Dalton — On Monday, Nov. 2, the team at Berkshire Money Management had one of our formal investment meetings. Most of our meetings tend to be impromptu — catching each other at the virtual water cooler or popping our heads into each other’s offices between client meetings. The formal meetings are a bit more fun because that is when people get to challenge hypotheses.
The formal BMM meetings are where the group plays devil’s advocate to make sure that we can genuinely defend our positions. It has the feeling of an interrogation, but a friendly one.
It is a useful exercise for a couple of reasons. First, of course, you want to be sure you have conviction in your holdings and new investments. Second, it’s an effective way to put dangerous variables on your radar. I get asked questions like, “Well, how does the investment perform if so-and-so happens?” Sometimes those examples of so-and-so are low-probability, but it opens your eyes to possible risks.
I will share with you our main themes and those possible risks.
Growth vs. value
I have been overweight in growth stocks relative to value stocks, emphasizing the technology sector. For example, in my typical “moderate” portfolio, there is a target allocation of 32.75 percent for large-cap growth and technology. That doesn’t include our allocations to investments in things like the S&P 500 index and the Dow Jones Industrial Average.
That much of an over-allocation warrants a formal conversation. The gist is that we’re not ready yet to reduce the allocation of our growth stocks. Our biggest concern isn’t the election or the size of any potential financial stimulus package. Our biggest economic concern continues to be the spread of the coronavirus and the resulting shutdowns and social distancing that are required to slow that spread. In the best-case scenario, a vaccine creates herd immunity and we can get back to something resembling normal life again. In that scenario, stocks will do well in general. We can then make a case for seeking the alpha (i.e., outperformance due to upside volatility) of growth stocks.
Suppose the second wave of coronavirus continues to harm our health and the economy. In that case, the stay-at-home technology trade should continue to work. Additionally, having to contend with the virus means a slower economy. The relative earnings growth of technology would be more attractive in a low growth environment.
Large-cap vs. small-cap
Fortunately, I’ve been out of those doggy mid-cap stocks. They’ve been horrible for years and don’t look as if they’re getting better any time soon. Small caps, however, I find more attractive.
As I told readers on May 27, we bought small caps by investing in the Russell 2000 Small Cap Index. We were making these investments as we reinvested back into the stock market after it collapsed during the shutdown. That investment has outperformed both mid-caps and large caps since then, as well as the last month and three months (as of Nov. 4).
Nevertheless, I wasn’t sure if I should hold those positions, add to them, or reduce the holdings and shift the proceeds to the relative safety of large caps. In my moderate portfolios, my investments are not tied directly to the Russell 2000 Small Cap index. Instead, I have quasi-exposure to the index by way of a hedged investment strategy. However, in more aggressive portfolios, in addition to any hedged small-cap holdings, the allocations range from 5.88 to 13.5 percent.
That’s not an alarmingly low or high allocation. It’s reasonable. We decided to maintain our current allocations. That’s an investment based on a recovering economy. Main Street USA will benefit, eventually, from America getting back to business. It may take a long time because stimulus needs to be accompanied by distributing a safe and effective COVID-19 vaccine. That may bring us deep into 2021. That length of time makes me uncomfortable, which is why we decided not to increase the small-cap allocation.
Regarding large caps, those companies are better suited for doing business during a pandemic. They are more adaptable and better capitalized than their smaller counterparts. That’s why the target large-cap allocation in my moderate portfolio is 80.5% (not including a direct allocation to health care stocks, which include large caps).
For the last five years, large caps have outpaced mid-cap stocks by nearly 30 — 30! — percentage points. We may be uncomfortably heavy in large-cap stocks, but can you imagine being the poor soul who has been invested in mid-cap stocks? The point is that it sometimes makes sense to buy more of something you already own a lot of. (And it’s probably not a good idea to keep holding onto losers for so long without going through some sort of your own devil’s advocate interrogation process in order to justify your decision).
Health care stocks
I have not been happy with my health care sector allocation. In my moderate portfolio, I’ve allocated 6% directly to that industry. For the last three months, it’s been trounced by the S&P 500. Hey, I get it. As the saying goes, “diversification means always having to say you are sorry.” A well-diversified portfolio will have laggards at times (even if health care did outperform the broader market by more than 500 basis points from Feb. 19 to March 23). While periods of underperformance should be expected, it doesn’t give me a reason to sit on a position and hope for a turnaround.
I brought up selling our positions during our meeting, and the team ganged up on me. Mind you, on Nov. 4, the health care sector was up nearly 6%, twice that of the overall market. So I may have been hasty in my consideration of reducing the sector. I was frustrated by short-term sub-par performance. Together, my team and I reminded ourselves of the benefits of being invested in this sector currently.
There continues to be a long-term demographic advantage to companies in that industry. Additionally, the sector is near peak levels of uncertainty not just from this election cycle, but also because the Supreme Court will meet Tuesday, Nov. 10, to decide if mandating health insurance is constitutional. Clarity on regulation, either way, will be a tailwind.
Furthermore, the sector’s relative forward price-to-earnings ratio (a metric of valuation) to the overall market is 2.2 standard deviations below its average. That’s not to say cheap stocks can’t get cheaper. However, a catalyst to higher stock prices is revenue-driven by pent-up demand for preventive care and elective surgery.
Post-election rally
If the stock market experiences a post-election rally over the next couple of months, don’t give credit to the outcome (as I write this, it’s after Election Day and we don’t yet know the outcome).
Since 1972, the S&P 500 has averaged a 2 percent gain from Nov. 3 through the end of the year for presidential election years. Annualized, that’s about a 12 percent gain, which is larger than the long-term average of all years. The long-term average return of Novembers, since 1960, is 4.1 percent for the S&P 500.
The election means less to the stock market than does the coronavirus. It’s all about the virus.
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Allen Harris is the author of ‘Build It, Sell It, Profit: Taking Care of Business Today to Get Top Dollar When You Retire,’ as well as the owner of Berkshire Money Management in Dalton, managing investments of more than $500 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/. Direct inquiries to email hidden; JavaScript is required.
This article originally appeared in The Berkshire Edge on November 9, 2020.