Podcast: Being intentional in equity markets

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Podcast intro

Welcome to Think Again, a podcast by Macquarie Asset Management, providing financial advisors with a fresh perspective and innovative insights designed to keep you and your clients a step ahead.

00:00:18 - 00:00:29

Denise St. Ivany

Thank you for tuning in to Think Again. I’m Denise St. Ivany.

Today I'm joined by Brad Klapmeyer, Senior Portfolio Manager at Macquarie Asset Management for the Large Cap Growth Equity strategy.

Brad, always a pleasure to have you on the show.

00:00:30 - 00:00:33

Brad Klapmeyer

Hi Denise. It's always a pleasure to be back and be chatting with you, so thank you.

00:00:34 - 00:00:54

Denise St. Ivany

So here we are, kicking off 2025 with topics from our recently published “Outlook 2025: Plan for growth, prepare for volatility.”

Today let's explore the realm of large-cap equities and delve into the recent uptick in concentration within market-cap weighted indices.

What are some of the key factors driving the increased concentration in large-cap indices?

00:00:55 - 00:04:23  

Brad Klapmeyer

I think some of these contributing factors are healthy. I think some are not particularly healthy. I think some are in the rear view and some quite frankly are head scratchers to us. And unfortunately – and herein lies the value of active managers – it’s not as simple as making a blanket statement of concentration is bad for all the names that have kind of topped the list. We have to be more thoughtful.

So just kind of ticking through the things that I think are contributing, number one is the Russell 1000 Growth benchmark, the S&P 500 benchmark, are cap-weighted indices. The higher these companies get valued, the bigger they get in the benchmark. Higher market cap equals higher weighting. It's that simple. We can all step back and say, wow, these companies are too big or too sizable, but on some levels, investors believe many of these companies to be valued correctly. Which just happens to mean we have these giants or titans as part of the indices. And I think it is important to note, I've got a positive starting place on all this, that revenue and profit growth during 2024 and prior years, the prior years for many of these mega-cap stocks has been exceptional. So, that is the starting place, it's partly been earned by the exceptional nature of certain businesses over the last decade. Let's give credit where credit should be due.

The next point I think is a little more interesting, maybe not as positive. Thematic investing has been a boost to concentration over the last couple years and really propelled the markets to new heights, which I think is dangerous. That underlying thematic has been data growth, cloud computing, data center growth, power scarcity, and, more and more so, really attached to this generative AI boom. AI was happening prior to 2022, but it's really ChatGPT in 2022 that really set fire to this narrative, and for me, it's really hard to believe we've had ChatGPT for over two years now, but that narrative has really expanded across sectors.

The third thing I think is behavioral dynamics. You know, I've been on a number of these podcasts with you, Denise, and so I hope people aren't starting to sigh every time they hear me talk about behavioral tendencies. But I think it's such an important factor for investors, for advisors, for consultants, for sales professionals, for humans generally, emotions can be extremely powerful, and I think a lot of the time they are helpful, but generally they don't lead us to the best outcomes when we put them to work for our investment framework. We've talked about many of these before: prospect theory, extrapolation hypothesis, the idea that this company is doing well, so it will do well into perpetuity. That's rarely the case in growth investing, unfortunately, unless you find something particularly unique in terms of quality, which is what we think we’re exceptional about.

The other thing that I think is front and center about driving the concentration in this market is just FOMO (fear of missing out). You know, people say, “My friend made money off company XYZ. I’m not going to miss that opportunity again.” Stocks are viewed as a no-lose proposition in some areas of the market, and optimism feels so tangible and real that the fear of missing out is so intense. I can speak to this personally because in the job I feel that daily, like we're always missing something where, you know, we got to go just follow the trends or something, but that's not a real way to invest.

00:04:23 - 00:04:38

Denise St. Ivany

You’ve definitely touched on a number of those things that are just front and center all the time, front and center all the time. So, what does it mean for the investor, though, for the investors’ portfolios to be top heavy? Can you elaborate on the “Magnificent Seven” and their significance in the S&P 500?

00:04:39 - 00:09:31

Brad Klapmeyer

It was in 2013 that we started with FANG, so it was Netflix and Google. Then we had to add Amazon, I think? And then we ditched Netflix, so we lost the N. And then Google went to Alphabet, so we had to add an A instead of a G, and then Facebook went to Meta, so we had to add an M. So, all these acronyms that get really tricky over time.

But let's get back to your main question. What does this mean for investors’ portfolios and the significance of these stocks on the S&P 500. For the portfolios being top heavy, I guess it can mean where I started, that investors own some great businesses in size. Parts of this are OK: big exposure to attractively valued great companies? I don't think anybody has a problem with that. So top-heavy doesn't really mean all these businesses are bad and it's all bad. As I mentioned earlier, we've interacted with a lot of these businesses. A lot of us use Google search multiple times a day and then you flip over to YouTube. Thank you, Google. And how many enterprises utilize Microsoft productivity tools for all their employees, while corporations are using Microsoft cloud compute tools for their data needs, and then they flip over to LinkedIn, which is a Microsoft company, for B2B networking.

Those competitive moats around many of these businesses are significant. So again, starting with the positive, I think investors with top-heavy portfolios do own some good businesses, but – I do have a ‘but’, it's a concerning asterisk here – it's what investors may be unaware of, the sort of risks that they're holding on to. And I think these are these are definitely sizable. And you know, I think one of them is just lack of diversification.

We've talked about this a lot, just this idea of market concentration. Exiting 2024, within the S&P 500, the Magnificent Seven accounted for about 70% of the index. Exiting 2024, for the Russell 1000 Growth, that number was around 55% of the benchmark, and the top 10 were over 60%. That doesn't strike me as comfortable, and I think what's even more concerning is not just market concentration but thematic concentration. And hopefully this gets more attention in 2025 as a concern for investors. Most of that 50% that I talked about has an AI thematic. And I don't have the right number, but if I had to guess, maybe 60%+ of the Russell 1000 Growth is somewhat strongly if not highly correlated to the success of AI, the GenAI narrative. The Russell 1000 Growth benchmark is not supposed to be an AI thematic benchmark, and to me that's a risky proposition.

The other concern that I have is just what this means for measuring the risk of these indices, in terms of exposure to risk or specific factors. I'm going to get probably a little too granular here, but I think it's important that people have this conversation and understand it. The S&P 500 benchmark, which should be a reasonable, broad benchmark, is as ‘growthy’ as it's ever been, looking over the last three decades. So, there's a massive growth skew within the S&P 500 Index, and that's diminished the exposures that do have value from time to time, cyclicals and defensive stocks. You know, who cares about those when you can dream the dream and own all these growth stocks. So, it's very tilted to not being a broad, diversified benchmark, it has become a growth-tilted benchmark.

And the same is true for our benchmark, which is the Russell 1000 Growth benchmark. We look at the underlying risk – we call it beta exposure – and the underlying risk of the benchmark in terms of beta exposure is as high as it was, if not percolating kind of above it, as it was in the 1998, 1999, 2000 period. I think there's a falsehood that lives in here that if you buy the Russell 1000 Growth benchmark, if you buy the S&P 500, if you buy an ETF or passive exposure to these benchmarks, the thought is I'm clearly getting strong diversification from this passive index exposure, and I'm here to tell you that's absolutely not true. I think investors are getting something much more ominous, and that's what's a concern.

I mean, just being top heavy, too, as I mentioned, the debated part about these asset flows into passive/active being a virtuous cycle, I think it can just as easily be a vicious cycle that once someone determines that the competitive moats around these major companies are not that strong, the flows can easily go the other way, and then we're chasing our tails for another decade on asset flows, and you really need an active manager to be ahead of that curve.

00:09:32 - 00:09:47

Denise St. Ivany

So why do you think it's important for large-cap equity investors to diversify their exposure in 2025?

You touched on, again, this big overweight, and what are some strategies then that investors can use to diversify their portfolios effectively?

00:09:48 - 00:15:03

Brad Klapmeyer

I think one of the best strategies is quality, obviously. There's a method of investment. But just on that word ‘diversification’. Let's talk through diversification first and kind of set the stage and really just address this underlying narrative that we have a concentrated market. So, quote, “we need to diversify exposure”. When this discussion usually occurs, it usually goes to other end of the spectrum. Well, you don't want to be owning of the Mag 7, there’s too much risk. You want to be anti-Mag 7 or something in that vein, and unfortunately for just, I think, how challenging this market environment seems to be over the next two, three, five, 10 years, it's wildly more nuanced than that.

As I mentioned through these other risks that have been created now, the fact that some of these companies are really good, and I think the problem is you can create just as many risks in investing by running away from something and not running towards something. So if we're just running away from Mag 7, you’ve got to have a strategy of something better to buy, something more interesting, some other opportunity. I don't think it's a “sell all the Mag 7” conversation. And looking back, you wanted to own Microsoft, you wanted to own Apple, you wanted to own Alphabet, you wanted to capture this magic in NVIDIA. And now we're all looking like, wow, these are big positions, but if you wouldn't have been interested in them as they were growing, you would have been a goner. I don't want to force an anti-Mag 7 narrative by any means.

So I want to be careful about the use of the term diversification. I think diversification is important. I think investors associate diversification with owning a lot of names, so this is my problem. People will associate diversification with loaning a lot of names or owning an index or owning a passive index, but that is not true, and diversification can still occur on an asset level, such as a growth style with very few names. We actually had an individual within our Client Solutions Group kind of help me out. Shout-out to Mason and an assist from Mike G. who really helped me solidify some important thoughts on this topic, and I guess this is proof you can always leave it to the Client Solutions Group to nail the messaging on something. There's a certain level of diversification benefits where diversification benefits start to diminish, and it's a surprisingly low number of stocks to realize the benefits of diversification. Maybe 15 to 20, then past 20 you start diminishing the skill of the manager by adding too many names to it. So it doesn't need to be 10 or 15 or even 20 or 30, but definitely 50, 80, 100 names by a single manager is just diminishing the active skill that that manager can potentially add to the portfolio. And as a Client Solutions Group, Mason noted that if you take a simple portfolio consisting of four mutual funds, you know, large growth, large value, small growth, small value, and each manager owns 100 stocks, all of a sudden you just own a basket of nothing. And those individual managers have totally diversified away their skill. So, I think concentration is super important on a small scale and actually it can be diversifying with just 20 names.

Kind of going back to the start, so we addressed diversification. And what are some strategies investors can use to diversify their portfolios, I think was the second part of the question, And the problems I mentioned earlier, like blind concentration and large weights, blind concentration of thematic investments, massive exposure to risk or growth tilts. I don't think investors have really had to have this conversation before, and it's not as simple as getting a manager that diversifies away from the Mag 7. That’s not the easy answer.

I think there's two solutions here. Number one is be selective with that concentrated end of the market. Find managers that are really good at stock picking at today's concentration levels. Not all the Mag 7 will earn their keep for the next 5-10 years ahead, though obviously a failure rate in that. So, my hope and ask is to find a quality manager that can be successful within that Mag 7 realm and use pure justification to buy things like quality. We use quality, and if you find your manager, their discretion is based on market cap, these companies are too big or I have to own them because they're too big, I have to sell them because they're too big, or FOMO or momentum, those are not sustainable investment strategies. Quality is. So, selective within the concentrated part of the market.

And number two, we think there's plenty of excess returns outside of the mega-caps, outside of thematic investing, and we think the opportunity is ripe. And while it only feels like there's one way to drive alpha right now, which is Mag 7, that won't be true over time. So let the style manager be concentrated actively within their style category and inside the Mag 7 names and outside the Mag 7 names. Unfortunately, that may mean in this current environment that your managers take even bigger skews versus a risky benchmark, but it may prove that they're even less risky than the market and still generate more alpha. Which is exactly what we want for the next three to five years.

00:15:04 - 00:15:11

Denise St. Ivany

So Brad, how do current valuation levels affect these companies, and what are the potential consequences of slight underperformance?

00:15:12 - 00:19:21

Brad Klapmeyer

Yeah, gosh, who wants to talk about valuations right now?

I think we know why no one really wants to talk about valuations. Because it's not a particularly attractive starting place for valuations broadly. And so that does mean there are very significant consequences because of that. I mean, one of the things we emphasize, this concept of minimizing mistakes and how that is just as important, if not more important, than the big wins. I mean, sometimes the big wins like NVIDIA come out of nowhere, right? Like we had a positive view, and I think a lot of investors had a positive view on NVIDIA as a company, but who in their right mind expected this type of move out of NVIDIA and expected ChatGPT to explode, this whole sort of froth around generative AI. I think most people would call that luck in timing. But what we can do is with our starting place, and we do quality evaluation sensitivities, do a reasonable job at missing bad businesses. And part of that is, as I mentioned, starting place on valuation for individual securities is important because it indicates, I think, the potential downside risks.

High valuations, by default, imply that investors are thinking the best about this business. They’re thinking great things about this business. If it doesn't get better, then valuations can compress, even with good earnings. If it gets worse, then you have a double whammy. You have a stock disaster, a period of negative revisions to numbers, while valuations are compressing, so you're paying less for lower numbers. That is deadly in terms of investing. And we saw that happen in a big way, it happens every day first of all, but just to give a narrative around this, we saw that happen in a big way with many of these pandemic beneficiary names, right? Investors saw some early growth, they raised their numbers significantly higher, they tried to get in front of the next round of revisions, they thought that these revisions would happen into perpetuity. And on all that enthusiasm, what did they do? They put very high valuation levels. So, when were wrong, the valuations were wrong, and the durability was wrong, and the stocks were down 90%. And that's the problem if you get something wrong about these businesses. Now that's obviously an extreme case, but we think this happens every year, every month, every day in growth investing. And within the Russell 1000 Growth, of course, this can be a significant problem, and we think it is a significant problem now. We think there are too many unrealistic growth expectations put on high valued stocks.

So, we think for 2025, the cost of being wrong, the cost of a mistake, which are frequent, you can look at empirical evidence, which are frequent in pure growth investing, will be significant. And I always say this every time I'm on this podcast with you, I'm going to get on my soapbox for a minute. There's always a soapbox moment here that we’ll go into. But I think something that also feels really underappreciated in the market for the last 15 years, really since the start of quantitative easing back in 2009, is that investors have become accustomed to a high frequency of good or great market returns.

The sustained drawdowns have really been scarce and short, and the reactive function for investors that have participated in the last 15 years is to buy the dip, the central bank and the fiscal policy will save the day, don't worry about valuations, they're irrelevant. These are all, in my mind, very dangerous narratives. And, I mean, for illustration, the Russell 1000 Growth has posted annualized returns of over 16% for the last 10 years. Like, really? It feels like that's expectation for people. So we've been trained in an unrealistic return environment. We have a false sense of reality.

00:19:22 - 00:19:26

Denise St. Ivany

If somebody extrapolates that into the future, that’s not a good premise.

00:19:27 - 00:21:23  

Brad Klapmeyer

It's not a good premise, and I think that's why we've seen equity risk premium or the yield that investors expect on an equity asset versus risk-free asset is as low as it's been since the internet bubble. So, there's really not much room for error, and that goes to your earlier question of what are the consequences of mistakes? And I think while they're just so significant. So, what does that mean for this year, 2025? Selectivity is important. You know, we think you can find some attractive valuations in the mega-large-titan space of the market. That's why I say selectivity is key, some of those don't look great, but you also find companies that have a really good opportunity to sustain highly durable growth that have been kind of swept under the rug because they don't fit one of these current narratives around momentum or beta or AI thematic. And so, I think sort of this idea of discretion really are used for the shift back from passive back to active. And I think this whole idea that there's no blanket statement that says, own this basket, and don't own this basket, I think that really makes it challenging for successful passive investing.

So, for us, I mean just to reiterate, I think where we always come back to is the best place to start, and this is confirmed by empirical evidence, is with quality businesses not FOMO, not momentum, not AI thematic. Find something unique about that business. Quality is durable and those businesses have historically proven advantageous over a multiyear horizon and given the list of accumulating risk flags, red flags, whatever you want to say it, it seems likely that quality will be emphasized even more this year and beyond. And fortunately, with a little market volatility, I think there'll be a wonderful opportunity for quality investing frameworks.

00:21:23 - 00:21:33

Denise St. Ivany

Perfect wrap-up. Thank you for sharing your insights with us, also your soapbox. I thought that was helpful too. So, we appreciate your expertise and for you taking the time to be with us today.

00:21:34 - 00:21:36

Brad Klapmeyer

Yeah, thank you, Denise, always great chatting with you.

00:21:37 - 00:21:55

Denise St. Ivany

Don't forget you can read all the insights and analysis from Brad and our other investment teams in the “Outlook 2025: Plan for growth, prepare for volatility” and you can also check out our program show notes to learn more. Don't forget to join us next time on Think Again where we will discuss another topic for investors to consider.

00:21:56 - 00:22:06

Podcast outro

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