I entered the investment industry and took my investment exams shortly after the last ice age (or at least that’s what it feels like). Even back then the Efficient Markets Hypothesis “EMH” was de rigueur which espoused that current stock prices reflect all available information, so, stocks were always trading at fair value. If you subscribed to the EMH, you became a passive investor and would buy the market, accepting its risk and return characteristics as you believed it was impossible to do any better. On the other hand, if you thought you could do better you would calculate whether the price of an investment was cheap or expensive using formula such as the one in the title of this article.
In recent years, those who subscribed to the EMH have been a noisy bunch as passive investment strategies, particularly in markets such as US equities, have outperformed the average active manager. Whether this proves EMH or is merely a reflection that some strong trends, in particular American exceptionalism, and the rise in passive investment have fed upon each other, is a key investment debate to be had today.
American equity markets currently represent 64% of the capitalisation of global equity markets and 10 American businesses (Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet, Broadcom, Tesla, Alphabet and Eli Lilly) represent 20% of the capitalisation of global equity markets (Source: MSCI ACWI factsheet 30 April 2025). These may be great global businesses with above-average growth and profitability, but their valuations fully reflect this. Coverage of the biggest businesses is extensive; Bloomberg details 80 analysts providing coverage on Nvidia, so the chance of anyone having an information edge when investing in the business is de minimus.
It is widely reported that the level of stock concentration in global equity markets is higher than at any other point in history. Why is this important? History has shown repeatedly that, over time, market leadership changes and premium valuations disappear through mean reversion. During my career I have witnessed the severe implosion of the Japanese equity bubble and the dotcom bubble – both saw extreme over-valuation followed by mean reversion. Passive investors accept these periods of mean reversion in investment markets as unavoidable.
A global equity investor has an investable universe of about 2,558 companies. When buying a passive fund following the MSCI ACWI index, you are choosing to place 20% of your money in 10 companies, representing less than 1% of the investment opportunities that are available to you. The impact of increased levels of passive investment, where the largest amount of money automatically flows into America and the biggest businesses, supports their valuations. Passive investment rewards yesterday’s winners, it doesn’t question whether they are as relevant in the future as they were in the past and it doesn’t question their valuation.
It may be that I am a tight Jerseyman, but I find it bizarre that an increasing number of investors will invest all of their money without any interest in the underlying valuation of the businesses they are investing in. I wonder if they are as price insensitive when shopping in their local supermarket?
One of the world’s most successful investors, Warren Buffett, has recently announced his retirement. He has guided Berkshire Hathaway since 1965 when he took over the textile manufacturer and turned it into his primary investment vehicle. The Sage of Omaha (as the global media like to refer to him as) liked to keep things simple and his enviable track record is built on the principles of buying great businesses at sensible valuations and if possible, hold them forever. According to the latest Berkshire Hathaway financial report, the company, intriguingly, only holds one of the Magnificent Seven (Apple), despite managing $1.15 trillion and Buffet was actively reducing this before the recent selloff in investment markets. Engaging a valuation discipline requires hard work and experience.
To make the point of how difficult it is to value a business let’s briefly consider Tesla. How do you begin to value the company? Is it a car company? Is it a battery company? What value do you give to robotaxis? How do you value its ability to on sell some of its technology? Will it be the beneficiary of Elon Musk’s next great idea?
Car sales represent the majority of the company’s revenues and outside of America they are plummeting, yet it trades on a premium rating with a P/E of 135 (5.6 times the MSCI ACWI index P/E of 24) and has a market value of $0.9 trillion. The share price at the time of writing is $275 and its 52-week trading range is $167 to $488. Cathie Wood of Ark Investment Management is one of the biggest fans of Tesla and recently announced a five-year price target of $2,600 for Tesla, underpinned by 90% of the value coming from its robotaxi business. When the best brains in the investment industry have such hugely divergent opinions, you need to question whether it’s an investment that you want to have significant exposure to. If you invest in a passive manner, you have a market weight in Tesla and you have to accept the highs and the lows along the way regardless.
At the risk of sounding hypocritical, I do think passive investment has a role in a diversified portfolio. It provides tactical flexibility, ensures diversification, lowers costs, provides exposure to parts of investment markets that may be difficult to access, and it will reduce portfolio tracking error (the risk of under or out performance relative to investment markets). However, at this point in time I am concerned that the net result of the recent and future actions of Donald Trump will be that the rest of the world turns at least one degree away from America and seeks to do more of their future business elsewhere, therefore negatively impacting American exceptionalism and prompting capital flows away from America. My many years in the investment industry also mean I bear scars from the words “it’s different this time” so I am confident that over the next decade America’s exceptionalism and dominance of global equity market capitalisation will reduce and the largest businesses in the world will be subject to change, as we have seen the largest holdings change time and again over the decades.
Therefore, today, we blend passive investments with active investments in select parts of our portfolios and will not rely entirely on passive investments as we know that we would be relying on yesterday’s winners to always win, which, in a world of constant change, seems highly unlikely.
