Starvine Capital Corporation commentary for the second quarter ended June 30, 2024.
Overview
- Glaring Imbalances Remain
- Small Caps vs. Large Caps: Still a Wide Gap to Close
- Cutting Through the Noise
Dear Partner:
During the first half of 2024, fully-invested accounts in the Starvine Flagship Strategy increased by 10.0% to 11.5%, while fully-invested accounts in the Mid-Large Cap Strategy increased by 10.3% to 10.6%. During the same period, the S&P TSX Total Return Index [1] increased by 6.1%, and the S&P 500 Total Return Index increased by 19.6% in Canadian dollars (15.3% in USD).
The benchmarks cited by Starvine are standards against which the performance of the strategies can be measured. However, the Starvine strategies approach portfolio construction with a bottom-up approach and thus do not refer to the composition of any index as a reference from which to select securities. Performance of the strategies may differ significantly relative to benchmarks in any time period.
The composite figures above are unaudited and include discretionary fee-paying accounts within each respective mandate. Composite results are presented as time weighted rates of return, net of management fees and other expenses. Results will vary with subscription date, most notably for recently formed accounts whose position weightings and cash levels tend to differ initially from the investment strategies. Clients will therefore each have their own net-of-all fees performance results from investing in Starvine. References made to indices may provide clients with a benchmark to compare results. However, the Starvine strategies are operated with a bottom-up framework and thus no effort is committed to tracking any index. Lastly, the composite results displayed above should not be interpreted as a reference for potential future returns.
Six months ago, I began the commentary with this passage: “The outperformance of big tech stocks - and moreover the largest companies in the sector - gained momentum since my last semi-annual piece. Given the market-weighted configuration of the S&P 500 benchmark, the skew from those mega cap tech stocks has since only increased. As a case in point, the total return of the equal-weighted version of the S&P 500 was 11.1% in Canadian dollars (13.4% in USD) in 2023, less than half the return of the most commonly referenced market-weighted benchmark.”
Since that time, the imbalance spurred by the “everything AI” narrative has become even more pronounced. The year-to-date total return as of June 30, 2024, for the market-weighted S&P 500 index was 15.3%, compared to 5.1% for the equal-weighted version of the index. (Both are expressed in U.S. dollars.)
Much market value has been ‘created’ from the hot narrative of AI without evidence yet of increased free cash flows to support the theme, as life-changing and disruptive a force as it may be. As shown in the following graph, the share of the S&P 500 represented by the top eight constituents is now hovering around 30%, a drastic increase from the beginning of 2013. Perhaps it would be less of a concern if there was sufficient industry diversification within those eight names, but they are all tech companies whose share prices will likely suffer from a setback in the sentiment toward AI.
Simple arithmetic highlights that if the market value of the group depicted above were to drop by 20%, the remaining 70% would need to increase by 8.5% just for the entire index to remain flat. If we contrast that to the beginning of 2013 when the same group comprised ~7% of the index, an equivalent 20% drop would have required only a 1.5% increase from the remaining 93% to keep the index flat. This discussion is not intended to deter individuals from investing in index ETFs, which will always offer the advantage of low expenses. There is the option of channeling funds instead to ETFs that replicate the equal-weighted index, which I believe to be a more sensible investment at this juncture.
The graph below captures the continued disparity in forward P/E ratio between U.S. large caps (S&P 500) and their small- and mid-cap counterparts. Since mid-2007, it can be observed that for a significant portion of the 17 years, large caps actually traded at lower relative valuations. The turning point was during COVID - tech companies benefited from the lockdown, and when that phase ended, the AI euphoria began in early 2023 as ChatGPT proliferated. I believe there will be a reversion-to-the-mean trade to be made, though I have not deliberately repositioned client portfolios based on that belief. The bottom-up process tends to position the majority of our capital in non-blue-chip companies.
The work underlying the Starvine strategies is predicated on absolute returns. Just as EBITDA (earnings before interest, taxes, depreciation and amortization) cannot be eaten, the same holds with relative returns. In contrast, it can be argued that true free cash flow and absolute returns are 100% edible. It is with those thoughts, and the application of value principles, that dictates the positioning of our portfolios.
A seemingly naive approach of attaching oneself to good businesses and not overpaying (or preferably underpaying) can lead to decent compounding over time. Cut out as much noise as possible, including who will win the election, potential wars, and relative performance, and this whole process, which results in an extremely uneven path of compounding, becomes more enjoyable.
Sincerely,
Steven Ko
Portfolio Manager
Starvine Capital Corporation