“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”
― Charles Dickens, A Tale of Two Cities
“It was the best of times, it was the worst of times”, inside the financial markets as well. This is the stark case for 2020. The market is embracing the future and discarding the past, rewarding the shiny and new, while punishing the old and staid, the large are crushing the small. Work from Work (WFW) stocks are down in the dumps and Work from Home (WFH) stocks are, as Buzz Lightyear from the Toy Story movies would say, “to infinity and beyond”. As an example, year-to-date returns for Zoom are up over 155% versus Build-A-Bear which are down over 42%, one you can do from home, whereas the other requires a trip to the local mall.
Another interesting example, travel in outer space is up quite nicely this year while travel on earth not so much. Virgin Galactic has a goal, keep in mind it’s a goal, of providing consumer trips into space. The stock is up 35% year-to-date through May 16th. The JETS Global Airline ETF is a basket of the biggest global airlines, down -62% over the same time period. Now to be clear, air travel will likely be depressed for some time and iconic investor Warren Buffet sold all of his airline holdings as a result. Virgin Galactic has a current market cap of about $3.4B with reported revenues of $3.5 Million in 2019. At the moment, that makes Virgin Galactic worth almost as much as American Airlines ($3.9 Billion market cap), and American had revenues of $45 Billion in 2019. We are not advocating to buy American Airlines, but just pointing out what appear to be very generous assumptions by some market participants.
Paypal is now worth more than Citigroup. Citigroup has estimated revenues of approximately $72 Billion for 2020 and a current market cap of around $87 Billion. Paypal has estimated revenues of $20 Billion for 2020 and a current market cap of $173 Billion. Paypal is now worth almost twice as much as Citigroup. To be sure Paypal has a more efficient business model, with no tellers and no branches, additionally Paypal has a higher Return on Equity 12% to Citigroup’s 9%.
In fact, across most sectors from finance (S&P Bank ETF “KBE”), to energy (US Energy ETF “IYE”) to autos (Global Auto EFT “CARZ”), to real estate (US Real Estate ETF “IYR”), 2020 has been a year to forget. While for the shiny and new (Dow Jones Internet Index ETF “FDN”, Nasdaq Biotech ETF “IBB”), like Fintech, Work from Home software, Biotechnology, it is the best of times. See chart below for the year-to-date returns of these ETFs.
The CARZ Global Auto ETF looks less devastated compared to what is actually being felt by the auto industry for one big reason…Tesla. Tesla makes up 11% of the ETF holdings and is up 92% this year. Tesla currently has a market cap that is larger than Ford, General Motors, Honda, BMW, and Fiat Chrysler combined. Tesla should sell about 500,000 cars in 2020, Ford by itself typically sells about 2.5 Million. Tesla is a technology company that happens to sell cars, but the other companies must have something to offer as well.
The market may be rational, the market may be crazy. It may be a bit of both. New companies usher in new eras all the time in what we now call creative destruction. Not all of these big moves in stocks can be bucketed into a place of silliness. Some of this can be the market looking into the future and seeing the new leaders. 10 years ago nobody had heard of Tesla, 20 years ago Amazon only sold books. Entrenched leaders are taken out by smaller players who attack areas of opportunities incumbents are not exploiting. We must at all times stay alert to these new leaders and the opportunities they present to us as investors, and the threats they may pose to the companies in which we are already invested.
While it is good to keep an open mind about the future and embrace new leaders, there are times that these moves can go to extremes. Price is what you pay, value is what you get. We could be in one of those times today where price and value are divorcing from actual prospects. This may actually be applicable more on the side of the old boring companies (getting too cheap) than on the new world companies (may or may not be expensive). The game may not have moved on from these traditional companies as much as the market is currently pricing. But recently the only safe place to invest has been in the largest of the large, and in particular, the Technology and Healthcare sectors. The chart below shows how the levels of market cap concentration today are similar to 2000 before the dot-com bubble burst. Of course, today the technology companies are quite different and much more profitable, but the performance is looking frothy. By no means do we imply that this trend must halt, but the trend needs to be acknowledged for its enthusiastic nature.
Historically diversification has paid off, and concentration in a few of the highest market cap weighted stocks has not provided superior returns. The charts below compare the performance of the S&P 500 (a market cap weighted index where larger capitalization companies make up a larger share) versus the Equal Weighted S&P 500 (all companies are weighted equally regardless of market capitalization) and the Reverse Weighted S&P 500 (stocks with smaller market capitalization are weighted progressively more than those with larger market capitalization).
Year to date, the S&P 500 has beaten the other two indices. Again, same stocks, different weighting. This has been true for a few years now as investors were rewarded for concentration into the very largest companies.
So why not just own the S&P 500 market cap weighted and call it a day?
Historically the other two indexes have been a better place to be invested. Since 1999, the S&P 500 Reverse Weighted Index has been the best performer by a wide margin followed by the S&P 500 Equal Weighted Index and the traditional S&P 500 market weighted index coming in last.
One of the reasons for this outperformance is because the largest companies tend to change overtime. New incumbents rise up and those that were the largest decrease in value. In fact, the chart below illustrates that the largest stocks in the global market have historically underperformed after reaching the top 10.
Source: Research Affiliates
In more recent times, the outperformance of the S&P 500 has been even starker as compared to small cap and/or value stocks. However, these two segments of investing have over longer periods of time registered good returns. Small cap stocks now make up the smallest proportion of the overall stock market as compared to mid and large cap stocks in 20 years.
Value stocks have had even a more dismal time, as they have seen the worst draw down on record.
The question for investors is has the game changed and moved on? Or, are brave investors going to be rewarded for the foresight to look beyond what is comfortable to find value in these unloved parts of the market.
We must respect that the market may be suggesting the world has moved to an environment where we all search the screens of our iPhones on Google for the things we want Amazon to ship us that we pay for with PayPal. And we may never again set foot in a mall or a store. This reality is here now and is also more our future than not. A more nuanced view might be that the old entrenched players will not just roll over, some will survive and are currently not priced for that survival. These small cap and value stocks may rise from the ashes to provide investors returns that nobody is seeing right now. A new paradigm may be unfolding before our eyes and recognizing that the future is always unknowable informs our approach. Nevertheless, while diversification has penalized investors who ventured beyond the shores of the very largest 10 stocks during the past five years, it is unlikely diversification has lost its benefit long-term.
“Doubt is not a pleasant condition, but certainty is absurd.”
― Voltaire, French author, humanist, rationalist, & satirist (1694-1778)
General Disclosures: The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions. All expressions are as of its publishing date and are subject to change. There is no assurance that any of the trends mentioned will continue in the future. Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of trading advice or guarantee of future results. Certain information contained herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. Any reproduction or distribution of this presentation, as a whole or in part, or the disclosure of the contents thereof, without the prior consent of Cardan Capital Partners, LLC, is prohibited. Investments in securities entail risk and are not suitable for all investors. This is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.