What to do about the ‘concentration conundrum’: Pzena

Owning the largest stocks has historically been a recipe for underperformance over every period, according to value house Pzena, but the madness of benchmark construction means some investors have few choices but to.

The recent market rally has been one of the narrowest on record, with most of the contribution coming from a handful of “mega-cap glamour names” experiencing multiple expansion rather than earnings growth.

And that rally is creating problems for value investors, because what happens in the part of the market that’s overpriced can paradoxically affect the part that’s (supposed to be) underpriced.

“The MSCI World Growth and Value Indices match market caps at index reconstitution dates,” Pzena wrote in a note titled The Concentration Conundrum. “To achieve market cap parity between the two indices, more stocks must be allocated to the value index, many of which are not true value stocks. As a result, the MSCI World Value Index now has more than 200 additional stocks compared to the growth series. This is a near-record level, and many of these additional stocks aren’t true value stocks.”

But benchmark-conscious value investors are more or less forced into buying them. Avoiding the pain of underperforming a poorly-constructed index is “understandable”, the note says, but investors still need to maintain their discipline and look through short-term relative underperformance.

That’s because owning the biggest stocks “has, on average, been a recipe for massive underperformance over every period”. The vast majority of the return of the top 10 index contributors has come from multiple expansion –  which has never been a reliable or sustainable contributor to long-term performance, according to Pzena, and has accounted for less than 10 per cent of historical market gains.

“Markets dominated by sentiment-driven, runaway mega-cap growth stocks, like the one we have seen in the first half of this year, are a test of an investor’s value discipline,” the note says. “As dedicated value investors, we will continue to avoid expensive mega-cap stocks due to their long history of underperformance.

“Our own experience bolsters our confidence that someday we may have the opportunity to buy many of today’s mega-cap glamour companies at much cheaper prices. Instead, we are looking among the cheapest stocks in the market that have superior long-term records and are trading at significant discounts to their long-term averages.”