Concentration

Answer: Market breadth is about concentration and refers to how specific sectors and companies account for market performance. The term has been in the news recently because a small number of companies account for the majority of returns. The lack of market breadth means that only a handful of companies contributed to performance with leadership being narrow. 

The six MAGMAN companies were mentioned in previous columns; they are Microsoft, Amazon, Google, Meta (formerly known as Facebook), Apple and Nvidia. During 2023, MAGMAN names fueled market performance. The seven largest companies dubbed “The Magnificent Seven” add Tesla to the all-star list.

Because only a handful of stocks were responsible for an outsized percentage of returns, we’ve experienced a lack of market breadth. These large companies have a greater impact on overall portfolio performance than those with smaller weightings due to concentration levels. This isn’t necessarily a terrible thing, but it’s important to be aware of this phenomenon going forward. 

There’s no denying that MAGMAN and The Magnificent Seven are all great businesses. The determining factor to investors is the relative price paid for an investment relative to the remainder of the market. At the moment, the disparity between the trailing price-to-earning (PE) ratios of these companies is at historically elevated levels. PE ratios are calculated by dividing the price of the stock by earnings per share a company generates. P/E ratios are a tool to compare valuations and may help in making sound investment decisions. 

In the absence of emotion, investors evaluate the math behind PE ratios. Pullbacks in the largest names could allow the remainder of the market to catch up and increase market breadth. Following periods of narrow market breadth such as we’ve seen recently, indexes typically outperform. 

Predicting what will happen with market breadth is a challenge. A one-year time horizon isn’t long enough to draw solid conclusions for a particular investment strategy, making diversification and proper asset allocation all the more important. 

Following narrow market participation, dominance historically shifts with snapbacks in the opposite direction being aggressive and quick. When the outperformers come back to more normal levels and “fall back to earth” there may be concern as well as opportunity for risk management and diversification. 

This may sound alarming, but periods of narrow breadth from MAGMAN names could provide opportunities in other areas over time as markets broaden out. Wider market breadth means a greater number of companies, and sizes of companies (small and mid-cap) that had previously been out of favor, might benefit from sentiment shifts for better valuations. 

During 2023 we saw a divergence of company fundamentals such as profits, and earnings per share. Increasing revenue can come with increased expense and doesn’t always lead to increased profits. Typically, investors own stocks for fractional ownership of a company to participate in future profits which is measured by earnings per share (EPS). 

To reiterate, only a handful of companies were responsible for much of the market returns in 2023. The broader base of stocks has yet to benefit from positive sentiment that drove prices of those companies higher. There could be many stocks to choose from that could benefit in a meaningful way going forward based on valuations. Elevated levels of free cash flow (FCF) may be a wonderful way to identify high-quality companies that are trading at attractive levels and could be poised to benefit if markets return to wider and deeper breadth levels. 

Free cash flow is the cash remaining after a company pays expenses and has reinvested in the business. Comparing FCF is a useful way to identify companies with less leverage and lower interest cost burdens as a measure of quality relative to peers as the cost of capital has risen the past eighteen months with higher interest rates. FCF helps determine if investors are paying a reasonable price for an investment during narrow market leadership. Stocks with high FCF are trading at historic valuation discounts. 

Without getting too complicated, investors seek companies that will grow faster than market expectations and profit. There are potentially many high-quality companies to choose from trading at attractive valuations as market breadth widens. Narrow market breadth was made possible by large companies trading significantly higher. Such narrow breadth is not always sustainable and involves risk management. Stay focused and plan accordingly. 

Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. The opinions expressed are those of the writer as of February 11, 2024, but not necessarily those of Raymond James & Associates, and subject to change at any time based on market conditions and other factors. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification. 

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