Auscap Asset Management's newsletter for the month of July 2024.
Auscap’s views discussed below are based on factual information available to us at the date of publication of this newsletter. Our views and market conditions as expressed below may change without notice. There is a risk that investments will not perform as expected, which could have an adverse impact on the performance of the Auscap funds. Past performance is not a reliable indicator of future performance. Any advice in the below is general only in nature and does not take into account a particular person's objectives, financial situation, needs or circumstances. Because of that, before making any investment decision, you should consider – with or without the assistance of a qualified adviser(s) – the appropriateness of any advice in the below to you, having regard to your objectives, financial situation, needs and circumstances. While all reasonable care has been taken to ensure that the information below is complete and correct, no representation or warranty is given as to the accuracy of any of the information provided.
Passive investing is currently all the rage. This is in large part due to the strong performance of the US stock market, which very few active managers have outperformed in recent years, and which passive investors can get exposure to at low cost through an ETF. At the time of writing the S&P 500 total return index is up 18.0% year to date. It has annualized 15.9% over the last 5 years. The largest S&P 500 ETF, the State Street SPDR S&P 500 ETF Trust, charges a fee of just 0.0945% per annum. What’s more, according to Morningstar less than 20% of active asset managers in the US have outperformed the S&P 500 in 2023 and year to date in 2024. What is going on? Why has passive investment performance been so strong? And does this void an argument for backing active asset management?
We think it is useful to start considering these issues by thinking about the ideal circumstances for a passive investment in a market capitalisation based, or size weighted, index. Such an index has its biggest exposure to the largest companies. So a passive index exposure is going to be a great investment when the biggest companies in that index are growing their earnings faster than most other companies in the index. If we look at the S&P 500 Index, its largest weights are currently Microsoft (7.2%), Apple (7.0%), Nvidia (6.7%), Alphabet (4.3%), Amazon (3.8%) and Meta (2.4%), because these are the largest companies in the US. These 6 companies account for 31.4% of the S&P 500 Index. They are also companies that are growing earnings a lot faster than the broader market, and in fact faster than most of the other companies in the Index. This can be seen in the chart below. Over the last decade the 6 current largest companies in the S&P 500 have compounded their earnings at 19.4% per annum. This compares to the Index, which includes these companies, which has seen compound earnings growth of 6.6%, implying the compound earnings growth of the other 494 companies has collectively been even lower than this.
The result is that a passive US index exposure in recent years has given investors a low cost overweight exposure to a group of companies with significant earnings growth. So significant is the earnings growth and corresponding stock market performance of these six largest companies in the US that less than 25% of individual companies are outperforming the S&P 500 Index, a record low number over at least the last forty years.
In such an environment, a passive index approach is very difficult to beat as an active manager. To do so, a manager needs to find stocks that will outperform the index by a margin that exceeds their management fees. If strong earnings growth continues to be a feature of the largest companies in the US market, we suspect it will continue to be a very difficult market for active managers to outperform. We should note for completeness that the multiple of earnings investors are willing to pay for these large companies and the broader market has also increased recently, aiding index performance.
On the other hand, we suggest that there are also certain conditions that make an ideal environment for active investing. These conditions include an index that is materially overweight large companies that are likely to exhibit low, or even negative, earnings growth over future periods. This is particularly the case when the particular market has plenty of other companies that should see strong earnings growth over time.
The argument for active management in Australia appears to us to be as strong as the argument for passive investment has been in the US. Australia does not have large technology companies dominating the domestic stock market. The largest weights in the ASX200 are the Commonwealth Bank of Australia (9.3%), BHP (9.3%), CSL (6.3%), National Australia Bank (4.8%), Westpac (4.1%) and ANZ (3.8%). Australia’s largest six companies, four of which are the large banks, account for 37.6% of the ASX200. If we focus on the four retail banks, collectively they account for 22% of the Index, yet they have failed to grow earnings meaningfully over the last decade. With the large banks continuing to display a more risk averse approach to lending, facing increasing competition in residential mortgages and business lending with the emergence of private credit providers, and having to deal with rising cyber security, information technology, compliance and employee costs, we struggle to see tailwinds for material earnings growth in the future.
