Many people think that the key to successful investing is “stock picking”. They might look for a portfolio manager with a reputation for finding great companies through research or proprietary computer algorithms. This suggests that finding great businesses to invest in is difficult. But the truth is that, these days, it is relatively easy to find companies that have demonstrated excellent growth and profitability, given the ubiquity of computer processing capabilities and wide access to databases full of up-to-date company data. Instead, the art is in finding a good investment at a reasonable price.

The largest and most successful companies are well-known by practically everyone. But that means they are investors’ favorites and therefore trade at expensive valuations. As examples, my top five stocks in terms of both growth prospects and market capitalization are what I call (after Eugene Fama – just Google his name) “the FAMA V” (V being Latin for five): Facebook, Alphabet, Microsoft, Amazon, and Visa. These five are market leaders because, although representing only 1% of the 500 stocks in the S&P index, they account for 10.3% of total index market capitalization of US$20.3 trillion.

Everyone knows about these large, successful market-leading companies. As a result, they are expensive. Compared to the price/earnings multiple for the S&P 500 of about 24x (on trailing 12-month earnings, according to the Wall Street Journal), the FAMA V trade at multiples of 40x, 30x, 31x, 173x and 35x (from Yahoo Finance). So while the market itself is expensive by historical standards (see the blog post below about investment returns), the leading stocks are even more expensive.

Market-leading stocks are expensive not only because they are the favourites of investors, but also because there is a positive feedback loop in today’s equity markets in the form of ETFs. ETFs have become very popular because investors believe they can achieve equity returns at low cost without the bother or risk of owning individual stocks. According to the Investment Companies Institute, a net US $235.2 billion was removed from American domestic equity mutual funds in 2016 while US $ 167.5 billion was added to domestic equity ETFs. In a recent report on Seeking Alpha, Mark Bern, CFA, put the total number for 2016 cash inflow into domestic equity security ETFs at US $426 billion, and suggests that the total assets in such ETFs now amounts to about US $2.84 trillion, or about 14% of the total market capitalization of the S&P 500 index.

ETFs are now a huge part of the market. Most of them are passive, market-weighted ETFs that simply have to own a lot of the largest capitalization stocks like the FAMA V because their purpose is to track overall market performance. When the market goes up, these ETFs have to buy more shares at current market prices in order to maintain market weights in the portfolio equal to the respective company weightings in the benchmark index (such as the S&P 500). And as market-leading stocks rise in price due to further ETF purchases, the index value goes up. Thus a feedback loop is established. But the quid pro quo is that there is no way the market can sell off without the FAMA V and other large capitalization market leaders experiencing healthy price corrections. And in a market decline, the feedback effect can be expected to  exacerbate downside movements for these same large-cap stocks.

Some people think they can time the market, but I don’t know of anyone who has done so successfully and consistently. Instead, it is better to stay invested and react to market dips employing the standard portfolio management strategy of rebalancing – if stocks sell down and become bargains, assets can be reallocated from cash and bonds into equities. And that would be the right time to add formerly expensive market leaders such as the FAMA V.

So perhaps ETFs can prove beneficial to us when the next inevitable market correction happens. In that scenario, ETFs will be forced to liquidate their heavily-weighted positions, including the most desirable stocks like the FAMA V. Good companies will be sold down along with the all the rest because liquidation by passive ETFs will be a function of mindless computer programs based only on portfolio weightings relative to an index benchmark. That kind of selling should produce a negative feedback loop, exacerbating the downside and creating bargains in the process. Individual investors then may have the opportunity to build positions in the FAMA V and other good companies at reasonable prices. But it will be necessary to have a list of potential targets at hand in order to be able to react quickly, because market leaders that often are the most desirable to own for the long term usually are the first to recover.

So, while I do not believe in market timing, right now I am watching very closely – and patiently – for the day when stocks like my FAMA V trade back in line with long-term average price/earnings multiples. If that were to happen, it would be a good sign that the time has come to allocate more capital to equities.

 

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