3 Unconventional Investment Approaches to Explore Today

The Magnificent Seven: A Double-Edged Sword for Investors

Investors don’t need to look too hard to figure out what’s worked recently. The so-called Magnificent Seven stocks—Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), Alphabet (GOOGL), Amazon.com (AMZN), Meta Platforms (META), and Tesla (TSLA)—have been the poster children of US large-cap stocks’ success in recent years. These tech giants have contributed to more than half of the Russell 1000 Index’s returns over the past three years, showcasing their dominance in the market.

However, this concentration of performance is not typical. Global market allocations have shifted heavily toward the US, especially its largest companies. While this trend may appear valid, history teaches us that the world’s biggest companies often experience declines or fade away over time. The reasons for such downturns are frequently unknowable until after the fact, making it difficult to predict which companies will falter next.

Historical Precedents: The Rise and Fall of Giants

Consider Cisco (CSCO), which was once the world’s most valuable company in the early 2000s. Its meteoric rise leading up to the dot-com crash led Fortune magazine to declare, “No matter how you cut it, you’ve got to own Cisco.” Yet, within a year, Cisco’s stock plummeted by 85%. It has only recently clawed its way back, meaning that investors who bought Cisco stock in May 2000 would have barely broken even after 24 years. This serves as a cautionary tale about the risks of investing in stocks at extreme valuations.

The Psychology of Performance Chasing

The current technology rally, characterized by stretched valuations, has left many investors wary. Yet, the allure of the Magnificent Seven is hard to resist. Investors often feel compelled to participate in what’s winning, driven by herding bias or fear of missing out (FOMO). This performance-chasing can create a self-fulfilling prophecy in the short term, but it can also lead to a sudden drop when the market runs out of new buyers.

Are we in a bubble that’s ready to pop? The answer is uncertain. The factors that can trigger a downturn are often unpredictable, underscoring the importance of diversification in investment strategies.

The Concentration of Market Power

Alarm bells are ringing as global stock performance has become increasingly concentrated in a handful of US stocks. As of August 22, 2024, the market capitalizations of Microsoft, Apple, and Nvidia alone account for over 12% of the MSCI All Country World Index, which captures 85% of global investable stocks. This concentration raises concerns about the sustainability of such dominance.

Moreover, a single product line drives a significant portion of revenues for two of these companies. Apple’s iPhone sales represent about 50% of its revenue, while data center products account for 78% of Nvidia’s revenue. This reliance on specific products creates vulnerabilities, as any downturn in these sectors could have outsized impacts on their stock prices.

The Case for Out-of-Favor Strategies

The successful run of US large caps leaves ample opportunity for investors to explore out-of-favor strategies. Historical risk premiums associated with value and small-cap stocks have not compensated investors recently. In fact, US large caps haven’t been this dominant relative to US large value, US small caps, and emerging markets since 2000. Now may be an opportune time to rotate into these underperforming strategies, which could benefit if markets revert to their historical norms.

Why might value and small-cap companies make a comeback? Investor sentiment has soured after a decade of underperformance, leading to a lack of demand and, consequently, undervaluation. As Corey Hoffstein of Newfound Research aptly puts it, “No pain, no premium.” Patient investors in value, small-cap, and emerging markets have endured enough pain to potentially reap the rewards.

The Opportunity in Undervalued Stocks

David Sekera, a colleague at Morningstar, highlights the opportunity for companies that embody these risk factors. Currently, value stocks are trading at a 15% discount to core stocks, while small caps are trading at a 25% discount to large caps. Notably, small-value stocks are trading at a staggering 35% discount to large-core stocks. This presents a compelling case for investors to cash in on what has worked and take some risk off the table by investing in stocks with a greater margin of safety.

Small-value stocks, unlike the high-flying tech giants, are not tethered to lofty expectations, giving them a lower bar for success and a shorter fall if things go awry. Additionally, the global allocation to international stocks has diminished as investors flock to high-flying US stocks. The US now comprises 64% of the MSCI ACWI, creating opportunities for those willing to venture into undervalued international markets.

Strategies for Incorporating Out-of-Favor Investments

Adjusting a portfolio to include out-of-favor strategies doesn’t require investors to abandon their current holdings entirely. For instance, switching from an S&P 500 exchange-traded fund to a total market ETF can add small-cap exposure, reduce the average market-cap weight, and lower the price-to-fair value ratio of the portfolio. This minor adjustment can enhance diversification while still allowing investors to benefit from current trends.

Here are some ETF ideas with Morningstar Medalist Ratings of Gold and Silver for harnessing out-of-favor strategies:

• All-In on Small Value

  • Vanguard Small-Cap Value ETF (VBR) — Gold
  • Dimensional US Targeted Value ETF (DFAT) — Silver

• Large Core Tweaks

  • Vanguard Total Stock Market ETF (VTI) — Gold
  • Dimensional US Core Equity 2 ETF (DFAC) — Gold
• Go International
  • Avantis International Equity ETF (AVDE) — Silver
  • Schwab Fundamental International Equity ETF (FNDF) — Silver

By strategically incorporating these out-of-favor investments, investors can position themselves for potential rebounds while maintaining a diversified portfolio that mitigates risk.