This framework is one component of a broader research effort—including quantitative artificial intelligence (AI) tools— to scour the market for high-quality businesses backed by healthy balance sheets and skilled management teams. Shares of quality companies with stable trading patterns and attractive prices—what we call QSP—can form a solid defensive foundation for evolving challenges. These days, some of these companies can be found at especially attractive valuations, which augments their recovery potential.
Valuation Matters as Concentrated Markets Unwind
Focusing on valuations is always important for investors. But it didn’t feel that way in recent years as the relatively expensive Magnificent Seven stocks rose to dizzying heights on enthusiasm for AI. While the mega-caps include great businesses, we believe equity portfolios should hold individual names based on their investing philosophies and at appropriate weights.
In concentrated markets, many investors ended up tilted toward the largest stocks, sometimes unintentionally. Portfolios that avoided or de-emphasized the mega-caps paid a penalty, even if underweight positions were backed by research conviction and were in line with an investment mandate.
Since DeepSeek’s AI breakthrough jolted the mega-caps in January, we’ve seen a divergence in the Mag Seven’s performance. Across the sector, valuations of AI-related stocks have come down significantly, while volatility has increased—in part because of the risk that more efficient use of chips will reduce demand for semiconductors. Broadening market returns within and beyond the US mega-cap stocks reminds us that investors who follow crowded trades could get hurt if concentrated markets unwind further.
Developing Defensive Diversification
The concepts above can help create effective defensive diversification in several ways.
First, following these guidelines should pull defensive portfolios toward services-oriented companies rather than goods producers, which are more susceptible to tariffs. For example, internet-based travel services and select financial-services firms simply aren’t in the direct line of fire of the trade war.
Second, defensive diversification requires a selective approach to technology. Software companies are less vulnerable to tariffs and offer opportunities to capture AI innovation in a risk-aware portfolio. Semiconductor and hardware companies are far more vulnerable to tariff risks and are a less defensive allocation, in our view.
Third, even in sectors that seem susceptible to tariffs, search for exceptions. Often, these companies trade at relatively attractive valuations because of perceived risks. Examples include industrial companies with operations primarily in the US, digital publishers or engineering groups that benefit from megatrends like global infrastructure spending.
Finally, regional diversification deserves attention in global allocations. Trade wars will have a global impact, but US companies are still relatively pricey and more vulnerable to tariffs, while European and Asian markets offer relatively attractive valuations. During the first quarter, European stocks outperformed, reminding us of the benefits of regional diversification.
The ever-changing landscape of global trade underscores the need for a disciplined investing approach that is attuned to changing market dynamics. For defensive investing to succeed in these unpredictable times, investors should resist the temptation to react impulsively to market movements while drawing on strategic investing lessons learned from past market crises.
