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Diversification in the face of bubble speculation

Soaring prices for the “Magnificent Seven” tech stocks have some people wondering if we’re experiencing a 2024 form of the dotcom bubble from the late 1990s. We understand why they’re asking that question, but don’t believe we’re in a bubble. 

Scott serves as Chief Investment Officer, and has in excess of 25 year of experience in investment management and equities research.
  • What is a stock market bubble?
  • Why do investors experience recency bias?
  • How a diversified approach helps reveal overlooked, high-value companies

In the late 1990s, I received many calls from clients who were upset with their investment returns. At the time, the internet was continuing to go mainstream, and the possibilities appeared endless. Every day it seemed like there was a new company going public and getting listed on a major stock exchange. The joke was to put “dotcom” after your company name to ensure you’d get a higher valuation. The dotcom bubble that enveloped technology and telecom companies was still inflating, and investors who had not yet participated were getting antsy.

 

Like many investors, the firm I worked at didn’t see value in a lot the high flyers of the time. The technology and telecom companies of the day were moving upwards on hype and not by profits, and in many cases had little (or no) revenue and poor business plans. Their valuation made little sense to us, so we didn’t buy their shares.

Instead, we continued to follow our “boring” discipline of diversifying by geography and asset class to manage risk and take advantage of opportunities. Our approach raised the ire of some of our clients, such as the one who called me. But in the end sticking to our discipline proved to be the right move.

 

What is a stock market bubble?

As we all know now, many people suffered when the dotcom bubble (as it came to be known) burst, because they owned too many stocks being driven by the same over-hyped story. By contrast, investors who stuck with a disciplined and diversified approach had a much better outcome. Cutting through all the froth and emotion, they saw value in “crazy” things like solid business plans, strong management, profitable companies, and reasonable valuations. This view prevailed in the end. Many great firms in traditional industries were undervalued, and investment flows moved out of technology stocks and back into these firms that saw their share prices rise.

Overall, the major indices took a beating. The more technology and telecom weighted an index the more pain there was, and the U.S. was the epicenter. Even given the amazing run that U.S. markets have had over the last decade plus, it may surprise some to know that the S&P/TSX Composite (Canada’s main index) and the S&P 500 (the U.S. main index) have generated essentially the same return over the last 23 plus years (see figure 1). This highlights how big the dotcom bubble was, and how quickly markets can change.

Figure 1: U.S. & CAD index comparison of $100 invested over 23+ years

U.S. & CAD Index Comparison of $100 Invested Over 23+ Years

Source: FactSet, December 31, 1999 to Feb 29 2024, total returns, CAD

Why do investors experience recency bias?

As investors, we always fight something called recency bias, which is the proclivity to favour recent events over historic events. Although, as mentioned above, Canadian and U.S. stocks have performed similarly over the last 23 years, they’ve gotten to it in a different way. Canada outperformed after the dotcom bubble burst, while the U.S. has outperformed over the last decade or so.

It’s no wonder then that we’re hearing more questions from clients about asset allocation and, in particular, investing more in the U.S. This is the recency effect in action. And it’s something we also heard a lot about in the ‘90s before the dotcom bubble burst.

Back then, when investors said they wanted more U.S. in their portfolios, what they were really saying is they wanted a portfolio more weighted toward technology. That’s where the spectacular returns were being generated. The rest of the world had companies that were perceived as great technology-related firms (like Nortel and Nokia). But the U.S. really had no competitors in the depth and variety of dotcom related stocks, even if some of those dotcoms (and billions of dollars) got washed away when the bubble burst.

We’re seeing similar behaviour again. Returns in the U.S. market are being driven by a small number of technology related stocks dubbed the “Magnificent Seven” (Amazon, Apple, Alphabet, Meta, NVIDIA, Microsoft and Tesla), and exposure to these companies is only available in the U.S.

How a diversified approach helps reveal overlooked, high-value companies

This leads to an important question some people are asking: are we in another bubble today?

A bubble is often defined by rapidly rising stock prices that become disconnected to the fundamentals of enough companies to move markets (or parts of markets) in aggregate. The dotcom era was a classic example. More recently, Canadians may remember the cannabis craze of six or seven years ago. Stock valuations went crazy as cannabis was legalized. Yet the market never materialized in such a way as to justify the valuations, causing many of those stocks to go up in smoke.

Some believe we’re in a bubble today with Artificial Intelligence (AI). The technology companies in the Magnificent Seven (excluding Tesla) have been substantial drivers and beneficiaries of AI, with chip maker NVIDIA the biggest winner so far.

Based on our analysis, we don’t believe this is a bubble for these stocks, or NVIDIA specifically. In fact, we own four of the Magnificent Seven in our U.S. portfolios. These firms have rock solid franchises with growing revenues and produce massive profits and cash flows. They are nothing like the firms of the late ‘90s. Although these stocks aren’t cheap, we don’t believe they’re all overvalued either. That said, we’re not putting all our eggs into one AI-shaped basket. The value of diversifying endures.

A famous quote about stock market bubbles is that you don’t know you’re in one until it pops. In other words, it’s only obvious to all after the fact. We rely on our disciplined process and rigorous analysis to help us see problems that may be forming in companies we own in portfolios, whether that be deterioration in business conditions or overvaluation, for example. By remaining diversified across economic sectors and geographies we add another risk management layer for our clients. For instance, if we’re wrong and a bubble is indeed forming in shares of these “magnificent” companies, we’ll be able to cushion the blow through investment in other sectors of the U.S. market as well as Canada, Europe, fixed income and beyond.

No one knows for sure what the future holds and what asset class will outperform over the next decade. What we do know is that the world is full of fantastic firms. Many such firms get overlooked when market participants start focusing on one sector, country, or theme. Our job is to take biases out of the equation, including recency bias, and focus on continuing to find high-quality, resilient businesses trading at attractive prices no matter their size or location.

Sources: FactSet, Bloomberg

 

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