By Alison Savas, investment director at Antipodes Partners
Equity markets were fixated on the AI investment cycle during the first half of the year, with an almost singular focus on Nvidia. The chip giant alone accounted for almost a quarter of the MSCI ACWI’s near 12% jump in dollar terms. Add the other ‘Fab Five’ – Microsoft, Apple, Google, Amazon and Meta – and the six accounted for 50% of the MSCI ACWI’s H1 gains.
Even before the sharp sell-off we have witnessed in recent days, we were concerned about how the performance of this group was becoming inextricably linked, reinforcing market concentration and the narrowness of returns.
Beware Nvidia assumptions
Comparisons to the dotcom bubble abound, and while there are nuances between now and then – on most measures Nvidia’s valuation is not as stretched as Cisco and the like in 1999/2000 – parallels exist. For example, Cisco, a networking business, produces the plumbing for the Internet. In the dotcom era, Cisco was considered unassailable – barriers to entry were high, the Internet was expected to change our lives, and the company’s growth and profitability were forecast to get stronger. In retrospect, these arguments still hold true, but ultimately the extent of this non-linear change played out over a much longer period than expected.
Likewise, AI will change our lives in ways we cannot predict and today Nvidia’s GPUs are facilitating this change. But it is not correct to assume – or price – that Nvidia will, over the long term, maintain its monopoly status and a gross profit margin of over 70%. In a market-based economy, large profit pools come under attack. We would also argue that the range of outcomes in the early phase of a disruption cycle is wide and, arguably this is not reflected in Nvidia’s current market value.
Vast valuation differentials
The extent of re-rating in the ‘mega-cap quality’ cohort – mega-caps with a high degree of profitability – should not be overlooked. Mega-cap quality is priced at 2x the world P/E, which is extreme relative to this group’s own history and relative to other mega-caps and quality stocks. Further, the valuation differential between quality mega-caps and non-mega-caps is at dotcom era extremes.
While mega-cap quality includes an assortment of stocks such as Eli Lilly, Visa, Procter & Gamble, Hermes, Coca-Cola & Home Depot, the complex is dominated by semiconductors and software. This is a function of the acceleration in investment in software, which has been running above trend for several years. It is now the largest component of US private sector investment, and its growth has helped offset the slowdown in residential and non-residential investment. This outsized software capex cycle, along with strong US household consumption, has helped power the US economy.
Hard landing possibility
Data released over the recent quarter continues to suggest policy tightening lag in action and the US consumer is normalising. Covid-related excess savings are almost exhausted across all income cohorts, the fiscal impulse is weakening, the credit impulse is negative, retail sales continue to decelerate towards long-term trend growth rates, and the employment balance is returning to pre-Covid levels. The abundance of jobs relative to unemployed people is evaporating and any further decrease in job openings will have a more significant impact on unemployment and wage growth.
The Fed’s ability to achieve a soft landing is contingent upon core inflation falling fast enough to avoid the ‘higher for longer’ scenario. While services is dis-inflating, goods inflation is already at a 50-year low. Leading indicators such as US import prices and China PPI have been inflecting for many months, which suggests goods could re-inflate and arrest some – or all – of the disinflation in services. This is not appreciated by the market. Our view remains the equity market is over-pricing a soft landing, or dovish rate cuts, and under-pricing the probability of higher for longer and the risk this transitions to a hard landing, or recessionary rate cuts, via a credit event.
Beyond the hype
Today, investors are prepared to pay 26x earnings for quality stocks that are compounding earnings at 8.5% p.a. but only 10x for value stocks growing earnings c. 7% p.a. The quality cohort is growing its earnings faster than the value cohort, but is the growth differential sufficient enough to justify the very meaningful valuation premium? Opportunities are available at very attractive valuations for investors prepared to look beyond today’s main acts.
Healthcare remains a key cornerstone of our long book, anchored by Merck, where key therapies continue to deliver, and Sanofi, which has begun the process of unlocking the value in its leading consumer health business. In addition, portfolio holding Alnylam Pharmaceuticals reported a best-case scenario Phase 3 trial result, which saw the share price increase 60% during the second quarter.
