A Case Study on Avenue’s Equity Strategy 101

Website – Case Study Q2 2024

It is 24 years since the dramatic rise and collapse of technology stocks in the year 2000.  While many of today’s circumstances are arguably different, the overarching risk remains the same. Extreme stock market concentration foretells challenging years ahead for the market leaders of today. History does not have to repeat in the same way with a dramatic decline but at Avenue we believe we can avoid this risk and that there is a safer way to invest. 

Market cap of the largest stock

The original testing ground for Avenue’s Equity strategy was the extreme US stock market rise from 1998 to 2000, which was then followed by a pronounced decline from September 2000 to March 2003.  During this period the S&P500 index was up 100% then down 50%, which left the index roughly at the same level where it started after 4 and half years.  The wild ride from exuberance to despair concluded with most investors swearing off technology stock investing forever, ironically.

However, our personal experience was that it didn’t have to be this way, if when investing we stick to the discipline of investing in high quality businesses at reasonable valuations. Investing this way is not as exciting but it keeps you invested for the long term, which lets compounding work its magic. 

Why does this kind of wild ride create confusion for investors? Because one is unsure when to get in and when to get out.  The technology stocks of 2000 or Nvidia today (the leading Artificial Intelligence chip maker) are likened to being a passenger in a car driving uphill without any brakes. Inevitably the car will run out of gas and gravity will determine the remainder of the journey. 

The initial question is always, am I going to get in this car knowing it will run out of gas? Then, when the gas runs out there is a point where the passenger will need to open the car door and do a shoulder roll to safety. It is very hard to get the timing right every time and being too soon or too late is an emotional roller coaster that puts off the average investor altogether. However, it is hard to overlook that owning those stocks during the wild ride upwards feels great!

We can solve this problem of getting ‘shaken out’ of our investments, or having to trade in and out, by owning businesses that we believe have a high probability of compounding but with the caveat that we haven’t paid too much for them. Avenue’s equity portfolios have investments that have done well this year. The big difference for risk management is that our high-quality compounders have valuations which are half that of the index leaders.

What is different this time when we compare 2024’s concentrated index to the concentrated index of 2000? Today’s index leaders like Microsoft, Apple and Nvidia are very profitable, and their businesses are global. Another difference is the indexing effect, as we discussed in last quarter’s case study, where most stock market investors hold index funds as opposed to individual stocks magnifies the concentration of money to the biggest stocks.

What is the same this time when we compare 2024’s concentrated index to the concentrated index of 2000?  We believe stock market investors are overvaluing the earnings of the index leading companies.  Continuing to compound at today’s rate of growth will be very challenging. Also, the new ‘new thing’ of Artificial intelligence (AI) might change the world as we know it, but like the internet stocks of 2000, AI costs a lot of money and has yet to make any. 

The strong stock market pattern which moves over decades from low concentration to high concentration then back to low should not be ignored. Getting this valuation pattern wrong can jeopardize investment savings for an entire retirement. At Avenue we will always err on the side of safety and look for greater predictability with our investments.  

 

Bill Harris
April 2024

 

 

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