Investors relying on share market indices to make decisions need to take care. Index concentration is intensifying risks – and opportunities – within indices.
Start with the S&P 500 Index in the US. Remarkably, the so-called “Magnificent Seven” tech stocks accounted for almost a third of the index at end-June 2024.
Simply, a third of every dollar invested in the S&P 500 went to Amazon, Apple, Alphabet, Microsoft, Meta, Nvidia or Telsa – regardless of their valuation.
Is it any wonder their share prices soared to unsustainable heights? As money poured into passive investment strategies, Exchange Traded Funds (ETFs) that track the S&P 500 had to buy more of these tech shares as their value rose.
To my thinking, index concentration is the single biggest risk to global equity markets today. It always ends badly when more capital is allocated to an ever-narrowing group of stocks. Or when too many investors own the same stocks.
Diversification is another issue. Investors are told ETFs provide instant diversification. Many do, but some tracking indices with high stock concentration are a diversification mirage. Often, their performance relies on a handful of stocks.
Consider the Australian banking sector. The S&P/ASX 200 Banks Index has an impressive total return (including dividends) of 36% over one year to end-July 2024. But 40% of that index is based on the Commonwealth Bank.
Put another way, 40 cents of every dollar invested in the ASX 200 Banks Index goes to CBA, which is overvalued compared to comparable global banks.
The Australian Real Estate Investment Trust (A-REIT) sector is another example. The S&P/ASX 200 A-REIT Index has a total return of 28% (including distributions) over one year. On paper, that suggests the A-REIT sector is rallying amid expectations that interest rates in the US and Australia have peaked.
Goodman Group, the star industrial property group and data-centre owner, accounted for almost 42% of the ASX 200 A-REIT sector at end-June 2024. Strip Goodman out of the index and A-REIT performance is more mixed.
More than ever, investors must consider index composition when relying on sector performance to inform decisions. Heavyweight stocks are increasingly dominating sector weighting as they attract more capital from ETFs.
That’s the bad news. The good news is that misallocation of capital through passive investing is creating attractive investment opportunities in stocks not in key share market indices or that have a low weighting in them.
As more capital flows into an ever-narrowing group of stocks due to ETFs, less capital is allocated to a widening group of stocks. That’s because index-tracking ETFs have to buy more of a stock when its index weighting rises and hold less of the stock when it falls. As an investment strategy, that’s nuts.
It’s an interesting exercise to look at sectors dominated by a stock heavyweight, and search for value in peer stocks not attracting passive capital. The A-REIT
It’s an interesting exercise to look at sectors dominated by a stock heavyweight, and search for value in peer stocks not attracting passive capital. The A-REIT sector is a good place to start. Here are two small-cap A-REITs to consider.
- Dexus Convenience Retail REIT (ASX: DXC)
Capitalised at $381 million, DXC is outside the top 500 on ASX and a minnow in the A-REIT sector, meaning it does not benefit from index investing. Only a handful of analysts cover DXC and it has a relatively lower. market profile.
DXC owns a portfolio of 101 retail petrol stations and convenience stores, mostly on Australia’s east coast. Its properties have exposure to an estimated 9% of the nation’s daily motor-vehicle fleet, such is the prominence of its locations.
DXC had 99.6% occupancy and weighted average lease expiry of 9.3 years at end-December 2023. Key tenants include Chevron, Cole Express and 7-Eleven. No major leases expire until 2030 or beyond.
DXC, like other petrol-station A-REITs, benefits from Australia’s strong population growth. Petrol stations and convenience stores in prime locations should have rising property values in the long term, assuming no significant land-remediation issues to turn a petrol site into an apartment complex.
Yet DXC has fallen from almost $4 in September 2020 to $2.77. The A-REIT is up from its $2.21 low in October 2023, but a long way from its previous high.
There are three main headwinds for petrol-station property owners. The near-term risk is higher interest rates if Australian inflation does not cool. Higher rates are bad news for A-REITs and other interest-rate-sensitive sectors. This week’s inflation data gives comfort that rates in Australia have peaked.
The medium-term risk is a slowing economy and possibly recession if rates rise or remain higher for longer than expected. A deteriorating economy would dent demand for petrol stations, particularly the convenience stores at the sites.
A longer-term risk is growth in electric vehicles. More EVs on the road and fewer traditional cars in theory means less demand for petrol stations.
DXC’s current valuation overstates these risks, especially the EV threat. The EV boom in the US has slowed this year as buyers raise concerns about the resale value of EVs and other issues. A Trump Presidency could further dent EV demand.
Slower sales of petrol stations in Australia this year, due to concerns over EV growth, may have overstated the risks in the medium term.
By my count, DXC trades at a 31% discount to its latest stated Net Tangible Asset (NTA) at its current unit price. That NTA might retreat a little due to property-portfolio devaluations, but the discount provides a decent margin of safety.
In the medium term, there’s a lot of life left in petrol-station properties, particularly as Australia’s population booms and accommodation demand soars.
Chart 1: Dexus Convenience Retail REIT
Source: Yahoo Finance
- Rural Funds Group (ASX: RFF)
Like DXC, Rural Funds Group trades at a hefty discount to its NTA. The market values Rural Funds at 29% below its last stated net asset value.
I’ll have more to say on Rural Funds in a coming column. Suffice it to say, Rural Funds’ fall from $3.18 in early 2022 to $2.08 looks overdone.
Like other small-cap A-REITs, Rural Funds has fallen over the past few years due to the effect of higher interest rates on the listed property sector, and also due to market concerns about the effect of higher rates on farm rents.
With the term deposits paying a similar yield to Rural Funds, it’s easy for income investors to stick with cash and avoid small-cap A-REITs.
Established in 1987, Rural Funds is a specialist agricultural fund manager that owns 67 properties across five sectors in Australia: cattle, almonds, macadamias, and, to a lesser extent, cropping and vineyards.
I’ve kept an eye on Rural Funds for many years, principally because I like its strategy to buy and lease farm properties in what remains a fragmented sector.
As an agriculture-related stock, Rural Funds is subject to weather-related risks. But it’s done a lot of work over the years to diversify its exposure to sectors, climatic risks and clients – and increase the value of its portfolio.
The market might be underestimating Rural Fund’s ability to grow profits faster. In its latest newsletter, Rural Funds wrote: “The most significant way RFF will increase AFFO (adjusted funds from operations) is through the rental indexation mechanisms contained in its leases. The mechanisms vary between leases, but generally speaking, leases contain indexation of around 2.5% per annum with periodic reviews to market value or simple indexation at the rate of the CPI.”
Rural Funds has a challenging few years ahead as it divests some assets that produce low returns or have weaker growth prospects. Longer term, the A-REIT should deliver steady income and capital growth from farm properties.
Chart 2: Rural Funds Group
Source: Yahoo Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 30 July 2024.
