1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #64!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points:
First, we will give you an update on the performance of the Magnificent Seven Stocks and the lessons investors should retain when investing in these high-flying stocks.
And next, for our second topic, we will review Warren Buffett’s Annual Letter to Shareholders of Berkshire Hathaway
Enjoy!
2) UPDATE ON THE PERFORMANCE OF THE MAGNIFICENT SEVEN:
François Doyon La Rochelle:
In our first topic today, we will review the performance of the Magnificent Seven stocks and how they have done year-to-date in 2024. We will ask ourselves if it has been worthwhile to chase these high-flying stocks.
James Parkyn:
Yes François, but before we go into the details, I just want to give our listeners a quick reminder of where that catchy label for these high-performing stocks came from. They may remember that at first, in the mid-2010s, the acronym FANG, popularized by Jim Cramer on his CNBC TV Mad Money show, was used to label a group of stocks namely, Facebook (now Meta), Amazon, Netflix, and Google (now Alphabet), who had spectacular growth and performance. Later in that decade, Apple was added to the group and another A was added to the label FAANG. Then, early in 2023, the term FAANG was replaced by The Magnificent Seven to label a group of seven mega-cap market-leading stocks. The companies in that group are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. You will notice Microsoft and Nvidia were added but Netflix is no longer there.
François Doyon La Rochelle:
Thanks, James, for the short history. I must say that this type of labeling by the Street is nothing new as it was also used occasionally in the past to refer to a group of market-leading stocks. Some will remember the dot.com era in the late 1990s or the Nifty Fifty period in the 1970s. Getting back to the Magnificent Seven, we highlighted in Podcast #59, when we reviewed the 2023 capital market results, how well these stocks had done in 2023. We mentioned then that their performance in 2023 ranged from 48% for Apple to an astonishing 239% for NVIDIA. Their performances apart from Apple were more than double the gains of the S&P 500 which gained almost 26% during the year. These seven stocks made up close to 27% of the S&P500 Index market cap weight and contributed to almost half of the gains of the U.S. market last year.
James Parkyn:
Exactly and at some point, as I highlighted back in January, in the first half of 2023, these Magnificent Seven stocks were generating all the gain on the U.S equity market. Their dominance over the market in 2023 has certainly created a buzz amongst investors and the investment industry which prompted several ETF providers to launch new products designed to profit from a concentrated bet on these stocks. Only the future will tell if these ETFs pass the test of time and be worthwhile investments. This being said François, how are those seven stocks performing in 2024?
François Doyon La Rochelle:
Well James, as of May 24th, cracks are starting to show amongst the Magnificent Seven since both Tesla and Apple shares are down so far this year. Apple shares are down roughly -1.1% and Telsa is one of the worst-performing stocks in the S&P500 Index with a performance of -27.9% YTD. Slowing growth is the main reason behind their current difficulties.
James Parkyn:
What about the other five stocks?
François Doyon La Rochelle:
The remaining five stocks are still contributing to the fabulous 11.2% performance of the S&P500 Index so far this year. Again, as of May 24th, Nvidia remains the leader with a stunning performance of 115.0% followed by Meta at 32.2%. The other three are also performing well with returns of 25.1% for Alphabet (Google), 19% for Amazon, and 14.8% for Microsoft.
James Parkyn:
Francois, there has been a lot of talk regarding the weight of these stocks in the S&P500 Index and the concentrated risk. So, what’s the weight of the Magnificent Seven now and also for the top ten securities in the S&P500 Index?
François Doyon La Rochelle:
Well, the total market cap weight of the Magnificent Seven in the S&P500 Index is currently around 28.8%. The largest security is Microsoft with a weight of close to 7% followed by Apple with a weight of 5.6%. It is worth noting that because of its poor performance YTD, Tesla is no longer among the top 10 stocks of the S&P500 Index. The top ten stocks now represent roughly 32%.
James Parkyn:
I think Francois that this concentration in the top 10 stocks is close to a historical high for the S&P500 Index. Is that correct, should investors be worried?
François Doyon La Rochelle:
Effectively James, this concentration in the top ten securities is high but it is not particularly unusual. Based on data from Dimensional on the US stock market, going back to 1927, there have been periods when the concentration in the top ten stocks was as high as it is now. For example, in 1940 the top ten stocks weighed 33.0% of the US stock market. Similar concentrations were also observed in the 1930’s and in the late 1960’s.
James Parkyn:
I understand Francois but do you think their outperformance can continue and they can stay on top? Michael Hartnett, the managing director, and chief investment strategist at Bank of America Global Research, who came up with the label, The Magnificent 7, said and I quote “They all have monopolistic/oligopolistic positions, pricing power, secular earnings power, balance sheets that can finance AI and so on”. What do you think, what does capital market history tell us about this?
François Doyon La Rochelle:
To answer your first question James is, I don’t know. Can these technology companies keep outperforming the way they have; can they stay on top? To me, only the future will tell. However, what I can affirm is that historically there has always been a rotation amongst the top 10 securities in the US stock market or in any other international market for that matter. If we go back to the year 2000, back then, cutting-edge technology companies were also dominating the U.S. stock market and making headlines. The top ten stocks in the S&P500 at that time included the following tech giants: Microsoft, Intel, Lucent, IBM, and Cisco. Today these tech giants and all the other stocks in the top ten of the S&P500 Index have all disappeared from the top except for Microsoft. IBM which was part of the US largest stocks for more than six decades now sits at number 47 in the S&P500 Index with a weight of 0.4%. In 1985 the weight of IBM in the S&P500 Index was at 6.4% which is close to Microsoft’s weight in the index today.
James Parkyn:
Yes, François and I will add another classic example of a major stock falling out of the top ten. General Electric (GE) had been in the top ten for nine decades when for many reasons, its business model collapsed. A recent Morningstar article titled “15 Stocks That Have Destroyed the Most Wealth Over the Past Decade” puts GE at the number one position for destroying wealth in the last decade ending December 2023 at an estimated U.S. $55 billion in shareholder value. Is it fair to say François that the top ten stocks and the next best-performing stocks 10 years from now will most likely be a different list of names?
François Doyon La Rochelle:
Yes, James, there is no doubt in my mind that they will have changed.
James Parkyn:
So, what would you say then to investors François, who may still be tempted to buy these stocks?
François Doyon La Rochelle:
Well, James, they may continue to outperform the market in the short run. However, in the long run, I don’t think that they can reasonably expect these kinds of outsized returns from the Magnificent Seven. Their stock valuations are now considered to be high and when stock valuations are high, future expected returns are lower. Investors need to remember that historical annualized returns for the S&P500 Index dating back to 1926 have been 10.3%, and in 2023 alone those stocks returned a market cap-weighted return of 76%. Investors often have unrealistic performance expectations for these types of growth stocks.
On that topic, Dimensional has studied the average annualized outperformance of companies before and after the first year they became one of the top ten largest firms in the US.
James Parkyn:
And what have been their results?
François Doyon La Rochelle:
Well from 1927 to 2023, the average annualized return for these stocks, for the ten years before joining the top 10, was 11.8% higher than the market. For the three years before joining the top ten, their performance was 27.2% higher than the market, but here is the catch, 3 years after joining the top ten, their overperformance had dwindled to only 0.5% over the market and 10 years later these stocks were underperforming the market by an annualized 1.5%.
Similar research from Antti Petajisto Ph.D. and former professor at Yale University comes to similar conclusions. He wrote in his paper entitled “Underperformance of Concentrated Stock Positions” and I quote “For stocks that have been among the top 20% performers over the previous five years, the median ten-year market-adjusted return falls to –17.8%, underperforming by 1.94% per year. Since the end of World War II, the median ten-year market-adjusted return of recent winners has been negative 93% of the time.”
James Parkyn:
Based on this research François, I think we can conclude that investors should not be chasing the past performance of these high-flying stocks. They should be very aware of the consequences of acting on their fear of missing out. I think individual investors should be disciplined to avoid making this type of behavioral mistake. At times like these, it’s always good to refer to Warren Buffett’s words of wisdom. In 2018, during Berkshire’s annual meeting, when questioned by an investor about not buying Microsoft, Warren Buffett gave a long-winded answer but finished by saying “We missed a lot in the past, and I suspect we’ll miss a lot more in the future.” What he is saying, as he points out, there will always be high-flying stocks.
François Doyon La Rochelle:
Yes, and I think this says a lot and it’s a good frame of mind to have. If you have been building your portfolio with broad-based market ETFs, you have benefited from the performance of those high-flying stocks, and you will undoubtedly benefit from the next ones that come around in the future. Hitting a home run is nice but it’s not an investment plan for the long-term.
James Parkyn:
So exactly François, investors should focus on their long-term objectives, diversify their portfolio across many different asset classes and countries and they should follow our mantra and have an “Investor Mindset” and continue to buy and hold investments with an owner’s mentality.
3)REVIEW OF WARREN BUFFETT’S ANNUAL LETTER TO SHAREHOLDERS OF BERKSHIRE HATHAWAY:
François Doyon La Rochelle:
For our second topic, we will do a review of Warren Buffett’s Annual Letter to Shareholders of Berkshire Hathaway. Reviewing this Letter is an annual ritual for many Investors. Warren Buffett has been writing these letters since 1965. Many serious books have been published over the years that have studied the Letters to summarize Warren’s pearls of wisdom on the topic of Investing. I believe James, we skipped the review last year in favor of other Topics, but this year we felt we were overdue to cover this for our Listeners. Why so? We feel that all investors including ourselves who have a disciplined Passive Investment Philosophy can learn from Warren’s insights.
James Parkyn:
Absolutely, François. For me, reading Warren Buffett’s Annual Letters is always fascinating. You realize that the businesses owned by Berkshire can be explained in plain language. There’s no need for the jargon so pervasive in the financial services industry.
François Doyon La Rochelle:
Given how long he has been writing Berkshire’s shareholder letters, reading through them offers a fascinating financial history of the past almost 60 years. Our Listeners should know they are all easily accessible online for free. So, James, where do you want to start the review of this year’s Letter?
James Parkyn:
This year Francois, there is a lot to talk about because there is a lot of news. For our Listeners, I will start our discussion with the news of the passing of Warren Buffett’s longtime business partner Charlie Munger at age 99. In the 2023 Letter, Warren has written an homage to his late partner, and I quote “Charlie was the “architect” of the present Berkshire, and I acted as the “general contractor” to carry out the day-by-day construction of his vision.”
François Doyon La Rochelle:
The passing of his longtime business partner Charlie Munger was indeed a major event in the world of Berkshire. Many people may not realize how important Charlie Munger’s role has been in the partnership.
James Parkyn:
François, for our Listeners I will again quote Warren in the 2023 Letter: “Nevertheless, Charlie, in 1965, promptly advised me: “Warren, forget about ever buying another company like Berkshire. But now that you control Berkshire, add to it wonderful businesses purchased at fair prices and give up buying fair businesses at wonderful prices. In other words, abandon everything you learned from your hero, Ben Graham.
François Doyon La Rochelle:
For our Listeners Benjamin Graham is widely known as the "father of value investing” and wrote two of the discipline's founding texts: Security Analysis with David Dodd, and The Intelligent Investor.
James Parkyn:
The Warren Buffett quote goes on: “Many years later, Charlie became my partner in running Berkshire and, repeatedly, jerked me back to sanity when my old habits surfaced.” I think François, this quote says it all about Charlie Munger’s influence on Warren Buffett.
François Doyon La Rochelle:
This is the important thing to remember for our listeners. They must have an investor mindset, which means ideally, they want to buy and hold forever. This is at the heart of our investment philosophy for passive investing. You don’t want to be caught up in the noise of the moment. For our Listeners who would like to learn more about Charlie Munger, there is a great book called “Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger”, edited by Peter Kaufman. They have recently published the fourth edition. So, James, now let’s explain to our Listeners what Berkshire does.
James Parkyn:
Well, François, Warren Buffett explains it clearly in this year’s Letter in a section called “What We Do”. I will quote from the Letter, “Our goal at Berkshire is simple: We want to own either all or a portion of businesses that enjoy good economics that are fundamental and enduring. Within capitalism, some businesses will flourish for a very long time while others will prove to be sinkholes. It’s harder than you would think to predict who will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen.”
François Doyon La Rochelle:
Well, this is another very important point to our listeners. Stock picking is a very rare skill and hard to replicate. We know that Warren Buffett is not a fan of Wall Street and Market forecasters. He has consistently recommended investors put their money in a broad-based index like the S&P 500. So, James, Warren Buffett, and Charlie Munger have shared many important lessons about investing over the years. What lesson is Warren highlighting this year?
James Parkyn:
François, Warren Buffett is very clear about one key rule he never breaks. In this year’s Letter, I quote him: “One investment rule at Berkshire has not and will not change: Never risk permanent loss of capital. Thanks to the American tailwind and the power of compound interest, the arena in which we operate has been – and will be – rewarding if you make a couple of good decisions during a lifetime and avoid serious mistakes.”
François Doyon La Rochelle:
This makes total sense to me James, and it is why we are always broadly diversified with our clients’ portfolios to avoid permanent loss of capital. Again, people who invest in individual stocks always incur the risk, because you don’t know what you don’t know, of dilapidating capital. So now James, many of our Listeners are probably wondering how Berkshire got this big.
James Parkyn:
It is a great story, Francois. I remind our Listeners we are not stock pickers, and we are not in any way recommending the purchase or sale of Berkshire Shares. Berkshire has performed so well that it is now the 7th largest public company in the U.S. markets by market capitalization.
François Doyon La Rochelle:
As the 7th largest stock in the U.S., Berkshire has a 1.7% weight in the S&P 500 Index and a 1.5 % weight in the Vanguard Total Market ETF as of March 31, 2024. Investors like our clients in these broad market ETFs have benefited from owning Berkshire shares.
James Parkyn:
It may come as a surprise to some of our listeners, that one of the reasons that Berkshire is now 7th, is that Apple stock represented at year-end nearly 50% of Berkshire’s public stock portfolio. Just to be clear for our listeners, this is not 50% of the total value of Berkshire Hathaway. As mentioned earlier, Apple is the second largest public company in the U.S. markets by market capitalization.
François Doyon La Rochelle:
The story of how Warren Buffett invested in Apple is fascinating. James, can you provide our Listeners with some background on how it happened?
James Parkyn:
The story is after an initial purchase of nearly 10 million shares worth about $1 billion in 2016, Berkshire added to its holdings later that year and then stepped up its buying in 2017 and 2018, spending about $36 billion on the stock over those years. Berkshire later trimmed some of those holdings. The move has paid off, in a very big way. Today, Berkshire’s 5.9% stake in Apple is worth about U.S. $157 billion. Berkshire is sitting on about $120 billion in paper gains, likely the most money ever made by an investor or a firm from a single stock. Nothing in Buffett’s long career comes close.
François Doyon La Rochelle:
That’s staggering to me James, but does it make Berkshire shares riskier?
James Parkyn:
In a WSJ Article published on May 3rd, 2024, titled “Apple Is Buffett’s Best Investment. It’s Also Now One of His Riskiest’’ Gregory Zucherman addresses this question. He states that “Berkshire has scored an annualized return of more than 26% from Apple, including dividends, topping a gain of 12.9% for the S&P 500 during the same period.”
To answer the question François, of whether the Berkshire stock is now riskier, really is to misunderstand how Warren Buffett thinks about investing. On the one hand, as you point out François, large companies that are in the top 10, over time start to underperform relative to the market. This Appel position is a concentrated bet, and we all know Warren Buffett is all about buy and hold forever. But that said, he has already started to trim the position.
François Doyon La Rochelle:
Historically Warren Buffett and Charlie Munger avoided Technology stocks. They said they were too hard to value. What changed?
James Parkyn:
François this is again a perfect example of why stock picking is so difficult to do well. Chris Davis, who is on Berkshire’s board of directors, is quoted in the same WSJ article. He said: “Warren’s ability to change his mind is what’s so extraordinary because that’s what most investors struggle with the most. Most of us anchor ourselves in our past statements, but Apple is a powerful example of the importance of being open to change.”
Because he has demonstrated over the years that he has a unique skill if the underlying fundamentals change, he can decide to sell. A perfect example, in this year’s letter Warren Buffett has admitted to making a mistake with Berkshire Hathaway Energy, which is a major investment that they control 100%.
François Doyon La Rochelle:
Berkshire is so big that the universe of companies it can buy in sufficient quantities to affect its returns is limited. Apple, with a market value of almost $600 billion at the beginning of 2016 fit the bill. It’s still amazing that although he wasn’t an early investor, he made a bundle of money in Apple. James, what is Warren Buffett saying now about the outlook for Berkshire shares?
James Parkyn:
Warren Buffett is very clear about the outlook. In the 2023 Letter, he warned that Berkshire Hathaway has “no possibility of eye-popping performance.” It’s a point he has made before that Berkshire’s size—it ended 2023 with more than $560 billion of shareholders equity on its balance sheet—will limit its future growth. Back in 1984, Buffett warned Berkshire was big enough that its growth would have to slow. In 1990, he put it this way: “A high growth rate eventually forges its anchor.”
François Doyon La Rochelle:
Yes, James, but despite what he said then, the company shares have risen spectacularly since 1984. In recent years, the performance of Berkshire has been much closer to the market. In 2023 Berkshire shares returned 15.8% vs 26.3% for the S&P 500. However, so far in 2024, Berkshire shares have outpaced the market.
So, what should our Listeners retain from all this James?
James Parkyn:
There are many important lessons François. First, what Warren Buffet has achieved with Berkshire is not matched by any other investor. He is the perfect example of a skill that outperforms the market over the long term. This skill is very rare and very hard to find. Warren Buffet has always said that the best option for investors is to invest in a broad-based index like the S&P 500. He is very clear that for investors to get the best outcome they must adopt an investor mindset of buy and hold for the long term.
The second lesson for our listeners comes from Jason Zweig who we have quoted often in our Podcast. He wrote a great Article in the WSJ on May 3rd titled “There’s more to Warren Buffett’s game than just picking great stocks. In it, he said: “Hunting for a great stock picker is necessary, but not sufficient. You also need to find a great stock picker who isn’t a pickpocket.” In this article, he points out that when you compare Warren Buffett to Hedge funds or private equity funds and their outrageous high fees investors need to beware when fund managers promote themselves as being just like Warren Buffett.
François Doyon La Rochelle:
This is a very important lesson for our listeners James. Very often in the financial media, you hear: Oh, we invest just like Warren Buffett. The reality is that they don’t. As Jason Zweig points out “For Buffett, his business strategy bred a structure that set him apart from other money managers—and made shareholders a bundle. He goes so far as to figure out what the difference would have been for Berkshire shareholders if he had charged Hedge Fund Manager-type fees. I quote from the article: “Put another way, if Buffett had charged conventional hedge-fund fees, his investors would have earned only about 10% of the wealth they have enjoyed”.
James Parkyn:
This is mind-boggling. Only 10% of the actual gain would have been left over. So, the lesson is to watch out for high fees especially nowadays when the financial services industry is moving to push investors into Alternative strategies with very high fees.
François Doyon La Rochelle:
Because Berkshire is a publicly traded holding company, rather than a mutual fund or hedge fund, it doesn’t charge fees. Jason Zweig points out that the Fund Management Industry is structured exactly the opposite. He adds: “Buffett never had to worry that investors would flood him with too much money at a market top or yank it out at the bottom. Most funds have fickle capital; Berkshire has permanent capital.”
James Parkyn:
So, François, I would like to end this segment by sharing with our Listeners that I’m always amazed at how investors keep ignoring Buffett’s advice. At the heart of what he is recommending is to have an investor mindset focused on the long-term, buy and hold for as long as it is sensible to do so, and make sure that you avoid investment funds with high fees. There is a lot more to what his investment discipline is all about, but this summarizes the essence.
4) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn: for sharing your expertise and your knowledge again today.
James Parkyn:
My pleasure. François.
François Doyon La Rochelle:
That’s it for episode #64 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
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Again, thank you for tuning in and please join us for our next episode to be released on July 4th. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon.