Just a month ago, the seven largest tech companies in the U.S. were responsible for virtually all of the stock market’s gains this year. Fortunately, market breadth is improving as other companies’ shares begin participating. The economic backdrop is not extremely robust, but it is meaningfully better than many of the dire scenarios predicted at the beginning of the year. Inflation is slowing, which should allow the Fed to end the rate hiking cycle. Uncertainties remain, but high-quality companies can continue compounding in this environment. Slower growth and high cost of capital make security selection important. Valuation is critical to long-term investment performance and even more so in todays concentrated market.
It’s common sense that buying something for less than it’s worth is better than buying something for more than it’s worth. Price is the essential determinant in every investment equation. Many inexperienced investors think they can avoid the issue of price by simply buying an index fund. But “buy low, sell high” applies to all investments, including index funds that track the broader market’s performance. This year’s concentrated performance of the S&P 500 index provides an excellent example of why price matters even to index investors.
The S&P 500 is a stock market index that tracks the performance of 500 of the largest companies in the U.S. The market value of the seven largest tech companies accounts for over a third of the S&P 500’s value. These seven companies have also contributed over 90% of the index’s return this year. This means that the valuation of the S&P 500 index fund is disproportionately impacted by the valuation of these seven mega-cap stocks. So, the price you pay today to own an S&P 500 index fund would reflect the run-up in valuations on those seven stocks. As seasoned investors know, big returns on a small group of stocks can also become significant losses if that handful of companies runs into trouble. Therefore, it’s essential to be careful when buying index funds, especially if they are heavily weighted towards a small number of stocks. It’s also important to remember that the past performance of an index fund is not a guarantee of future results.
For Cardinal, we look at this market and recognize that it brings opportunities when you have such significant outperformance by a small handful of stocks and such significant underperformance by the rest of the market. Rather than buying an index fund, we aim to produce superior risk-adjusted returns by managing diversified portfolios of carefully selected securities. Our investment process is entirely bottom-up. We begin with Cardinal Capital’s proprietary statistical model that is systematic and unbiased in identifying stocks trading at significant discounts or premiums to their normal price value. We emphasize consistency in our investment approach. We apply a value-oriented approach that is predicated on selecting individual stocks. Our long-term investment perspective improves risk control, minimizes taxes, and enhances overall performance results. But we can be highly opportunistic in the short-term by identifying good companies that are undervalued by the marketplace.
We have great clients, which is the real key to investment success. Ideal clients have two characteristics. One is that they understand our disciplined investment methodology founded on risk control, consistency, and bottom-up analysis. The other is when the market is down and stocks have gotten cheaper, our clients appreciate that we are actively adding to rather than selling our favorite stocks and taking advantage of attractive bargains. If our methodology is applied consistently over time, we know that we have done right by our clients, put them first, and honored our fiduciary duty.
As always, amid an uncertain outlook, we are confident in our long-term approach and commitment to our clients’ financial goals. Thank you for your continued trust in us, and please get in touch with us for a personalized portfolio review.