lack of breadth remains disturbing for investors with a sense of history. The sectors to which investors’ money is flowing often do deserve to be favored based on their long-term fundamentals. But the investment public tends to mistake an industry’s promise and its ability to generate profits over time.
In this respect, I am grateful to the insightful team at Grant’s Interest Rate Observer for having recently quoted from my December 1999 paper: “AOL, RCA and the shape of history.” In that paper, I drew a parallel between radio in the 1920s and the internet in the 1990s. Radio revolutionized man’s perception of space and time in the 1920s, just as the internet began to do in the 1990s. The growth of radio did not disappoint and was explosive even through the Great Depression. However, investors in RCA and many other radio-related shares saw their large, early market gains evaporate in the ensuing years. I ventured to anticipate a similar future for AOL and some early leaders of the internet.
The biased weighting of leading indexes is aggravated by the increased role of performance measurement consultants, who tend to influence investment management systematically and over shorter and shorter periods of time. To avoid underperforming the indexes against which they are measured, investment managers feel pressured to load up their portfolios with stocks carrying the greatest weight in these indices. In doing so, they further inflate the price of the indices and make it more challenging for portfolios to perform according to consultants’ criteria.
These self-feeding episodes are the times when it is wise to ask oneself: “Do you want to look right temporarily or to become richer eventually?”
A company’s stock price is the result of two influences: its profits and its price-to-earnings ratio (P/E). Profits derive from the uniqueness of its products and the quality of its management, while the price/earnings ratio reflects the investing crowd’s hope for its future. Of these two influences, the price/earnings (P/E) ratio is by far the most volatile, often being cut in half or doubling within one stock market cycle.
In theory, contrarian investing and value investing are supposed to have much in common. The lower the P/E for a stock, the less enthusiastic potential buyers are about that stock’s prospects. The converse is also true: a higher P/E indicates high hopes among the investing set.
However, there is something paradoxical about stock selection, and this is where value investing and contrarian investing come closest to each other. The more expensive a stock is, based on its P/E ratio, the more vulnerable its price is to earnings disappointments. Conversely, the lower its P/E ratio, the further a favorable surprise can boost the share price. This is particularly relevant to the present situation: it can be observed that many stocks today are expensive historically – in particular, the heavy-capitalization members of the leading indexes — but this is not true of all.
I recently re-subscribed to the Value Line Investment Survey of more than 1600 companies, mostly but not solely American. The median P/E of the survey (half above, half below) is just under 17, but there are many names, including the usual suspects with wonderful narratives, with current P/Es above 30 or 40. On the other hand, I found a surprisingly large number of companies with current P/Es close to the single digits and fairly strong and liquid balance sheets.
So, it seems to me; the question is: what kind of surprise are we willing to take a chance on? Expensive companies with immaculate narratives where the slightest disappointment might prove painful? Or companies with no narratives where any positive surprise likely would lead to an upward reappraisal?
François Sicart – June 21, 2023
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