4th Quarter 2024.
Market Review
Performance Driver Review
Market Perspectives
In the 2Q24 Market Perspectives, the topic of discussion was market highs fueled by a narrow set of very large stocks. While there have been small performance rotations in the market since that letter, the S&P 500 ended the year at another record concentration level with the 10 largest stocks in the index representing 38.7% of the index value.
As a diligent reader of this letter, you may remember the conclusion of the 2Q24 writing was “market concentrations have no predictive implications for market returns,” so why talk about them again? Well, headline market returns often disguise much of what happens under the surface, and those under-the-surface moves can have material implications for portfolio performance depending on how a portfolio is constructed. This quarter, WoodTrust explains what it means to construct a diversified portfolio of high-quality businesses at reasonable prices, when that type of portfolio construction can cause performance lags, and why it is important to maintain that type of portfolio through market cycles.1
Constructing a Diversified Portfolio of High-Quality Businesses at Reasonable Prices
For decades, WoodTrust has avoided significant single-stock or single-sector concentrations when building portfolios. Despite periods of increasing market concentration such as the last few years, WoodTrust maintains its discipline by owning a handful of companies across all major economic sectors2 to avoid the risk of becoming overly focused on a specific investment idea or theme.
When selecting businesses to own, WoodTrust seeks those that are of the highest quality. This means the typical WoodTrust holding generates consistent and substantial free cash flow, maintains lower levels of debt, and is led by exemplary management and strategy.
The cherry on top of WoodTrust’s portfolio construction is understanding a reasonable price to pay for these high-quality businesses. This is where art meets science, and it’s an opportunity to dive into a relevant example… Nvidia.
Nvidia has been a hot topic in much of the investment management industry over the last couple years with its prolific stock price inflection on the back of AI craze. While WoodTrust sees strong evidence that Nvidia is a high-quality business, the firm has struggled to rationalize Nvidia’s recently high weighting within relevant indices. This high index weight is based off the significant total market value of the company. For Nvidia, that number is $3.4 trillion. For perspective, here is a basket of other WoodTrust portfolio companies an investor could own in its entirety with $3.4 trillion: Walmart, UnitedHealth Group, Home Depot, Johnson & Johnson, Chevron, American Express, PepsiCo, Disney, Applied Materials, Deere & Co, Nike, PayPal Holdings, Northrop Grumman, Kroger, and Microchip Technology. These fifteen companies across eight different sectors generate $150 billion in annual free cash flow, nearly triple that of Nvidia. WoodTrust prefers the basket’s diversification and cash generation.3
When Diversification Underperforms
With a fresh understanding of the portfolios WoodTrust builds, one can now explore the aforementioned implications of portfolio construction on portfolio performance during different market concentration cycles.
As a reminder, owning a diversified portfolio means an investor owns a broad set of companies across a variety of sectors, industries and themes. Generally, when market concentrations are increasing, the market is being driven by a narrow set of companies outperforming the rest. When a narrow or concentrated set of companies is outperforming, diversified portfolios will generally lag a concentrated index or a concentrated peer group as it is unlikely they hold the narrow group of outperformers in weights as large as the index.
An investor may then assume that any concentrated portfolio would surely outperform or at least keep up while market concentrations are increasing, but it is unfortunately not that simple. To do well during a period of narrow market performance, an investor cannot simply own a concentrated portfolio, they must concentrate the correct stocks in the portfolio. This proves the difficulty of outperforming during these time periods.
Diversification through the Cycle
After acknowledging the periodic shortfalls of a diversified portfolio, one can aptly consider the periods when a diversified portfolio earns its keep: periods of broad market performance and declining concentrations. These are periods when winners and losers are spread across several sectors and themes. Periods of declining concentrations can occur over short periods such as the 12 months of 2022 or long periods of time like the market broadening from 2000 to 2015.4 During that 15-year cycle of declining concentrations, diversified portfolios like that of WoodTrust’s outperformed their concentrated peers by almost 4 percent per year, or a cumulative 133%.5
In Summary
Market concentration levels do not give any indication of whether the market will go up or down in the future, but concentration cycles must be considered when constructing portfolios. WoodTrust understands that diversified portfolios generally outperform when concentration levels are declining. WoodTrust also understands the difficulty of picking the correct concentrated portfolio to outperform when concentrations are increasing. With this foundation, WoodTrust has conviction in the long-term merit of building diversified portfolios of high-quality businesses at reasonable prices. As always, we thank you for your trust and look forward to our meetings with you in the near future.
1The WoodTrust Equity Program is the portfolio specifically discussed in this piece, but these same tenets generally apply to the types of managers WoodTrust employs in its mutual fund program.
2Sectors with index weights below 5% are considered “minor” – WoodTrust may or may not own securities in these sectors.
3The Institutional Manager Stock Program has a weighting to Nvidia driven predominately by the utilization of the Fidelity 500 Index Fund and to a lesser extent by the William Blair Large Cap Growth Fund. WoodTrust understands the merit of holding Nvidia at its current valuation in both of these strategies and feels the overall program position size manages the risk appropriately.
4The official performance period is June 30, 2000 through March 31, 2015. Over this period, the top 10 stocks in the Bloomberg 500 Index went from 25.27% of the index value to 16.41%.
5S&P 500 Index is used as a proxy for a concentrated portfolio in this comparison, and the S&P 500 Equal Weighted Index is used as a proxy for a diversified portfolio.
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