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Aug 21, 2021
May 16, 2019

Extreme concentration

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Firth Investment Management
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For quite some period of time we have emphasized in our monthly portfolio commentaries (for the Firth Asia Systematic Equities Fund [FASEF]) some unusual aspects of market trading activity. The points have particularly focused on:

  1. Performance being driven by liquidity flows rather than relative stock fundamentals;
  2. This performance has been highly concentrated in a small number of large cap names; and,
  3. The extreme longevity of this behavior.

Typically, while markets often feel rather irrational, they are in fact anchored by the underlying fundamentals, and expectations for future fundamentals are anchored by current fundamentals. Simply, markets don’t normally get too far ahead of themselves. The key exceptions to this occur at cycle extremes. Either:

  1. Very late cycle when true “irrational exuberance” takes over and every taxi driver and their dog is buying stocks. i.e. the final liquidity-driven blow-off rally at the end of the cycle; and,
  2. In the depths of a substantial market sell-off when the proverbial baby is thrown out with the bath water and investors capitulate to an end of the world scenario.

The saving grace for medium to long term stock investors, who are buying/selling based on the fundamentals, is that these two scenarios have historically been short-lived; e.g. one to three months in the case of scenario 1 and potentially only a matter of days in the case of scenario 2.

What is so unusual to date is that these characteristics have been present for arguably 3 years plus. We have never seen such concentrated market performance for such an extended period of time.

To illustrate market performance concentration, we calculated the proportion of total market monthly returns driven by the 10 largest contributors to those monthly returns, every month back to 2001, for a sample of over 2000 Asia ex Japan firms. We then smooth this time series (12 month moving average), and results are presented in Figure 1.

Prior to 2013 the 10 largest contributors to monthly performance represented around 25- 35% of those returns. However, through 2014 and onwards this has increased to around 50%. That is, half the market return comes from just 10 stocks.

Given we manage a highly diversified portfolio strategy, driven by the relative fundamentals of stocks, and with high active share, our relative performance has been constrained by this behavior…especially given the biggest drivers of index performance have tended to be trading on what by any historic standards could be viewed as extremely rich pricing. By way of example, the most recent 10 biggest contributors to market performance in Figure 1 have an average PE of just under 30x. That is a huge amount of future growth already baked into stock pricing. Performance concentration in Asia ex Japan is further aggravated by the domination of this by just two industries in one country—Chinese insurers and, in particular, technology-related firms.


Figure 1. Performance Concentration: Asia ex Japan proportion of market performance driven by the top 10 contributorsWe took a sample of more than 2000 Asia ex Japan firms (meeting minimum size and data requirements), and calculated the proportion of monthly aggregate market performance represented by the 10 largest contributors to that market performance. This process is repeated monthly back to 2001 to generate a time-series indicator of market performance concentration, including adjustment for changes in sample size in early historic data. A rolling 12 month median value for performance concentration is calculated, which is further smoothed by averaging over rolling 12 months. This moving average is presented in the chart.

As a key part of any assessment of what happens next we desire to know what is driving this performance concentration. However, answering this is very difficult. Is it a consequence of ETF flows (which in turn are driven by highly supportive liquidity dynamics that favour passive over active investing)? Is it a consequence of surging investing activity in China and by Chinese investors (and, again, favourable liquidity dynamics in China)? Is it a consequence of high frequency and machine learning algorithms (which represent a huge proportion of trading activity) chasing each other’s tails and being trained to follow the liquidity trail?

Ultimately we can only speculate on the real answer. Nonetheless, there is nothing in any of these explanations (nor in any others we can think up) which imply a permanent shift in how stocks ultimately trade. We cannot envisage a scenario in which fundamentals never again matter.

So what is the catalyst for reversion to trend? Possibilities include any tightening in liquidity conditions (which China is attempting to achieve in a highly controlled fashion) and/or a significant slowing in global economic growth (something that is increasingly being forecast by market commentators, government organisations, and the like).

As we wrote in our April 2019 fund report, our systematic strategy has been carefully constructed for optimizing expected risk/return dynamics across the macroeconomic cycle, i.e. an extended multi-year time frame. To simply chase liquidity and price momentum in a selection of stocks that have been doing very well is not only just not something that is a part of our process in any way, shape or form, it is also anathema to our investment philosophy. Hence, we will not consider re-jigging our process to simply neutralize our exposure, buying Alibaba, JD.com and the like.

We recognize this approach therefore has near term risk if China stocks continue to defy the gravitational forces of stock fundamentals (which have been steadily weakening). Indeed, this has been a major problem for factor-based investors around the world, and has even resulted in the closure of some high profile funds.

While being wary any time investment commentators use some variation of the phrase “this time it is different”, we must recognize that the length of time to date that market performance has been highly concentrated (and thus negatively impacting our highly diversified portfolio) is uniquely long. History tells us that the unwinding should be commensurately strong. After extensive re-analysis over the last few months of our strategy, its drivers, its risks and its expected outcomes we remain firm in our conviction that backing quality, robust growth and refusing to overpay for it remains the best longer term strategy.

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