For the past decade, the advantage described by Mr. Buffett has been cold comfort to fundamental investors who believe in the power of bottom-up analysis. Instead of leveraging the benefits of their work, portfolio managers with an active approach had to watch as index funds were flooded with cash and valuations for growth stocks hit stratospheric levels.
However, signs are emerging that investors are beginning to say “enough.” Flows into passive products have slowed during the pandemic according to data from the Investment Company Institute, and performance for small caps ended the year on equal footing with returns posted by mega caps. The emerging trend had a meaningful impact on the performance of attractively valued businesses.
As value investors, we were cheered by this budding return of reason, but recognize not all investors have abandoned their spendthrift ways. Whether its total sales in Manhattan’s luxury home market clocking in at 30% higher than the previous highwater mark set in 2015 or investment bankers bringing a record volume of initial public offerings to market, pockets of the public seem to still be clinging to a “price is no object” mentality.
For equities, the result has been a sliver of stocks driving returns of broad indices. For instance, just five companies accounted for more than 65% of the gains in the tech-heavy Nasdaq 100 Index for the year. The byproduct of investors chasing the largest names has resulted in top-heavy indices, as shown below, where a handful of names can make or break performance for passive investors.