Is Index Investing Safer?
Is Index Investing Safer?
Why the tech-heavy index might be riskier than it seems and the case for active management
In this week’s article, I highlight some learnings from my latest podcast. I interviewed Bill Nygren, a Chicago-based value investor who is well-known in the US value community, perhaps less well so elsewhere. Which is a shame, because I learned a huge amount from speaking to him.
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I met Bill Nygren when I visited Omaha this year. He was the guest speaker (actually in a fireside chat format) at the CFA Society Dinner on the Thursday night. More behind the scenes commentary on that for premium subscribers at the end, but we agreed to record when I returned from Japan in August and it really was a wonderful conversation - I learned a lot from talking to Bill.
Is Passive Riskier than Active?
One of the most important takeaways from our discussion was that Bill views the S&P 500 as akin to a risky growth stock fund. In his last quarterly, he talked about how the dominance of growth stocks has changed the composition of market indices. There is widespread awareness of the weight of the tech sector in the index today:
S&P500 Sector Exposures
Source: Morningstar rating for UBS S&P 500 Index Fund C Accumulation 27/09/24
There is widespread awareness of the weight of the tech sector in the index today. Less appreciated is that Morningstar creates a growth/value score for every stock. Portfolio scores can be derived by taking an average of the underlying stocks. A portfolio with a score under 125 is considered value, a portfolio over 175 is classified as growth.
S&P 500 Growth/Value Classification
Source: Morningstar rating for UBS S&P 500 Index Fund C Accumulation 27/09/24
In Oakmark’s last quarterly , they highlighted that the S&P 500 scored as a growth portfolio with a score of 192. The Oakmark fund was at 73. These are quite extreme levels. Of course, I am not forecasting a sudden reversal of the growth to value relationship in the next month. But it’s helpful to monitor such situations closely when levels appear extreme.
I don’t have access to that Morningstar analysis today, so I downloaded from AlphaSense the top 2000 stocks quoted in the US and crudely filtered out some of the overseas listings – I then charted the top 1000, ranked from largest to smallest and their cumulative value – it’s easy to see in the chart below that the top 200 stocks dominate the group.
Cumulative Value of US Stocks Ranked from #1 to 1000
Source: BTBS from Alpha Sense data
Rather than comparing to the S&P500, continuing with this top 1000, the so-called Magnificent 7 account for 29% of the top 1000 market capitalisation and 11% of revenue. I understand that they are a lot more profitable with much higher margins than average, but I consider the revenue comparison to be relevant as we can think in broad terms about the degree to which they can
Grow revenues faster than the market average
Maintain superior margins
Improve revenue per share by applying surplus cash to buybacks
I don’t know the answers, but revenue growth must be a constraint at some point; margins cannot continue to increase forever; and buybacks may continue but their additive value is dependent on multiples being reasonable.
I don’t want to get into a debate here as to whether Apple is expensive at 34x P/E with limited growth and a soft introduction of its latest phone. The more important question is whether the average investor might be safer in an active fund, rather than an S&P500 index.
Bill Nygren thinks so, but some readers might consider him unlikely to offer an unbiased opinion. I don’t want to offer an opinion on his fund or to promote a podcast guest, but I think that if you showed Bill’s portfolio and a blinded version of the S&P500 to a seasoned investor, you might get an answer which says
this one (the index) has 30% of its stocks in one sector with a high valuation
the other fund has 40% of its stocks in one sector (financials) but with a very low valuation
this is quite tough to call.
Bill argues that there is no correlation between some of his investments in the financials sector - for example, Fiserv’s data business is totally different from Bank of America’s consumer facing bank. Hence they should not move together, in contrast to the tech sector.
Given its concentration, the S&P 500 is clearly riskier than formerly. And unlike in Europe where the GRANOLAs cover a wide cross-section of stocks, sectors and countries, the top stocks in the US are driven by tech, in different forms certainly, but often with a common sentiment driver.
Historical Market Concentration
Source: Datastream, Goldman Sachs Global Investment Research
The index was highly concentrated in railway stocks for decades in the 19th century so there is precedent for such a phenomenon to endure. I have no idea what would cause sentiment to such stocks to sour, but I think index investors should be aware of the risk.
I have in the past commented here that there is no guarantee that markets will go up and if they went sideways in real terms for a decade or two, it would not really be that surprising, given the historical precedents. I made this argument again recently, when I appeared on what is claimed to be the UK’s largest finance podcast.
This is hosted by a finance YouTuber and his best friend from university who is not a finance expert. Damien, the YouTuber in question, recommends that his listeners buy a global index fund, but he was keen to tell me that he had had some success in his own single stock activities.
I tried to explain my perspective – if you are interested in the stockmarket, you can do quite well investing in individual stocks. This isn’t for everyone, but if you are interested, invest in yourself and acquire a sufficient understanding of financial terms, of how markets work and of valuation, you can do pretty well. And, contrary to popular perception, the index isn’t riskless, either, especially over shorter timeframes.
I have been on lots of podcasts, so I know how to do this and was unprepared for the barrage of criticism I encountered in the YouTube comments. I share some below as I thought you might find them amusing. Who are these people, though?
@iCozzh: This guy is genuinely handing out BAD advice.
@nk9070: As a financial plannner I can also confirm he is talking absolute nonsense 90% of the time. The contradictions are quite alarming
@RoryMcveigh-b6i: Bit too sure of himself.
@DeputyChiefWhip: This guy is talking about a casino!
A number were suspicious that I offer training courses:
@adamobrien12: So what Steve is saying is that people in the finance industry make things sound really complicated whereas for only £1,197 you could attend his three courses that'll allow you to beat the market. Suspicious.
@regresscheck: The guy is either delusional or dishonest to listeners. Given that he sells courses, definitely the latter.
@rjScubaSki: Training scammer. If you have run out of decent people to interview, just don’t bother.
I am all for a dose of scepticism, it’s healthy, but I clearly need to refine my marketing pitch. The funny thing is I didn’t even try to sell my courses!
The weight of argument in favour of passive investing and the weight of passive funds suggests to contrarians that active management might have a better period ahead – wishful thinking?
The Oakmark/Harris Philosophy
Bill and team look for three factors when initiating a new position in a company:
1. They look to buy businesses that are trading at a significant discount to their estimate of intrinsic value, using a 7 year timeframe. They assume that in 7 years the world will be a “normal” place (useful when there are major dislocations like Covid or the GFC). They definitely do not consider themselves growth investors and will not underwrite above market growth for a company beyond that time horizon.
2. They like to invest in companies which are expected to grow shareholder value over time. They don’t want to buy value traps - value investors often buy a stock that is inexpensive for a reason—because the company just does not grow. They don’t need revenue growth – they are happy if the company is generating a lot of cash, and Bill points out that a lowly rated company with 1-2% revenue growth which is cash generative can produce 10%+ eps growth if they buy back stock.
3. They seek to invest with management teams that think and act as owners. They want CEOs and CFOs who understand the dynamics of per share value growth and are focused on achieving that. They look for management to own shares in the company and look for incentives based on per share growth that align managements’ interests with those of shareholders.
The philosophy sounds pretty simple but such concepts are always trickier to implement in practice. And they have developed some interesting processes to help them, of which more in a second.
This Value Fund Owns Growth Stocks
Oakmark is marketed as a value fund yet Bill’s current largest position is Alphabet and in the past couple of years, the fund has owned Meta, Netflix and Amazon, all typically thought of as growth names. Bill likes to look beyond the optics of the P/E multiple and they spend a lot of time recasting the GAAP numbers to reflect investment in intangible assets.
Bill believes (and I share this sentiment) that GAAP is better calibrated for dealing with companies that deploy physical assets – build a factory and depreciate it over 20 years. GAAP is less well suited to companies which are investing or future growth by spending on R&D or advertising. Such investments are expensed but may have a significant life.
Bill first happened on this disconnect when he started looking at the cable TV companies – the value investing community had written these off as unprofitable, yet industry transactions were being done at 10-11x EBITDA. This attracted Bill’s attention and first got him thinking about the shortcomings of GAAP.
Oakmark analysts will recast the P&L, capitalising and amortising such spending over a longer period. Bill explains in the podcast how he worked out that Netflix was quite cheap because its market cap was a low multiple of the value of subscribers being added each year, even though it wasn’t profitable.
Conversely, this approach worked well in avoiding the likes of Kraft Heinz where the 3G Capital zero based budgeting approach – which was the delight of Wall Street for a short while – actually ended up in cutting not just the fat but the meat and bones of the brands. GAAP earnings were boosted short term, but not the Oakmark earnings model and hence the stock never looked cheap to them.
This focus on accounting methodology is of course something that is core to my philosophy. Check out those courses mentioned earlier for more on this.
About Bill Nygren
Bill Nygren is the Chief Investment Officer-U.S. at Harris Associates, which he joined in 1983, and a vice president of the Oakmark Funds. He served as the firm’s director of U.S. research from 1990 to 1998. He has been a manager of the Oakmark Select Fund since 1996 and Oakmark Fund since 2000. He holds an M.S. in finance from the University of Wisconsin’s Applied Security Analysis Program (1981) and a B.S. in accounting from the University of Minnesota (1980). He is a big fan of the Chicago Cubs, an avid follower of sports and enjoys wine.
Premium subscribers can read on for some thoughts on why the Harris Associates organisation is unique in its approach to handling possible investment mistakes and more, plus some “behind the scenes” material from Steve’s first meeting with Bill.
This was one of my favourite discussions on the podcast and I hope you enjoy it too.