Just a handful of stocks led the market in 2023. Here’s why we still own 35

The stock market this year has been led by just a handful of the biggest and best tech companies. It’s enough to make you question the whole idea of diversification. What’s the point of owning stocks across different sectors and industries? Jim Cramer raised this very question in his latest Sunday column , noting that diversification was a failed investment strategy in 2023. There is no denying it. Just look at the S & P 500 market-cap weighted index, which is viewed as a barometer of the overall stock market. This index, which gives more weight to stocks with higher market caps like Apple and Microsoft, has gained more than 18% this year. Compare that to the 3% increase in the S & P 500 equal-weight index, which treats each stock the same regardless of market value. The reason for the difference in performance? The market’s largest stocks were the biggest winners in 2023. So why not just own those stocks, starting with the Magnificent Seven — Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA) and Tesla (TSLA)? For starters, six of those seven are long-time holdings in the Club, along with another couple dozen names or so. Hindsight is always 20/20. It’s much tougher, if not impossible, to pick the handful of stocks that will dominate in the year ahead. More importantly, the key to making real money is simply staying in the market. Diversification allows you the best chance of doing that, year in and year out. Had just one or two of those big companies bombed this year, your concentrated portfolio would be in big trouble. Owning a variety of stocks may cap some of the upside in any given year, but it also lessens the downside enough to keep you in the game another year. To be clear, this is not a defense of names that underperformed this year. We aren’t trying to say that Honeywell (HON) had a great year when it didn’t. We also don’t believe in diversifying just to check a box. We never buy a stock we don’t already like because we need exposure to a sector or industry. You don’t need to own every single sector as designated in the S & P 500. For example, out of the 11 S & P 500 sectors , we currently don’t own any real estate or utility names. What we are arguing is that focusing on companies with real profits and growth across many industries is still the best recipe for long-term success. Even now, there are great companies with strong fundamentals and attractive valuations outside of technology. And while the stocks may fall out of favor from one quarter to the next (or one year to the next), you might still own them. If 2023 has taught us anything, it’s that most people, even professionals, can’t tell you when the market is going to turn or which sectors will benefit the most. Consider the 2022 returns of the Magnificent Seven, a year in which the S & P 500 was down 19.64%: Apple: down 26.8% Alphabet: down 39.1% Amazon: down 49.6% Meta Platforms: down 64.2% Microsoft: down 28.7% Nvidia: down 50.3% Tesla: down 65% Had you built an equal-weighted portfolio of these seven mega-caps at the start of 2022, you would have lost more than 45%. Now if you just held on through 2023 to the present, you recouped much of that money. But that’s a tough proposition for most investors. It’s hard to turn off the monitors and wait for your seven stocks to come back after a terrible year. More likely: You sell at the bottom or rotate out at the exact wrong time. This psychological benefit of diversification is often overlooked, a shame given that control of your emotions — backed by homework — will do more for you than almost any other aspect of investing. On top of all that, how many experts really knew heading into 2023 that these were the seven names to back the truck up for? Interest rates were high, inflation was moving lower but slowly. Tensions with China were on the rise as the U.S. had just implemented export restrictions for cutting-edge semiconductor chips and the war in Ukraine was and still is a major threat to global commodity prices. There were even calls that the mega-caps would be laggards in the next rally. Here’s how we think about diversification in this context: We need companies with specific qualities no matter their sectors. Real earnings aren’t enough, we need earnings growth. Don’t confuse that with a “growth company” that is increasing sales at all costs, including by losing money. We also need to consider that revenue streams are unique. Some sales streams grow slower, but are less tied to the business cycle (staples and health care), while others grow faster but are more prone to boom-or-bust dynamics as supply and demand ebbs and flows (chipmakers). Lastly, diversification didn’t completely fail for everyone, it was just a lot harder than usual to pick the winners in each sector. Within the portfolio, Linde (LIN), Eli Lilly (LLY), Palo Alto Networks (PANW) and Oracle (ORCL) are all up more than 38%. Stanley Black & Decker (SWK), GE Healthcare (GEHC), Broadcom (AVGO), Salesforce (CRM), and Eaton (ETN) are all outpacing the S & P 500 and span sectors including technology, industrials, healthcare and materials. Other names, like Caterpillar (CAT) and Constellation Brands (STZ) were having fantastic years before recent pullbacks, proving just how hard it is to time the market. Looking ahead to 2024, we will stay diversified and look for those high-quality stocks that were dumped this year as investors gravitated to the more obvious winners. That’s never easy. But it should be easier than most years because so many great companies have been beaten up. You can call these stocks coiled springs, ready to rally on any positive news. Danaher (DHR) may well be one of those names as the bioprocessing inventory glut thins out. Morgan Stanley (MS) could be another one as IPOs and M & A activity return now that interest rates seem to have peaked. Will Disney (DIS) be a 2024 darling as CEO Bob Iger continues to find new ways to cut costs, consolidates Disney+ and Hulu, and works to build out a broader sports offering? Time will tell but if the 12% run since its earnings report on Nov. 8 is any indication, things at the house of mouse aren’t as dire as the Street would have had you believe two weeks ago. Going from horrible to less bad than feared is enough to get you 12% in less than two weeks. As stock pickers this is exactly the kind of market we love. We still believe that putting in the work will reveal unique opportunities for outsized returns. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.