Why You Should Diversify Before the Growth Bubble Bursts

2020 will be ingrained in our memories as the year that everything changed. A global pandemic has led to the shutdown of major economies and mass unemployment; many countries are teetering on the brink of recession or have already slipped into one. In the first quarter of 2020, this “black swan” event saw the fastest 30% sell-off in equities in history.¹

Despite this dismal economic picture, stock prices rebounded to pre-lockdown levels within a few months of the sell-off. Looking deeper, however, one finds that things are not as they seem. For example, even as stock prices climbed, the underlying fundamentals of many publicly traded companies fell. In addition, much of the rise in global markets has been driven by trendy “growth” stocks: those companies whose valuations rest on estimates of future growth rather than current earnings.

What is driving this misalignment between markets and fundamentals? And why have growth stocks been disproportionately impacted? Most importantly, what does this mean for investors?

Increased Retail Participation Creates Market Inefficiencies

Most participants in developed equities markets are professional institutions. For example, in the pre-COVID U.S. market, less than 5% of U.S. stock trading was done by non-professionals.² But that has all changed in the wake of the pandemic.

Over the past six months, there has been a dramatic increase in “armchair speculators” – those individuals with time on their hands and no sporting schedule on which to place their bets. There are also hosts of young people with no investment experience who fear “missing out” as they watch markets climb while employment prospects wane. Both of these groups have increasingly turned to stock markets for short-term thrills or and the hope of a big win.

In fact, according to Financial Times,³ three of the four biggest U.S. online brokerages collectively signed up 780,000 new customers in March and April; March alone accounted for three times the monthly average of new sign-ups over the prior two-year period. Individual investor participation in the U.S. has doubled post-COVID, and retail trading now accounts for up to 25% of daily market activity.⁴ There have been comparable increases in retail trading activity in other developed markets across Europe and Asia.

As amateur investors flood the market, it begins to feel more like a casino: an enjoyable wealth transfer mechanism with little positive benefit to the real economy. Why does this matter? It matters because retail gamblers are more susceptible to the behavioural biases that lead to trading mistakes, pushing prices away from fundamentals.

For example, retail traders are often attracted to (1) “sexy” household names or thematic concept stocks, (2) companies whose products or services they personally prefer, or (3) companies with recent positive stock performance. Such companies sound exciting, but do not always make for sound investments.

The Emergence of a “Growth Bubble”

Unlike professional institutional investors, enthusiastic retail traders pay little attention to the fundamentals of the companies in which they invest – in part because they lack the experience, knowledge, or willingness to perform meaningful fundamental analysis. This leads to an inefficient market, in which companies’ stock prices deviate significantly from their fundamental valuation. When this disconnect becomes extreme, we call it a “bubble”.

Bubbles can develop anywhere in a market, but in the post-COVID era stock prices have risen most sharply among so-called “growth” stocks. Growth stocks capture the imagination of inexperienced investors – think Tesla or Amazon – and tend to be younger companies. As a result of retail speculation in growth stocks, the valuation spreads between growth stocks and their less exciting counterparts, called “value” stocks, are now higher than at the peak of the dot-com bubble.

Unfortunately, it often seems the only way to beat the market during transient periods of retail exuberance is to be “more retail than retail” – a risky proposition, even in the best of times. Luckily, there is an alternative approach available to more experienced investors: wait the bubble out in a diversified portfolio that includes a mix of value stocks with strong fundamentals and quality growth firms, while avoiding crowded and speculative trades in overpriced high-flyers, however tempting those names might be.

Would You Rather Be David Portnoy or Warren Buffett?

Barstool Sports founder David Portnoy, who has substituted sports betting for day trading, recently suggested his investment style is more successful than that of the legendary Warren Buffett.⁵ Of course, he’s not the first to make this claim. Buffett has been challenged many times over his career, but he’s always stayed true to his philosophy of value investing: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Buffett understands the value of patience, which has resulted in long-term success for Berkshire Hathaway.

Despite occasional bouts of underperformance, we know from experience that Buffett’s value model performs well over time. Likewise, Portnoy’s exuberant bets on growth do occasionally outperform in the short-term, even if buying expensive stocks with no fundamental support is not a long-run recipe for success. In a dream world, we would have a crystal ball (or a quant model) that tells us when we should invest like Warren Buffett and when we should mimic David Portnoy. Unfortunately, most people who attempt the dark art of market timing do the wrong thing at precisely the wrong time. They get caught up in the bubble, buying near the peak, and are left with nothing when it bursts.

The good news is that we have a solution to this problem: diversification. The best way to build family wealth is simply to be diversified in all aspects of one’s investment exposure. Stated differently, because one never knows when a particular market geography, industry, or investment theme may suffer a long bout of underperformance, it makes sense to be exposed to many of them.

Striking a Balance: Factor Diversification

At Henderson Rowe, diversification is at that heart of our investment process: from our asset allocation policies to the way we select individual stocks. Our portfolios are built on the basis of a wide range of inputs – what we often refer to as “signals” or “factors” – each capturing a different aspect of assets making up the market. So-called “multi-factor” strategies paint a more complete picture of the assets in our portfolio, diversifying our investments not only across geographies and industries, but also in terms of the information we use to identify favourable firms.

If you think of investing as a puzzle, then each factor is like an individual piece of that puzzle. Common factors outline the edges of the image. Buffet’s “value” approach reflects perhaps the most successful and well-understood factor; and Portnoy’s approach reflects elements of “momentum”, another well-understood factor that captures, in part, the irrational exuberance of day traders. Over time, we identify trickier pieces of the puzzle and the image begins to fill out. Factors used in our models include fundamental signals based on information from firms’ accounting statements, to indicators based on how stocks are trading, the actions of companies’ managers, and the sentiment of other market participants. Putting a wide range of complementary factors together ultimately provide a fuller and more-complete image of the market than any single factor or investment approach.

Through Henderson Rowe’s multi-factor approach to investment, we ensure our investors are diversified not just in terms of asset class or region, but also in terms of the inputs and process by on our portfolio is built. This approach ensures that the portfolio captures growth and sentiment when the market rallies but is anchored to value and quality when fundamentals once again take centre stage. At the end of the day, you may not need to choose between Warren Buffett or David Portnoy – you can be both.

Endnotes

¹Yun Li, “This was the fastest 30% sell-off ever, exceeding the pace of declines during the Great Depression,” CNBC, 23 March 2020

²Phil Wool, Ph.D., “Where Retail Rules: Buying Into China’s Alpha Opportunity,” Rayliant Research Note, 27 August 2019

³Richard Henderson, “Frustrated sports punters turn to US stock market,” Financial Times, 19 May 2020

⁴Ben Winck, “Retail traders make up nearly 25% of the stock market following COVID-driven volatility, Citadel Securities says,” Markets Insider, 9 July 2020

⁵Shawn Langlois, “Barstool Sports founder believes he’s a better investor than Warren Buffett and has determined day trading is ‘the easiest game’ there is,” MarketWatch, 13 June 2020