Back in 2022, our Investment Management team said that global equity markets would move sideways with volatility. Looking at the past 20 months, stubborn inflation has led to rate rises, and a weak post-Covid manufacturing downturn has led to quickly changing sentiment – creating exactly that environment.
Recently, of course, the financial markets have become extremely excited about a new trend emerging this year - the rise of AI has been met with excitement and talk of promise, which has translated into investor optimism, albeit in a very small number of companies.
This year to mid-August, we’ve seen Nvidia’s share price grow 221%, Meta 141%, Microsoft 35%. These companies are part of the so-called the Magnificent Seven, which also include Tesla, Amazon, Alphabet and Apple.
And when investors get excited about something – like the rise of AI – the market moves accordingly.
Source: 7IM/Bloomberg, data is 01/01/23 to 22/08/23, “The rest” refers to S&P 500 excluding Meta, Microsoft, Alphabet, Apple, Amazon, Tesla and Nvidia.
But some things look just a little too good to be true. For Nvidia, which sells chips for companies to be able to use AI, in order to sustain its price-to-sales ratio of 30 as of July this year it would have to hit revenues higher than those of Apple, Amazon and Google – all combined – for the next 10 years.
For reference, Nvidia’s price-to-earnings ratio in 2019 was around 7 – which is also pretty expensive.
There are two important points about this:
All things being equal, expensive businesses have a lower margin for growth than cheap businesses
We’re quite sceptical of businesses that are beneficiaries of a popular trend, given that trends come and go and they don’t inspire certainty.
The most interesting feature about these two points is that, intuitively, they lead us in different directions.
On the first point, businesses have to sell more to make more, and that becomes more difficult for expensive businesses. After all, the more expensive a business becomes — like Nvidia — the harder it is to make it grow. Intuitively, that is easy to accept.
On the second point, though, while it might seem intuitive to want to follow a growing trend, the story that trend tells might not always lead to a happy ending.
Over the past decades, it is common to find the leaders of an investment mania lose their dominance. As the graph below shows, that happened with the top 10 global oil majors of the 1980s, the Japanese financials in the 1990s, and those at the forefront of the 2000s internet bubble when it burst.
Source: MSCI. Darker shades indicate weight of 10 largest stocks at peak concentration (dates noted above); lighter shades indicate weight of the same 10 securities one decade later.
The chart shows plainly the winners of today’s bubble are not necessarily the winners over the medium or long term. We think a trend is often inflated with excitement and promise, and that is reflected in the valuation of companies whose names are associated with such trends.
This is just an example of why we’re anti-fashion, which is one of the principles that underpin our identity. What we mean by this is:
we tactically lean against prevailing trends when they are at extremes
we look for opportunities where others won’t go; in unfashionable areas, over unfashionably long time horizons
we don’t chase high-risk, expensive trends for short-term gains.
Anti-fashion portfolio positioning
There’s no need to dig too deep into our portfolios to find our anti-fashion approach.
In one recent portfolio change, we have replaced our position in Berkshire Hathaway with the US Equal Weight Index.
As of June, Apple made up 51% of Berkshire’s stock holdings; in tough times, the mega-cap tech companies are the first ones to get hit.
De-concentrating from the likes of Berkshire and increasing our position in the S&P 500 Equal Weight Index ensures we’re increasing diversification. At a time when economic indicators are pointing towards a recession, it is our conviction that having access to quality US names in this way is the right thing to do.
Source: 7IM/FactSet
That is what the chart above tells us: in tough times (think global financial crisis in 2008, or Covid in 2020), this index has been able to deliver the highest returns.
In a downturn, not all assets lose money.
Whatever direction the economy takes, people will always want access to healthcare.
Both public and private health investments are on the rise following demand for better quality of life, supported by the fact that life expectancy is increasing.
Healthcare spending is not cyclical, so earnings don’t necessarily follow the downwards trend in an economic downturn.
Demand for innovation in healthcare has enabled the sector to grow over past decades, as the following chart indicates. Healthcare companies are not affected by recessions, and that’s why we like them.
Source: 7IM/FactSet