As the S&P 500 continues its march higher, a common observation (and a factor that we’ve pointed out in the past) is that US market performance has been dominated by a small number of very large, “new economy” oriented companies. Though the rise in these market leaders has been mostly supported by earnings growth, some now argue that prices are starting to outrun fundamentals and, with the top 10 stocks accounting for roughly 40% of S&P value, a pullback in these names would put significant pressure on the benchmark.
Beyond the direct investment that the mega stocks have attracted, they’ve also been outsized beneficiaries of the explosion in index investing. Because the S&P weights its members by equity value, every dollar added to index investment winds up buying relatively more of the largest companies, resulting in a virtuous (or vicious?) cycle where momentum causes the big get systematically bigger. While this dynamic has helped to propel a small number of mega-cap companies to record values, it’s reasonable to assume that some measure of the reverse will also play out in a market downturn, especially if index investors decide to rebalance away from equities at the margin. In this case, they’ll wind up selling relatively more of the same market leaders that they’d been overbuying on the way up and, because of this lopsided structure, index investors may find out that they’re less diversified than they currently believe.
While money has flooded into the upper echelon of the S&P, the rest of the market has largely been ignored — in fact, 35% of US stocks are currently in a bear market, down by 20% or more. This condition also helps to explain the chart below, which shows valuations for different market gradients. As you can see, on a price to forward earnings basis, the 10 largest companies in the S&P are significantly pricier than the rest of the market. Once one looks below the top 100 stocks, however, (which are also dominated by the big 10), multiples begin to look more reasonable and, at the bottom of the spectrum, they even qualify as cheap. This creates the opportunity to simultaneously stay invested and become more defensive simply by moving down market.
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Portfolio Activity
In November, we eliminated our position in Zoetis in DM US Equity on disappointing guidance. We also trimmed our allocation to TopBuild and opened a new position in Uber Technologies Inc.
Feature Stock
Dollarama Inc. (DOL)
DOL is one of the longest held positions in DM Canadian Equity, with our team having first added the stock in 2013. At the time, we bought it for its attractive growth profile, with its footprint of store locations still relatively small, leaving much room for profitable expansion. Since then, the stock has risen nearly twentyfold, and the company has matured from plucky upstart to senior member of the TSX retail sector. Despite its formidable size (2700 locations in seven countries), however, the company remains nimble and continues to execute with efficiency and precision. Despite DOL shares having gained more than 40% so far this year, RBC feels that they have more room to run, citing a strong Halloween season and an unexpected boost from the sale of Blue Jays-related items. With both the economy and consumer sentiment soft, consumers will likely be looking to save this Christmas, which should also favour Canada’s largest discount retailer. Notably, CEO Neil Rossy, son of company founder Larry Rossy, purchased more than $10m in company shares last month, signaling man-agement confidence in DOL’s outlook.Our Monthly Insights