Changing of the guard

Safety and comfort mean different things to different people. In an investment sense, the traditional safe havens have historically been things like government bonds, gold and the Japanese yen. That’s not been the case in the past few tumultuous years.

Egged on by the seemingly relentless rise in popularity of index trackers, the new safety has been found in the arms of mega-sized, monopolistic American technology stocks. The so-called Magnificent Seven accounted for 29.15% of the S&P 500 on 18/09/2024.

It’s helped, too, that themes du jour also play into the size argument: the artificial intelligence leader is Nvidia, a $3 trillion chipmaker, and the bigwigs in GLP-1, or weight-loss, drugs – Novo Nordisk and Eli Lilly – have a combined market capitalisation of $1.4 trillion.

This isn’t new. Think back to the 1960s and 1970s, when the Nifty Fifty (a collection of 50 buy and hold forever blue-chip US stocks) were all the rage. Still, eventually these trends come to an end – and we may be witnessing the end of the Magnificent Seven’s dominance.

To be clear, we’re not suggesting that technology is in a bubble that’s about to burst. There’s no need to sell your exposure to the sector. However, a couple of recent milestones suggest that market leadership is changing.

Nvidia has been in and out of bear market territory since its June peak, leading the technology-heavy Nasdaq Composite to falter after an astonishing bull run. Berkshire Hathaway, Warren Buffett’s value-investing conglomerate recently became the first non-technology company to breach the $1 trillion market cap barrier.

Since 09/07/2024, the S&P 500, an index that weights America’s largest 500 publicly listed companies by size, has returned 1.2% in US dollar terms. By contrast, the S&P 500 Equal Weight Index, which weights the same 500 firms equally, is up 7.6%. The Russell 2000, the US small-cap barometer, has surged 8.1%.

This points to a broadening out of market leadership, which the imminent interest rate cuts from central banks could accelerate.

The US economy seems to be slowing enough to justify rate cuts, but it does continue to grow and data does not suggest that a recession is on the cards. Still, it’s certainly worth considering positioning for two potential scenarios.

A soft-landing play

Smaller companies are perhaps the best way to play a scenario where the global economy skirts a recession.

Recessions are particularly tough environments for small companies, because they are naturally more attuned to local economies, meaning demand for their goods can wane. In addition, banks become less likely to lend to riskier enterprises so their potential sources of capital dry up.

Fears about a potential recession may have contributed to mega-cap stocks pulling further away from their smaller counterparts. If investors start to doubt that the recession will come, that wall of cash that went into the Magnificent Seven may start to take profits that get recycled further down the market cap spectrum.

Rate cuts would also benefit smaller companies. These firms tend to have more debt than larger firms and more of it is variable, meaning the amount of interest they must repay goes up when rates do, crimping profit margins, and vice versa.

Staying defensive

It could pay to own some assets that might do relatively well if a recession does occur, offsetting what you might lose elsewhere but not dragging on returns too much if the landing is soft.

We suggested earlier that mega-cap stocks seem to have become a new safe haven, but that may not hold. High valuations may scare off some investors, with profit-taking adding to the pain.

In this scenario, cash may be recycled into the more traditionally defensive equity market sectors. These include consumer staples, telecommunications and healthcare. Companies lumped into these categories tend to benefit from consistent and stable demand for their products and services and reward shareholders attractive dividends.

Healthcare is perhaps the more interesting area here. Treatments should go ahead no matter what happens with the economy – if you’re seriously ill, you will go to the doctors or the hospital, or get checked out online, recession or no recession.

Meet me in the middle

One could argue that the investment company universe’s Venn diagram of small-cap and healthcare investors brings up just one match: Bellevue Healthcare (BBH).

BBH sits in an interesting area. It is predominantly small and mid-cap healthcare, giving it exposure to the higher-risk but higher-reward parts of the market such as biotechnology, which is balanced out by its investments some of the more traditionally defensive areas such as health insurers and software providers.

As mentioned, the MSCI World Health Care Index has been dominated in recent times by Novo and Eli, which have shot to prominence by being first to market in GLP-1 diabetes drugs. The two account for 14.5% of the index. This has weighted on BBH’s relative returns, leading to a long period of underperformance.

Yet, the benefits of BBH’s investment process and expertise has come to the fore in more recent weeks. Since 10/07/2024, BBH’s total share price return has been 10.2%, well ahead of the 4.2% gain for its benchmark.

BBH does have 10% of its portfolio invested in alternative investments that play into the diabetes theme, notably through Dexcom, which provides glucose monitoring systems. The portfolio is ready for phase two of the GLP-1 boom, once it broadens out from its narrow focus on two companies.

Any portfolio should, of course, be well balanced and diversified across different sectors, countries and assets and small-cap healthcare is a small part of that, but at the same time, perhaps the sector should no longer be ignored.

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