Think you’re well diversified? Think again (plus 3 stocks that can help)

The top 10 stocks in the S&P 500 accounted for around 18% of the index 10 years ago. Now it’s closer to 40%. The chart below from VanEck compares this shift with the MSCI EAFE Index, which captures large and mid cap representation across Europe, Australasia, and the Far East.

That may make it seem like concentration is just a US problem, but the same forces driving consolidation in the S&P 500 are also tightening the spread in other markets. The Nikkei 225 and the KOSPI, which Talaria Asset Management co-CIO Chad Padowitz notes is “basically one big semiconductor trade”, are even more concentrated.

In many cases, the concentration has been a boon for investors. The KOSPI returned 178% over FY26, the Nikkei 225 80.3%, and the S&P 500 delivered 20.4%. However, as has been seen through the chaos in the Korean market in recent weeks, the high correlation among a very concentrated index means losses can also snowball.

One very big egg

The answer for investors, as is often the case, is diversification. Unfortunately, while a portfolio may look well diversified across different equities markets and asset classes at first glance, Padowitz says this could be a mirage.

“In the mid-1990s, you had about 26% of global invested assets meaningfully correlated to the S&P. Three-quarters of other assets you had were giving you a fair amount of diversification, so you had quite a lot of choices to make to construct a diversified portfolio,” he says.

“But for a range of reasons, that correlation has moved to around 90%, which is quite extraordinary.

“One factor is the significant growth of the trillion-dollar tech names. The S&P is 75% of the MSCI, and within the S&P, you've got a tremendous amount of just a handful of tech names. So you've had that concentration of a few names driving everything, but you've also had the buildout of AI seeping into other asset classes.”

On a scale where 1.0 means moving exactly in line with the S&P 500, listed property has moved from a correlation of 0.61 in 1995 to 0.82 today, while developed market shares outside the US have gone from 0.46 to 0.79. Hedge fund strategies now sit at 0.81, while the main US bond index stands at 0.60.

“If you shouldn’t put all your eggs in one basket, what do you do with one basket and one very big egg?”

Where is the real diversification?

If 90% of global assets are correlated with a single index, the question becomes how investors can utilise the other 10% to build a higher level of diversity into their portfolios.

“Firstly, it's not easy, which means very few people will actually end up doing it,” Padowitz says.

“There are a couple of different strategies, things like trend following strategies and merger arbitrage, catastrophe bonds, things that just do their own thing. What we quite like, because we embrace it in our process, is volatility risk premium.”

This is essentially getting paid for volatility and is a strategy that’s negatively correlated with the S&P 500. When the correlated trade comes off, volatility goes up and Talaria can get paid for that.

“We definitely think of different strategies further away from the index, because it's not like everything within that 90% is perfectly correlated,” he adds.

While the S&P and equity markets are correlated, there are still companies that you can find which don’t have valuation issues and aren’t linked to the expectation of AI-driven growth.

“Business models are a bit more uncertain today than they were because no one quite knows what will happen with AI. A strong balance sheet just puts you in better shape, as well as allows you to be less dependent on borrowing in a world that needs to constantly refinance and borrow, with interest rates being a bit higher and stickier than they have been for a while,” Padowitz says.

“Then diversification of return, because with this high level of concentration real diversification is quite difficult, which makes it quite rare, which makes it quite valuable. So it is something that we think is a valuable thing to have, and diversification would be broadly not so much about asset classes because of that correlation, but rather about sourcing and duration.”

Stock picks for diversification

Padowitz and Talaria Analyst Stefan Stoev highlighted three companies that meet the criteria for low correlation with the broader market that can help build some diversification into investors' portfolios.

Newmont Corporation (ASX: NEM)

“We don't invest in it from the perspective of forecasting the gold cost because that’s very hard to do. What we can say is they produce at about US$1,500-$1,600 an ounce, and they have 50% of the world's top-tier mines at a very long duration,” Padowitz explains.

“They can keep doing it for a very very long time, at circa that cost, and they're selling the product, which granted moves around a lot, at US$4,000. That as a business is a very high margin business, and given the asset, which obviously we all know gold does have probably the longest track record maintaining and increasing inflation real adjusted value.”

The company is running on a very high margin and no debt, and if gold stays at the level it’s at for another six months, the share price should go up “quite a bit”.

“The volatility in the gold price is creating a lot of uncertainty about what gold price to use in the valuation. We think that creates an opportunity. It's about 10 times free cash flow yield, so very high returns, very low debt, very good asset base,” he says.

Padowitz adds that it is a little more correlated to markets now than it previously has been, but expects the miner to “eventually re-cycle out of that”.

“You don't need to take a view on AI or interest rates and the economy, and it is a long-term beneficiary from this financial repression and debt. So all of those things we think make Newmont as an equity quite interesting.”

Exor NV (AMS: EXO)

“Their biggest asset is Ferrari. Then they own a big stake in Philips, they also own an asset management business that runs about $10 billion, they own CNH, which is a mining equipment, construction equipment business. They also own the Economist, as it happens,” he says.

“They have a range of assets, the vast majority are listed. If you price those assets that are about €150 a share, you can buy the shares at €68. Now that gap is always going to be a bit of a gap because it's a holding company, and there's the holding company discount. We don't think that discount is likely ever closed, but that discount broadly has long term been close.”

Importantly, the value of the underlying assets doesn’t even need to go up, Padowitz says, for the gap to close to around 30% rather than to roughly 50% it’s at currently.

“They're about €32 billion of assets and around €14 billion of market value, and they've bought back about €1 billion of their shares just last year. It's a meaningful amount because if they want to sell any assets themselves or equity, they've got to take that gap and they don't want to take that gap either. They want to close that gap,” he adds.

“We see that as an interesting opportunity that doesn't require your belief in almost anything positive. Just that gap will close. There's a lot of reason why it will close, and if it doesn't, we're actually buying just those companies at half price and we're getting the earnings yield and the dividend of those companies that is double what the market's currently prepared to pay anyway.”

A.O. Smith Corporation (NYSE: AOS)

“It's a pretty oligopolistic market. There's three players that sell hot water heaters and control around 90% of that market,” Stoev says.

“It's selling at a very reasonable price today, more reasonable than in the past 10 years, so it's the cheapest it's been over that past decade. It's not linked to AI in any way.”

Impacting A.O. Smith’s current price is interest rates, which have slowed the US residential property investment market and led to a cyclical lull in boiler sales.

“We expect that once that recovers, they're really well placed to capture some of that. They're making about 6% free cash flow yield today and they pay most of that through dividends and buybacks, so while you're waiting for that residential cycle to turn, you're still getting paid 6% per year.”