relative vs. absolute performance: a summary

Everyone wants absolute performance–stocks that will go up, so that at the end of the year we can look back and say that we have more money ( preferably, a lot more) now than then.

The common sense approach to more money is to pick stocks that will not only go up, but will go up more than the market.

It turns out that for basically everyone this is a lot harder than it might seem. Professionals deal with this by focusing on relative performance. Three tenets:

–stay fully invested

–concentrate on relative performance, that is, make “a is better than b” choices rather than “a (or b) is good in the absolute.” and

–stay in your lane. If you’re a growth investor, pick fast-growing companies, which is what you think you’re good at; if you’re a value investor, sift through the bargain basement for stocks whose price is (far, one hopes) less than the value of the assets they hold.

why write about this?

I’m a growth investor. Strangely enough, though, I spent the majority of my career in value shops–both GARP, where I got my first job, and deep value.

Right now, I find myself most attracted to value names. Valuation of growth names seems to me to be high–and therefore so too will likely be the penalty for earnings disappointments. And the macro environment seems at best opaque and not particularly good. Add to that Trump’s tariff agenda, his apparent intention to deport a significant chunk of the workforce and his apparent Biden-like cognitive decline and it’s not clear that we’ll be awash in positive earnings surprises next year.

I’m also beginning to reorient my IT holdings to a broader set of AI beneficiaries.

more on Monday

In the most general terms, as I see it, a professional portfolio manager creates a structure for holdings that deliberately deviates from that of a target index in a way the manager thinks will end up performing better than the index.

Conceptually, there are two main ways of doing this: by selecting individual stocks or by choosing sectors that the manager thinks will do better than the index. Some managers are more comfortable with creating a sector structure based on reading macroeconomic signals and then filling the sectors in with individual names; some do the opposite, select individual stocks they like and let that selection process create a sector structure more or less by default. Taking either approach without awareness of the other is risky. To my mind, there’s nothing worse than having a string of good ideas but not having position sizes that work against your intentions–usually, in my experience, by being too small.

I have two strong sector views. The first is Energy. I think we’ve finally reached peak global oil usage. If that’s correct, the combination of big oils and OPEC will seek to keep oil production constrained. Nuclear is something I know nothing about but I really have to get myself up to speed on.

The second is Utilities. Electric utilities have been on life support since I entered the stock market in 1978. No longer. AI demand. The short story is that regulators will have to boost allowable returns in order for utilities to raise money for expansion.

I also think that sectors that benefit from economic expansion, like Industrials and Materials are likely to have a hard time next year. Consumer discretionary is big enough that there’s always something to buy. My guess is it’s the lower end–think, Walmart (which I own stock in), avoid luxury (China’s a big reason here).

That leaves secular growth areas like IT and Communication services in my plus column.

Then there are what I would broadly characterize as special situations–meaning, in essence, I think it probably would be good to have some value names in the portfolio, especially in a year when Trump, who has shown a knack in his business career for turning silk purses into sows’ ears, will be back in power.

more tomorrow

During my first half-decade as a full-time equity portfolio manager, I was basically a stock picker. Gradually I began to think of the target index that it was my job to outperform as a perfectly round sphere of clay that it was my job to reshape, My aim was to make that sphere into something better, not in an aesthetic sense (although I kind of thought of it that way at the time), but to reshape it into a form that would produce a higher return than if I were content to stay with the original spherical shape.

I could do this either by pulling a big chunk out or pushing a big section in (overweighting, underweighting an industry/sector) or pulling/pushing a small section (an individual stock). I could distort the shape a lot with a given move, or a little. I considered, and still do, the sum of all these distortions as a measure of the risk I was building into the portfolio.

The two polar alternatives would be either to do nothing or to flatten the ball into a pancake. Experience shows that for almost all professionals doing nothing would achieve better results than they would be able to achieve. Hence, the justifiable allure of index funds (which is where the largest part of my own money is).

The pancake, an all-or-nothing concentration on a few names, is something I’ve only seen done by a professional once. And once was enough. At one time I had a deep-value colleague who made a huge bet on Digital Equipment (DEC) for an exceptionally long period during the 1990s. As it turns out, and as the market understood very well, DEC products were an intermediate stage between the IBM mainframe and the personal computer. DEC was left in the dust behind Microsoft, Compaq Apple and the IBM PC, starting in the late 1980s. As the stock went down, my former colleague, a deep value investor with a strong belief in the power of book value, bought more. This ended up destroying his career.

As for me, I try to separate the ideas I think will work into two categories, basically either sector/industry or individual stock.

Sector/industry

2024 S&P performance by sector

This is a copy of the list I posted a couple of days ago.

YTD S&P 500 sector performance

Financials +36.0%

Communication services +34.2%

IT +34.2%

Utilities +30.1%

NASDAQ +28.2%

S&P 500 +26.5%

Consumer discretionary +26.2%

Industrials +25.8%

Russell 2000 +20.1%

Staples +18.2%

Energy +13.1%

Real estate +12.0%

Materials +10.2%

Healthcare +7.8%.

So far this year, only four of the 11 sectors have been outperformers. Being heavily involved in the sectors at the bottom of the list, e.g., Healthcare or Materials, has been like rolling a giant snowball uphill.

2025?

One of the big questions for next year is whether the outperformers from this year continue to power ahead or whether the laggards will catch up. My guess right now is more the former than the latter.

Another consideration is that the bottom six are all in relatively mature economic areas. This implies that valuation will likely be an important consideration in their performance. Healthcare is an area I don’t know much about. My guess, though, is that there are interesting names for investors using value metrics, enough for me to want to poke around.

Materials, on the other hand, does well if world economies are booming. That’s a real question mark until we see how much Trump follows through on his campaign rhetoric, which is a recipe for recession.

We may well be at peak world crude oil usage. If so, the Trump “drill, baby, drill” philosophy is likely to depress prices more sharply than would otherwise be the case. Will OPEC be able to control overall output?

I think Utilities will continue to be a good place to be, as will Consumer discretionary. Tech, too, although it’s likely that the leading names will be different from this year’s winners. The issue with the consumer is linked to Trump, too. Typically, as recovery matures consumers who have traded down begin to move back to the higher-priced vendors they abandoned during bad times. As can be seen from Trump’s soybean tariffs from his last term, his program will likely depress economic growth.

DeBeers is lowering the price of its diamonds by 10%, according to a Bloomberg report I read today. The news service asserts the reason behind this is weakening demand in a high inflation, slow real growth global economy. Put a different way, lowish income growth + still-high prices for food and other necessities leaves little over for non-essentials. Ex the ultra-rich, therefore, diamonds are at the top of the list of what people are cutting back on.

Reasonable, but I don’t think this is anywhere near the whole story. For one thing, the typical initial move DeBeer’s would make would be to restrict supply. So part of what makes the price cut newsworthy is that it signals the first line of defense has already been breached. I think the much more serious issue for DeBeers, however, isn’t over-mining. It’s the development of synthetic diamonds.

How so?

–once pretty ugly looking and mostly festooned on the tips of oil and gas drill bits, synthetic diamonds now hard to distinguish from their naturally occurring brethren. Probably more important,

–tastes have changed. For buyers under the age of, say, 50, it doesn’t matter whether a diamond is manufactured in a lab or mined. What’s more important is how it looks. Arguably, younger customers prefer a synthetic stone over one that is dug up and then cut and polished. The fact that the former is much less expensive is a secondary plus. This would imply that

–naturally occurring diamonds are no longer a store of value and may well already be a wasting asset. If so, their superior portability vs. bars of gold as an off-the-books store of value is probably already lost as a selling point.

Professional equity investors by and large concentrate on achieving relative outperformance of a target index (typically the S&P 500 in the US) as opposed to absolute performance.

Several reasons:

—it’s easier to judge that x is better than y than to say that either is good/bad in the absolute. Rather than say that Nvidia (NVDA) was cheap in the absolute five years ago, you could have reasoned that no matter what NVDA might do in terms of profits and therefore stock performance, it would in all likelihood be better than Micron (MU). If each stock were, say, 1% of the market cap of the S&P 500, I could easily decide to have 2% of my portfolio in NVDA and 0% in MU. I’d have an overweight in a designer of highly specialized semiconductor chips and underweight a manufacturer of more or less commodity chips. My exposure to the overall area of semiconductors would be more or less unchanged.

Over the past five years, MU has somewhat more than doubled, and is slightly ahead of the S&P over that span. NVDA is up by 24x. So that one decision would have gotten me roughly 5 percentage points of index outperformance. This is enough to put me deep in the first quartile of all managers over the half-decade–provided I didn’t muck things up by deviating from the index in any other way (tough to convince someone to pay you for making one decision and then sitting on your hands, though).

—risk control can be more precise than with simple stock picking. Professionals–most explicitly, some implicitly–regard risk as deviation from the structure of the target index. The standard over/underweight parameters are: sector, industry and individual stock. If I replace MU with NVDA, I’m making an individual stock decision. If I decide not to own any oil and gas stocks (a tiny sector in today’s market) and put that money into NVDA instead, I’m making a more complex bet, against the energy sector and in favor of IT plus an individual stock bet on NVDA.

–as one of my mentors said, very often, “The pain of underperformance lasts long after the glow of outperformance has faded.” So having a framework that enables you to articulate and quantify risk has a value of its own.

YTD S&P 500 sector performance

Financials +36.0%

Communication services +34.2%

IT +34.2%

Utilities +30.1%

NASDAQ +28.2%

S&P 500 +26.5%

Consumer discretionary +26.2%

Industrials +25.8%

Russell 2000 +20.1%

Staples +18.2%

Energy +13.1%

Real estate +12.0%

Materials +10.2%

Healthcare +7.8%

Prospects for AI have been the main driver of market returns this year. So it makes sense that IT and its clone, Communication Services, should have been so strong. Utilities are also an AI beneficiary, in a less obvious way: AI needs lots of electric power, implying that utilities must add capacity. This means regulators are being compelled to allow higher returns on plant than has been the norm for very many years, so utilities can raise new capital.

Financials have achieved outperformance since the presidential election, on the idea that more M&A may be permitted under Trump, as well as perhaps the thought that his so-far incoherent money policy/currency ideas will present lucrative trading opportunities.

These sectors are also currently showing the strongest earnings growth, although Consumer discretionary, a mild laggard, is also showing similar profit strength.

Next year? ///hard to know.

more tomorrow