The Magnificent Seven continue to capture the attention of advisors and investors, dominating U.S. equity performance over the last year. Will this trend continue throughout 2024? Will growth stocks continue to beat value? What about large versus small? And what is 2023's signal about where markets are headed this year? We're delighted to be joined by John Owens, Senior Portfolio Manager for Morningstar's Select Equity Strategies, and Paul Tait, Portfolio Specialist at Morningstar Wealth. Together, they help unpack the landscape for U.S. stocks in a digestible manner.
(Stay tuned for additional important disclosure information at the end of this episode.)
Nicholas VanDerSchie: Markets love to fool the masses, and last year was a great example. U.S. stocks defied expectations and Wall Street price targets, finishing up 26% for the year. That marks the 14th best calendar return since 1970, but those gains were not evenly distributed. Growth stocks with typically higher valuations sucked up the oxygen while everything else fought for air. 64% of the stocks that make up the Morningstar U.S. Market Index trailed its stated return, representing the highest number of companies to underperform the index in decades. Why? Market performance was top-heavy and dominated by a few select companies, notably the Magnificent Seven. Will this trend continue throughout 2024? Will growth stocks continue to beat value? What about large versus small? And what is 2023's signal about where markets are headed this year? We're excited to dig into these topics and others with today's guests.
Hello, and welcome to Simple But Not Easy, a podcast from Morningstar's Wealth Group, where we turn complicated financial developments into actionable ideas. I'm Nick VanDerSchie, Head of Strategy and Execution for Morningstar Wealth, and I'm delighted to be joined by our two special guests today, John Owens, Senior Portfolio Manager for Morningstar's Select Equity Strategies, and Paul Tait, Portfolio Specialist who works with our advisor clients across the country.
Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com.
Now, let's get started. John, Paul, welcome to Simple But Not Easy. For our newer audience members who may not have listened to you on past episodes, can you share a little bit about your background and role here at Morningstar?
John Owens: Sure, Nick. It's great to be back. I've been in the financial services industry for three decades, and just starting my 20th year with Morningstar. I began here as an equity analyst covering restaurant stocks like McDonald's, Starbucks, and Chipotle. But for the past 15 years, I've managed equity portfolios, and I'm our lead portfolio manager for All Cap Equity and Small-Mid Cap Equity. But it's not just me. I work alongside five other members of our equity PM team, not to mention a small army of analysts at Morningstar Equity Research.
VanDerSchie: Thanks, John. And Paul, welcome to Simple But Not Easy. We're glad to have you. So, your title is Portfolio Specialist. Can you tell us exactly what a portfolio specialist does at Morningstar Wealth, and how did you get into the role?
Paul Tait: Yeah, thanks, Nick. First off, really excited to be here. As a portfolio specialist, I really do two things. The first is work with portfolio managers like John to understand how they're thinking about the markets, how they're preparing their portfolios, and then two, I work with financial advisors to help with a range of things, such as breaking down our thoughts on the markets, taking deep dives on our portfolios, or helping them analyze their own portfolio models and seeing if we can improve them. My background is actually in portfolio construction and analytics. Prior to Morningstar, I was with a large asset manager where I helped advisors build and improve their existing portfolio models. And then out of college, I worked in equity research, and I was a financial advisor for a bit. So, I think those really did a good job of just laying the groundwork for what I do today.
VanDerSchie: Great. Thanks. So, to kick off, there's that age-old question, is it a stock market or a market of stocks? And I think that feels particularly relevant, given the valuation levels on U.S. stocks, specifically large cap. So, John, is the U.S. stock market expensive or are only select stocks expensive?
Owens: I believe the answer here to both questions is yes. So, based on many measures, I think the market's valuation looks pretty expensive here. That's true for the S&P 500's forward P/E and the Shiller P/E, also known as the cyclically adjusted price to earnings ratio. And it's true for price to cash flow. On all those measures, all are well above their long-term historical averages. And dividend yields are lower than they have been historically as well. But as you point out there, there is a small cohort of stocks, including the so-called Magnificent Seven, which account for a pretty significant weighting in the market, and they are really driving those valuations higher for the most part.
VanDerSchie: John, can you maybe define the Magnificent Seven for audience members who may not be as familiar? And then, I guess more broadly, how should investors be thinking about valuations on U.S. stocks?
Owens: Yeah. So, the Magnificent Seven is a list of stocks that was originally referred to by a sell-side analyst on Wall Street and made popular by Jim Cramer on CNBC. And basically, they are seven mega-cap internet technology-oriented stocks that drove incredible performance in the stock market in 2023, and they include well-known names like Alphabet, Amazon, Apple, Tesla, Meta, Microsoft, and NVIDIA. So, those are the stocks that make up the Magnificent Seven. Again, as I mentioned before, they make up a big weighting in the market, and they drove a lot of the performance of the market in 2023.
VanDerSchie: Yeah. And so then, with that as the backdrop, how should investors be thinking about valuation overall with respect to the U.S. stock market?
Owens: Yeah. Taking a step back, I think investors should be a little cautious here with their expectations. We've seen market environments like this before. I think of the NIFTY 50 in the 1970s or the dotcom bubble in the late 1990s, where you had fairly high valuations or very high valuations in a cohort of stocks that proved not to be very sustainable in terms of what the market could do going forward. I think the good news is that the rest of the market offers some bargains. So, rather than being a buyer of a broad market index fund or ETF, we think investors should be a bit more discriminating here.
VanDerSchie: Thanks, John. That's definitely solid advice. Paul, shifting over to you and your interaction with advisors, what's the sense that you get from them and their clients? Are valuations a concern at this point?
Tait: Well, I'd say yes and no. I think most advisors are aware of the valuation concerns in the U.S. market, but I still sense a hesitancy to deviate from what's been working, which has, of course, been large cap and growth-focused portfolios. I think that after a year like last year with the Magnificent Seven dominating returns, some clients might feel reinforced to keep buying those stocks irrespective of what their valuation is. But what I would tell them is that if we rewind to the beginning of 2023, those stocks weren't trading at the valuation they are today. Coming out of 2022, those names were down anywhere from 30% to 60%. So, I think that's really where the value of a financial advisor can come in and help clients look a little bit more towards the future instead of chasing past returns.
VanDerSchie: Yeah, I couldn't agree with you more on the behavioral coaching benefits of working with a financial advisor. Speaking of advisors, how are the advisors you work with communicating all this to clients? And maybe more specifically, are they leaning into U.S. stocks, perhaps with a fear of missing out attitude, or are they urging some caution there?
Tait: Yeah. The truth is that portfolios are still leaning into U.S. stocks, and it might take something more than valuations to change that behavior. I think advisors have heard the valuation story before, and they've been rewarded for holding what's been expensive. I think part of that is just dealing with the behavioral side of investing.
One of the things we'll do to just address that is we'll do an exercise, and we'll talk to advisors about benchmarking. If I ask an advisor what their benchmark is, sometimes I'll get an answer like, I don't have one, or it's the S&P 500. We both know those – it's important to have a fair benchmark when you're making asset allocation decisions, and the S&P 500 isn't always a fair benchmark. So, we'll talk about the importance of knowing what your goalposts are, because at the end of the day, it's okay to have opinions on the market and to have overweights and underweights, but it's not okay to not know how much you are overweight versus a fair benchmark.
So, if we just take, for example, the U.S. versus international conversation, and we just look at how much exposure should you have for your equity sleeve. If we look at the global market cap of stocks, just the entire world, the U.S. has a little bit over a 60% weighting of the entire world, so anywhere from 60% to 65%. If you are totally agnostic about country weightings, your benchmark might have around that kind of weighting, around 60% weighting, and then you would overweight and underweight based on what your opinions are on the U.S. market. But if I bring that up, nine times out of ten, someone isn't going to be willing to commit roughly 40% of their equity sleeve to international right off the bat. And that's fair, right? Even if we look at large asset managers or professional investors, their benchmark probably isn't 60/40 U.S./non-U.S. as well. So, we'll talk about shifting the benchmark; it might be two-thirds U.S., one-third international, or 70% U.S., 30% international. Again, whatever it may be, it's okay to have overweights and underweights, but just know why you are overweight and then size it appropriately. And then I think from there, it just gives us a good starting point to talk about other areas of the market, why they might be attractive, how much you might overweight, and then what the overall portfolio looks like versus your benchmark.
VanDerSchie: That's great, Paul. And thanks for those insights from the field. Okay. So, it's fair to say that calling for inflection points in markets is a little bit like trying to predict the weather. That said, there are two obvious trends we've observed in U.S. equities last year. First is that growth has outperformed value. And in fact, growth stocks have beat value stocks by the second widest margin in the last 20 years. And the second is that large cap outperformed small cap and specifically there, large caps beat small caps by 10% last year. And really this continues a pattern that's held steady for over a decade. And if you look at the 10-year annualized numbers, large caps have been at a little over 12% and small caps just a little over 7%. So maybe let's start with growth and value. And before we dive into the details, John, can we first define these terms for our audience?
Owens: Yeah, sure, Nick. There are different definitions of growth and value that are out there. But from Morningstar's perspective, the way we look at value stocks, those are stocks that trade at lower prices to sales, earnings, cash flow, dividends, and book value. Whereas growth stocks are those that deliver faster growth in those underlying measures – faster growth in sales, earnings, cash flow, and book value. And I think one thing that really differentiates Morningstar as well is that it doesn't consider just historically-based measures, but Morningstar also looks at forward-looking ones when classifying companies into those value and growth style boxes.
VanDerSchie: Okay, great. So, can growth outperformance continue? And is there any sign of an inflection point?
Owens: So, as you noted, growth stocks have outperformed for a long period of time. And sure, it could continue. But using history as a guide, leadership tends to rotate back and forth over time. Now, timing those terms is very difficult, which you alluded to there, Nick. But I'd say according to the Morningstar analysts, from a long-term perspective, value stocks appear more attractive. And that's especially true for small and mid-cap segments of the market. Now, that's not to say that value stocks will definitely outperform in 2024. Who knows? But the analysts do think that they have the potential to outperform over a longer horizon, thinking several years. And I'd agree with that. And speaking for my two portfolios, All Cap Equity has a modest tilt toward value stocks and Small-Mid Cap Equity has an even stronger tilt toward value stocks.
VanDerSchie: Got it. Thanks, John. So, let's transition to large versus small. And as you mentioned, you manage strategies across the market cap spectrum. Where are you seeing the most interesting opportunities?
Owens: Well, we are seeing opportunities across the market cap spectrum for sure. But we've certainly been increasing our exposure to small and mid-cap stocks. At the end of 2023, small and mid-cap stocks represented about 38% of the value of the All Cap Equity portfolio. I'd also note that foreign stocks, which we discussed earlier, they represent nearly 10% of my portfolio. But if you'd like, let's take a look at the S&P 500 for the sake of comparison. In my view, the S&P 500 is much more of a bet on large cap stocks and in particular large cap growth stocks. And it has no exposure to foreign stocks. So, I'd argue that the S&P 500 isn't all that diversified today. So, if large cap growth stocks were to fall out of favor, the S&P 500 wouldn't fare that well at all. And we saw that happen in 2022. So, we think at a minimum, investors should seek out more diversification beyond just U.S. large cap growth stocks.
VanDerSchie: So, Paul, I'd be interested with John's guidance in mind, what has your experience been with advisors navigating small caps as of late? Are they interested in this asset class or at least warming up to it?
Tait: Yeah, I actually had an advisor bring this up to me last week. We were going through our 2024 outlook, and he asked me about small caps before I even had a chance to get to it. So, I think that advisors are definitely aware of the potential of small caps, but I do still think there's a bit of hesitancy to pull the trigger. The truth is, the valuation story looks really great. Small caps versus large caps have looked more attractive than they have in over 20 years, but I think still the hesitancy comes from the timing aspect of the trade.
So, one of the things we did was some research on at what point in the economic cycle do small caps generally outperform large caps. And if we just segment the economic cycle into three phases, we have the downturn, which is where recessions occur; we've got the subsequent repair and recovery phase; and then we have the expansion in late stage. And we can see that the period we're in right now, the expansion in late stage, large caps generally do outperform small caps historically. In the repair and recovery stage, small caps will generally outperform large caps. In the downturn stage though, it's somewhat of a mixed bag. Generally, I think we would expect that small caps might underperform large caps, but there have been some cases where small caps have outperformed, which is notably back in the early 2000s. And the interesting thing is back in the early 2000s, we had a similar valuation gap as we did today. So, what we're telling advisors is that it might be next to impossible to perfectly time any kind of trade, but if we're using valuations as our compass, small caps look really attractive right now and the advisors have been really receptive of that.
VanDerSchie: That's great. Good to hear. John, I did want to ask you about money market funds as they attracted over a trillion dollars in flows last year. It was the biggest single year of flows since Morningstar began tracking this data. The Fed and rate increases obviously played a big role, and now the market is expecting rate cuts. So, could the proverbial cash on the sidelines go looking for a new home at this point? What's your take?
Owens: It's a good question, Nick, but I actually think this cash on the sidelines is a myth. So, we have to remember for every buyer of a stock, there's a seller. So, Nick, if I buy your shares of XYZ, then my cash moves off the sidelines. I've taken my cash, and I bought those shares of XYZ. But then you're getting my cash. Your cash moves to the sidelines. There's no net change in cash. But I would acknowledge that sentiment can play a factor in valuations. If market sentiment terms from negative to positive, then the market can rise because more people will be trying to buy stocks pushing up prices. But as I look here today, U.S. investor sentiment is already fairly bullish, so I wouldn't expect much price earnings, multiple expansion from here for the broad market. I really think that earnings growth and dividend and buybacks will need to do the heavy lifting to drive future returns, and we could even see some multiple contraction here.
VanDerSchie: That's good insight, John. Let's shift the conversation to active management because I'd love to get both of yours take. In 2022, according to Morningstar flow data, investors pulled almost a trillion dollars from actively managed strategies, and it was one of the worst years ever from the industry's perspective. And then in 2023, while we did see markets recover, active flows didn't recover nearly as much. What I'm hearing is that some have called for the demise of active management, and others believe active management's death probably has been greatly exaggerated. John, maybe starting with you, can you tell us about the select equity portfolio's approach to active management, and how, meaning Morningstar, do we do things differently?
Owens: Yeah, Nick. Well, what I'd say is our overall philosophy and approach to investing has really been inspired by legendary investors like Benjamin Graham, Warren Buffett, Peter Lynch, John Templeton, among others. And first, and most importantly, I'd say we're long-term investors, and I really think that we're an endangered species these days. When you look back into the 1960s, the average holding period for a stock was around eight years. Today, it's just a few months. So, I think most participants in the market are very short-term oriented, but we, on the other hand, we focus on the long run. We take the mindset that we're investing in businesses, and the value of those businesses are going to be driven by their long-term earnings and cash flow generation.
Second, I'd say as long-term investors, we favor high-quality companies. If we're going to invest in a business for the long run, then it better be a good one. So, we like companies with durable competitive advantages, solid balance sheets, consistent earnings and cash generation over a cycle, and good growth prospects. Importantly, we prefer companies to be led by a strong board and management team. I think thirdly, we prefer to buy those companies when the shares are discounted to our estimate of their intrinsic value. So, price really does matter to us. And then fourth, we believe in focused portfolios. We don't think it makes a lot of sense to invest in your 101st and 102nd, 103rd best idea. So, in our portfolios, we'll focus on our highest conviction ideas. For example, All Cap Equity currently holds 41 stocks. Small-Mid Cap equity holds 36. We think that provides sufficient diversification while still allowing us the opportunity to deliver alpha.
VanDerSchie: Thanks, John. Totally get your point about being focused, yet still diversified. So, Paul, while we're on the topic of active management, are you seeing any interesting trends around advisors' preference for different managed account program types or specific fund wrappers?
Tait: Yeah, no doubt ETFs are becoming more and more popular (from IC), especially as we see emerging trends like actively managed ETFs gain more and more traction. Still, I think there's a lot of great strategies and great managers that are offered through the mutual fund wrapper. So, for us, what makes a lot of sense is usually a combination approach. At Morningstar, we actually have a series of active/passive portfolios that we manage. And those tend to be really popular. A lot of FAs just really see the value of that best of both worlds approach.
But if we take a step back and just look a little bit more broadly speaking, yeah, I definitely see a lot of advisors follow the trend of outsourcing their portfolio making decisions to third-party managers, whether it's model portfolios or SMAs. I think there's a lot of research that has shown this. It's not something we're just seeing at Morningstar. Across the industry, there's just been the secular trend of outsourcing. And if we've talked to some of the largest and fastest growing advisors out there, one of the things they'll tell us is that they keep trying to find ways to make their business just more efficient, and outsourcing their investment decision-making to asset managers means they can focus more on growing their bottom line, which means spending time with their existing clients, finding new ones, growing their book. It's not more about choosing whether growth or value is the winning trade next year.
VanDerSchie: Yeah, no doubt. And I think about the advisor market in terms of the advisor count specifically and how it stayed relatively stagnant over the last decade, yet the demand for advice and household assets in the U.S. continue to increase. And so, obviously, it's a great time to be an advisor, but as you point out, they're being tasked to do more and more and bring on more and more households and assets. And so, scale really becomes something that is top of mind in terms of how they run their practice.
We've covered a lot in the episode. And John, I wanted to ask you, do you have any interesting investing trends or topics that investors should be paying attention to, maybe perhaps something that's under-followed at this point?
Owens: Yeah, Nick, I'd encourage investors to really try to ignore the short-term noise, including any kind of predictions for 2024. Don't pay too much attention to trends and what I call topics de jure. Focus on the long-term instead. And for us, that means investing in the undervalued stocks of high-quality businesses. One of my favorite musicians of all time, Tom Petty, he's saying the waiting is the hardest part. And I think that's true for a lot of folks when it comes to investing. But Charlie Munger said that the big money is not in the buying and selling, but it's in the waiting. And so, I would just encourage investors not to get too wrapped up in trends and topics of the day and to stay focused on the long run.
VanDerSchie: John, I didn't know you were such a Tom Petty fan. I'll jot that down. Paul, similar question. What should advisors be keeping in mind or paying attention to this year?
Tait: Yeah. Well, I agree with John. All great points. I'd say in a similar vein, focus on what you can control. Something is just inevitably going to stir up the story of the stock market this year, whether it's positive or negative. Last year, it was AI that was kind of a positive trend. 2022, it was Russia-Ukraine; 2021, inflation; 2020, COVID. So, there's unknown unknowns that we can't account for as investors. As a financial advisor, just remind your clients why they are investing and don't let emotions influence your decision making.
VanDerSchie: Great insights, Paul. Before we wrap, let's get your 10-second takeaways for this episode. So, if you want our listeners to take one thing away from the discussion, what would it be? Paul, let's start with you.
Tait: Yeah, I'd say the future is uncertain. There's a lot of risks on the table, whether it's economic, geopolitical, but there's also a lot of opportunities out there. It's always good just to remind ourselves as investors that valuations play an incredibly important role in future returns. And being a good, disciplined investor, it doesn't always feel right in the moment, but over the long term, we know it pays off.
VanDerSchie: Thanks, Paul. John, what about you?
Owens: Yeah, those are good thoughts there. I'd say when investing, don't focus too much on the rearview mirror. Yes, U.S. large cap growth stocks and in particular tech stocks, they've performed exceptionally well in recent history. But many of their valuations, not all of them, but many of them are now stretched. And it takes tremendous growth just to move the needle for a company like, say, Apple with a $3 trillion market cap. There might be some curves in the road ahead. So, I would encourage everyone to spend some time looking forward through the windshield. And I'd say if you don't own small and mid-cap stocks or foreign stocks in your portfolio, consider diversifying.
VanDerSchie: Great. Thanks, guys.
Owens: Thanks.
Tait: Thank you.
VanDerSchie: And there you have it. Another episode of Simple But Not Easy. As always, we thank our guests for their time and engagement. And once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me directly at Nicholas.VanDerSchie@Morningstar.com. That wraps up this month's episode. Before we depart, if you enjoy hearing the insights on our podcast, please consider leaving a 5-Star review on Apple Podcasts. Until next time, thanks for listening.
(Disclaimer: This podcast is produced and issued by Morningstar Investment Management LLC, a registered investment advisor and subsidiary of Morningstar, Inc. The content is intended for U.S. audiences only. Individuals featured in this podcast are employed by Morningstar, Inc. and its subsidiaries. This includes, but is not limited to, Morningstar Investment Management LLC and Morningstar Research Services LLC. Morningstar Investment Management and Morningstar Research Services are registered with and governed by the U.S. Securities and Exchange Commission. This podcast is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of publication. Such opinions are subject to change. No Morningstar entity, including Morningstar Investment Management and Morningstar Research Services, shall be responsible for any trading decisions, damages or other losses resulting from or related to the content presented. Morningstar makes no representation as of the completeness or accuracy of the information presented. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives, and risk profile before making any investment decision.
This podcast is for informational purposes only. It does not constitute investment advice and references to specific securities or other investment options mentioned are not an offer to buy or sell that specific investment.)