Second Quarter 2024 Review: Where’s the Breadth?

Global stock returns were mixed yet relatively flat in the second quarter—except for a handful of mega-cap U.S. companies (“The Magnificent Seven”), which once again dominated the return of market capitalization-weighted indices. Nevertheless, all equity asset classes in client portfolios posted positive returns over the past year, many in double-digits.  

Rate Cuts Finally on the Horizon

After two surprisingly strong inflation reports in the first quarter dashed investor hopes for as many as 6 or 7 interest rate cuts in 2024, the second quarter resumed an encouraging trend of moderating prices (Figure 1). An expanded labor participation rate and declining job openings cooled wage growth. After bottoming out at 3.4%, the unemployment rate slowly increased to 4.1%. While the Federal Reserve has erred on the side of patience in ensuring no resurgence in inflation, it is now widely expected to cut rates once or twice before the end of the year.

  Figure 1

Source: JP Morgan Guide to the Markets, 6/30/2024

Mega-Caps Rule the Roost

A running theme in recent commentaries is the outperformance of U.S. large-cap growth stocks and the large weight they’ve come to occupy in capitalization-weighted indices. Much of this momentum stems from investor speculation on the likely winners of emerging artificial intelligence (AI) technology.

This surge has important implications not just for U.S. stock indices but for global indices as well. Over the last 18 months, more than 60% of the S&P 500’s market appreciation was attributable to just the “Magnificent 7” stocks (Figure 2). The S&P 500 finished the first half of 2024 up over 15%. Excluding the Magnificent 7, the remaining stocks in the index were only up 5%. Meanwhile, the typical global stock index (such as the MSCI All-Country World Index used in your quarterly portfolio report) carries a much higher allocation to U.S. stocks today than 10-15 years ago (Figure 3). As of the end of the quarter, 9 of the 10 largest weights in the MSCI ACWI (comprising 21% of the index) are U.S. companies.   

Figure 2

Source: JP Morgan Guide to the Markets, 6/30/2024

 Figure 3

Source: JP Morgan Guide to the Markets, 6/30/2024

We acknowledge that some of this development is supported by these companies' superior fortunes relative to the rest. Still, we also feel that the extent of the outperformance exceeds what these companies are collectively likely to deliver in the next few years. In other words, current investors’ enthusiasm is likely excessive.

Implications of Index Concentration

Reviewing our investment process at major inflection points in the market is important. We begin with three core tenets that have served our investors well over time:

1. Diversify broadly across asset classes.
2. Keep investment costs (commissions, fees, and taxes) low.
3. Selectively overweight securities or asset classes trading at a discount to fundamental value (in relation to prospective future cash flows).

The case for the first two is rather intuitive. The case for the third is supported by both economic theory and market history. Asset class returns exhibit mean-reversion over time through market cycles, meaning that returns converge to their long-term average. An investment approach rooted in periodic rebalancing among different asset classes enforces a discipline to “sell high” and “buy low.” This rebalancing will occasionally improve absolute returns, but more importantly, it will reduce overall portfolio volatility (improving risk-adjusted returns vs. a static “buy and hold” approach).  

Typically, our clients are well served by having the core portion of their portfolio broadly mimic the global stock and bond universe (with the relative proportions adjusted to an individual client’s risk profile and return objectives). However, there have been a handful of inflection points over the years when valuations in specific asset classes swung to an extreme (substantially over or under-valued, relative to fundamentals).

Such historical examples include the first tech bubble of the late 1990s, the fallout from the 2008-09 Great Financial Crisis, and most recently, the extended period of ultra-low interest rates following successive waves of “quantitative easing” from the Federal Reserve.  At such points, we’ve made tactical adjustments to our mix of investments to reduce the impact of a perceived significant downside risk or to capitalize on an unusual opportunity. Generally, we make these adjustments incrementally over a period of several months, cognizant of the folly of trying to time these shifts precisely.

We believe that, at the end of the quarter, we are amid another potentially historically significant inflection point. The valuation gap between small and large stocks (Figure 4), between growth and value stocks (Figure 5), and between U.S. and non-U.S. stocks (Figure 6) has grown to relative extremes in recent history. 

Figure 4               

Source: JP Morgan Guide to the Markets, 6/30/2024

Figure 5

Source: JP Morgan Guide to the Markets, 6/30/2024

Figure 6

Source: JP Morgan Guide to the Markets, 6/30/2024

More recently driven by speculation over AI, these valuation gaps seem very reminiscent of prior cycles of boom-and-bust capital spending—a common byproduct of technological innovation. With new technology, there is often an enthusiastic period of capital investment as firms race to capture a “first mover” advantage by building scale and market share faster than their competitors. Frequently, such investment substantially overshoots actual demand growth, leading to excess capacity and (eventually) impaired assets. Historical examples of this pattern abound in prior emerging technologies such as railroads, automobiles, and fiber-optic cables.

Whether this pattern repeats itself with AI remains an open question. According to this skeptical note from Sequoia (A venture capital firm), AI-related capital investment has thus far done little to boost incremental revenues for any company other than Nvidia or OpenAI. However, it seems logical that if the productivity enhancements made possible by AI are to justify the heavy investments made in the technology thus far, then the benefits will ultimately redound to a broader cohort of the global economy than a handful of the very largest U.S. companies.   

For now, we maintain a greater proportion of our portfolio in small-cap, value, and international stocks than in a market-cap-weighted global stock index. This contrarian bet has undeniably hurt our performance relative to the S&P 500 and the MSCI All-Country World Index (Figure 7). In doing so, we believe we are appropriately positioned to outperform when the cycle eventually turns.

Figure 7

Ironically, as both indices have moved further into the "US large growth" quadrant, the effect of our rebalancing combined with our tactical bets on value, international, and small-cap stocks compared to the same index weights has sometimes been amplified beyond our comfort zone. To offset this and ensure our contrarian bets remain within our desired range relative to our clients’ core benchmarks, we plan to incrementally rebalance some portfolios’ exposure to market-cap-weighted domestic equity ETFs. We will accelerate this process when the S&P 500 lags and out-of-favor investment categories outperform.

Large Cap Value Review

(Not all clients of Bristlecone are invested in our Large Cap Value (LCV) equity portfolio strategy, depending on the overall portfolio size and the client’s objectives and constraints).

Our Large Cap Value portfolios modestly lagged the Russell 1000 value index in the quarter but trailed the S&P 500 index more substantially (~8% spread), as the gap between growth and value stocks widened again in June (Figure 8).

Figure 8

During the quarter, we reinvested accumulated cash in two long-term holdings that have been laggards of late: Nestle (NSRGY) and Liberty Broadband (LBRDK).   Nestle is a mature and fairly slow-growing business with many valuable consumer brands that allow it to earn high returns on invested capital consistently. Nestle generates copious free cash flow, which it uses to pay an annual dividend (current yield: 3.1%), make bolt-on acquisitions, or repurchase shares (share count has declined 17% over the last decade).

Liberty Broadband is a telecommunications company serving Alaska cable, wireless, and internet subscribers through its GCI subsidiary. More significantly, Liberty owns about 27% of publicly traded Charter Communications (CHTR), which we may know as Spectrum.  Both Liberty and Charter have significant debt on their balance sheets, and this leverage magnifies the impact of operating results at each company (both positively and negatively).  However, Liberty Broadband is currently trading at what we believe is a significant discount to the value of its stake in Charter (not to mention the ancillary GCI business, with approximately $1 billion in annual sales). Our thesis is that this valuation gap will eventually narrow as each company uses its cash flow to repurchase its discounted shares in the public markets.

For taxable accounts invested in the LCV strategy, we also executed a pair of tax-loss harvesting trades during the quarter (one in Liberty Broadband, the other in Bayer). While we never set out to lose money, the reality is that individual stocks can be very volatile, and even in a diversified portfolio (30-35 stocks), there is often a wide range of individual stock return outcomes. To give some recent context: during the second quarter, our 3 best-performing stocks were up an average of 20%, while our 3 worst-performing stocks were down an average of 28% (the median stock in the LCV portfolio declined about 4%).

By aggressively capturing periodic short-term losses as they occur, we can offset capital gains and measurably improve a client’s after-tax returns. Indeed, one of the advantages of investing in individual stocks (as opposed to mutual funds or ETFs) is the ability to customize tax planning for each client. This added value improves net tax-adjusted performance, even if it is not explicitly recorded in our quarterly reports.  

Of course, the flip side of harvesting tax losses and our “buy and hold” philosophy is that they eventually create large unrealized gains (capital gains deferred into the future). These can discourage rebalancing trades that might otherwise make sense at a certain point as we need to weigh the benefits against a significant tax liability—especially for older clients whose spouses or heirs will benefit from a cost-basis step-up.  

This is not unusual as some clients have been invested in our LCV strategy for over 20 years and accumulated large unrealized gains, complicating our efforts to diversify their U.S. large-cap exposure more broadly. To the extent that our tax-loss harvesting regime can mitigate the tax consequences of rebalancing, we will do so—ideally spreading the tax impact over multiple calendar years.

As usual, we encourage you to contact us if you want to know more about our strategies and how rebalancing trades may impact your tax situation.

In the meantime, enjoy the rest of the summer!

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.