S&P500 vs. R2500 Will the Herding Continue?

Introduction: The Herd Runs Rampant
Performance, Size and Value: When They Coincide It May Signal the End of the Ride
Should History Rhyme, Allocators May be Wise to Rotate to Smaller Size
Conclusion: Simple but Not Easy, The Pain of Breaking from the Herd
Exhibit

Introduction: The Herd Runs Rampant

From the end of 2016 through the end of January this year the S&P500 has risen 53% with nearly 30% of that total coming from the index’s five largest stocks. These five leviathans put up average returns over the period of over 150% and closed the month of January out with a combined market cap of over $5.5 trillion USD or north of 25% of total US GDP.¹ Kailash has written about this issue in A Market Cap Concentration Flag Part I and Part II and broadly expanded upon the relationship between market cap to GDP, Buffett’s favorite valuation metric, in Better a Seller than a Buyer Be.

For investors in the S&P500, being underweight much less omitting one of those big five firms has created brutal performance headwinds. Kailash, academics and dusty history books have repeatedly attempted to teach investors that following the herd, particularly at extremes, is a most unprofitable enterprise. This paper seeks to expand upon that concept by looking at opportunities in places that, while objectively obvious, investors have clearly forgotten.

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Figure 1 below shows that the concentration effect within the S&P500 has radiated out into the broader equity universe in a manner only seen once before. The chart below plots the sum of Russell 2500’s constituent market caps and divides it by the sum of the S&P500’s constituent market caps. Rarely has the world seen Small & Mid Cap stocks represent such a small proportion of the overall economic value ascribed to the publicly traded portion of corporate America. While possibly early, Kailash believes a foundation that may underpin many of the next decade’s winning strategies lies in the simple chart below.

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Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “Kailash Capital Research, LLC ”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital Research, LLC . In preparing the information, data, analyses, and opinions presented herein, Kailash Capital Research, LLC has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital Research, LLC , however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital Research, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital Research, LLC – All rights reserved.

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