In our sixth Collingbourne annual investment review we look at the recent dominance of the US equity market – and in particular its technology sector – and what, if anything, we can learn from this.
In previous reviews we’ve covered:
- 2018: returns reality versus expectations
- 2019: ‘randomness’ of asset returns
- 2020: investor behaviour in volatile markets
- 2022: inflation and how to protect assets
- 2023: the return of returns on cash
The US tech sector has certainly generated plenty of headlines, led by the huge increases in share price of some of its biggest names – you may have heard the phrase “The Magnificent 7” being touted around. For those unfamiliar with the term, it isn’t an Enid Blyton story, rather a phrase coined for the largest US tech firms; Alphabet (i.e. Google), Apple, Amazon, Meta, Microsoft, Nvidia and Tesla.
These groups are always created in hindsight after good returns, it was previously the FAANGs in vogue, before Netflix was turfed out and Facebook and Google changed their names.
2024 turned out to be an almost universally positive year for UK investors, with real returns across all major asset classes as inflation subsided:
The overall picture of these returns is very similar to that of 2023. Once again Global Equities delivered comfortably the largest gains. But, as alluded to, Global Equity as a whole doesn’t tell the full story …
USA, USA, USA!
If we break that above 2024 Global Equity return down into the USA and all the developed equity markets in the world excluding the USA, we see a stark difference:
USA Equity: 27.3%
World excluding USA Equity: 7.1%
Different stock markets can produce widely different results in any given year, so this in isolation doesn’t show us a huge amount (other than how much of the global equity market the US now represents). However, 2024 wasn’t a one-off in this regard; the US stock market has massively outperformed for about a decade now. The chart below shows the returns of the US stock market (S&P 500) against the rest of the developed world, emerging markets and (for reference) the UK market (FTSE All Share) from 2015 to 2024:
If you have been investing in equities over the past decade, the amount you have had allocated to the US has been a major factor in whether you’ve had a good return or a great one over the period.
Technology – Growth
The above chart shows an index representative of the US stock market as a whole. But what if we just look at technology stocks? The Nasdaq Composite index is often used as a proxy for US technology stocks – over the same period this returned 459%, over half as much again as the S&P 500!
Unsurprisingly there’s been a lot of research into what drives equity returns. Broadly it’s the expectations of future company earnings, which is impacted by many things. Shares can be broken down into categories, based on proposed drivers of return.
A well-known example is company size i.e. large company and small company shares. Another driver is the Relative Price of shares, ranging from ‘Value’ to ‘Growth’ shares. Value shares are broadly those that have a low price relative to various metrics, such as shareholder equity, or earnings, whereas Growth shares are those with higher prices.
Growth shares are named as such, as the market expects them to grow to justify their share price, which wouldn’t otherwise be supported by current sales/profits. Value shares are named so, as you are buying their existing income and assets at a cheaper price.
All the Magnificent 7 (and many other successful tech firms) are definitely Large, Growth companies. They are generating big sales/profits, but their multi-trillion-dollar valuations are predicated on further big increases in the future.
If we take the previous chart and break the US market down and compare these Large Growth companies against Small Company shares and Value shares we gain further insight into where returns have come from over the past decade:
This now shows the massive outperformance of US Large Growth Companies over this period. And although dominated by tech firms, it’s interesting to note that the MSCI Large Growth index has delivered even higher returns than the Nasdaq Composite index (or the specific Nasdaq Technology 100 Sector index).
When assessing the returns of different equity portfolios/strategies over the past decade, a key factor in outcomes will likely have been their allocation to these shares. Put another way, an underperforming, badly managed strategy focussed on US Large Growth shares will likely have easily beaten an outperforming, well-run strategy focussed on any other type of equity over the period.
This is very much a story of unusually high returns for US Large Growth companies, rather than a bad return on other shares. The above return on US Value shares still amounts to about 10% p.a. – an outcome most Value investors would have gladly accepted beforehand! It’s just that US Large Growth shares have delivered a return of about 20% p.a. over the past 10 years, far in excess of long-term averages.
Decision Time
So, does the above lead us to conclude that investment should be focussed into US Large Growth Companies?
Although in some respects a decade is quite a long time – I was a carefree young man in 2015, now I am knackered old father of two – in investing it really isn’t. Nobel Laureate Eugene Fama says you need 30, ideally 40 years of data before you can start drawing meaningful conclusions.
So, what does this long-term data and academic theory tell us?
Well, investors demand a higher rate of return from riskier investments than those perceived to be safer. The other side of the same coin is that a company which is deemed to be riskier will have to pay more to access capital.
A smaller company is generally riskier than a larger company – it will need to pay more to raise capital / investors will demand a higher rate of return. Similarly, value shares are perceived to be riskier than growth companies – the price difference reflects the relative optimism about growth companies compared to value ones – investors will demand a higher return and capital will be more expensive.
This is what we see in the decades of market data, despite the past 10 years. Across all equity regions, smaller company shares have tended to deliver higher returns than larger company shares, and value shares have tended to deliver higher returns than growth company shares.
The chart below (sourced from Dimensional Fund Advisors) compares annual equity index returns in different regions, for the longest data set available in each (2):
Small company and value shares clearly don’t always deliver higher returns. This logically must be true, as otherwise they wouldn’t be any riskier and investors wouldn’t get compensated with extra return. Large company shares can outperform small company shares and Growth shares can outperform Value shares for long periods of time – the past decade of US returns is a clear example of this!
But over the long-term, theory and data shows we shouldn’t expect US Large Growth shares to carry on outperforming. That is absolutely not to say that they won’t, just that it’s not the most likely outcome.
Conclusions
Basing portfolio decisions on recent past performance can be a very dangerous thing to do – both at an asset allocation level and when picking individual investments.
What has just performed well is not a reliable indicator of what is about to perform well. Chopping and changing strategies, moving into recently high returning investments, after its already happened, is not a sensible strategy.
You need an investment process based on what does matter; academic investment theory and decades of market data, which you then stick to with discipline.
None of this is to say we don’t believe in investing in large US technology companies – they’re a very important part of the investment landscape. Apple is still the largest holding in our equity portfolios and all of the Magnificent 7 are represented in our top-10 equity holdings.
But rather than increasing exposure to these firms, we are wary of concentrated positions. Apple represents about 1.3% of our equity model portfolio, not 5.5%. And the Magnificent 7 represent about 6% of the portfolio, not 24%! (3).
By tilting investments away from Large Growth shares, spreading them across thousands of other companies whilst simultaneously targeting known drivers of return, we aim to create more diversified and efficient portfolios, which aren’t as dependent on the performance of a handful of firms in one country and one sector.
All returns stated are Total Returns (including income reinvested) of various indices representing individual asset classes. Indices are not available for direct investment and take no account of charges or tax. They are presented for comparison purposes only.
(1) As measured by S&P 500 and MSCI World ex-USA indices. Data sourced from Financial Express Analytics.
(2) Chart sourced from Dimensional Fund Advisors. Europe returns in DEM pre-1999 and EUR post-1999. Bars are represented by the following indices in order: Dimensional UK Small Cap Index, MSCI United Kingdom Index (gross div.), Dimensional Europe Small Index, MSCI Europe Index (gross div.), Dimensional US Small Cap Index, S&P 500 Index, Dimensional Emerging Markets Small Index, MSCI Emerging Markets Index (gross div.), Fama/French UK Value Index, Fama/French UK Growth Index, Fama/French Europe and Scandinavian Value Index, Fama/French Europe and Scandinavian Growth Index, Fama/French US Value Research Index, Fama/French US Growth Research Index, Fama/French Emerging Markets Value Index, Fama/French Emerging Markets Growth Index.
(3) Combined weightings of Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla in the MSCI World Index, as at 31/12/2024.
Disclaimer:
This document should not be considered a recommendation to purchase or sell any particular investment. Care has been taken to ensure the accuracy of content, but no responsibility is accepted for any errors or omissions. We do not predict or guarantee the future performance of any individual security, investment, portfolio or asset class.