MICHAEL KOSKUBA 16-Dec-2020
For years now, standard operating procedure for large-cap growth investors seemingly has been to allocate to passive strategies that track an index and move on. Set it and forget it. But as successful as that approach has been over the past five years and longer, we’re here to remind investors it’s not the only way forward for a large-cap allocation. In fact, there are growing concerns—warning lights even—that suggest investors may want to consider an alternative, active approach.
Consider how extraordinary 2020 has been for large-cap growth stock investors. Fueled by massive liquidity from the Federal Reserve, a TINA (“there is no alternative”) mindset, and earnings multiple expansion, secular growth stocks have fared significantly better than their value and cyclical counterparts in this pandemic-influenced year. And looking deeper, leadership among the Russell 1000 Growth Index’s largest holdings has been extremely concentrated. Through the end of October, the FAANG stocks, plus Microsoft and Tesla represented 75% of the index’s total return. This astounding concentration of winners begs the question: How should investors allocate to large-cap growth for the longer-term? And more specifically, does active management in the large-cap growth space make sense?
We believe the extreme concentration within the Russell 1000 Growth Index is exactly the reason why investors might consider pivoting from an existing passive approach. What happens if there’s a reversion to the mean among the performance of the very largest holdings? What happens if and when leadership changes? It may seem inconceivable right now, but if one looks back at the largest constituents of the index five, ten or more years ago, the dynamic nature of leadership is obvious.
Perhaps more importantly, what happens in an environment where liquidity (and correlations) decline? We believe an alternative approach to large-cap investing (and a potential path to generating alpha) is to invest in a focused portfolio of high-quality secular growth companies. In other words, we prefer some portfolio concentration in certain high-conviction names, but not to the extent in which the large-cap indexes have evolved.
From a fundamental standpoint, we also believe it is prudent to hold some of the index’s largest companies if they appear to have a runway for continued earnings growth. But we also think it’s important to allocate meaningfully beyond those household names. Fundamental research should be able to identify companies positioned for market leadership, with solid financial positioning, talented and responsible management teams, and sustainable revenue and earnings growth. Such attributes represent attractive company-specific fundamentals, which will become ever more important if liquidity dries up and correlations among stocks fall.
Should this happen, and we believe it will, fundamental research may be valued for its potential to differentiate between the haves and have-nots, even in the large-cap growth space where returns have recently been dominated by a handful of stocks. For passive investors who have benefited to date from the dominance and concentration of the large-cap indexes, it’s not too late to pivot.