At GAM Investments’ latest Active Thinking forum, Mark Hawtin highlights some of the key triggers that could swing the pendulum in favour of growth stocks. He also considers the significance of ChatGPT and the geopolitical situation in China.
During 2022, there was a share price devaluation of companies in line with their estimated sensitivity to interest rates; the higher duration the business, the harder the share price was hit. Some disruptive growth businesses that we think have strong futures, but are still unprofitable, saw their share prices fall markedly.
In addition, there has been significant uncertainty about where inflation will peak and the future path of interest rates. This type of environment is always the scourge of growth investing. In the first quarter of this year, the S&P 500 Index returned 4%; flight to safety led mega caps to generate all of that return. The MSCI World Growth Index experienced a similar situation, as the top seven companies in the index contributed two thirds of the performance.
The performance of the Russell 2000 Index, a small-cap index and a proxy for more growth-oriented companies, rose only 2% in Q1 2023 reflecting the duration issue. At the same time, the Philadelphia Semiconductor Index, a source of cash generative and, in many cases, incumbent businesses, performed much better. We have seen a dichotomy emerge between businesses perceived to be safe versus those perceived as risky judged only, by the market, in terms of the proximity of cash flow generation. The Goldman Sachs (GS) unprofitable technology basket peaked at the beginning of 2021 at a valuation of about 12 times. It looked to have bottomed in the second half of 2022, but in Q1 2023, it lurched down falling to levels not seen since the 2015/16 duration press. The 80% plus decline in valuation for what GS defines as unprofitable tech leaves it trading on 1.7 times revenue. This suggests that the market believes that these companies are in trouble structurally, something we disagree with. This is not 1999/2000, when businesses had no revenue and were fighting for survival. Today, these businesses, in most cases, have significant amounts of cash to fund themselves and generate significant revenues. They tend to invest cash or surplus cash into growing the business faster or further to retain competitive positioning and hence a lack of profitability is deliberate and planned. Some businesses may re-evaluate and start to focus more on balancing revenue growth with profitability given market perception. As we have seen from some of the larger cap companies, the ability to cut costs to compensate for softness in revenue is substantial. We are in a cycle we have never seen before in this part of the market. Many of the mega caps and those in the unprofitable segment have never experienced an interest rate cycle or more importantly, a softening of the economy.
Valuations are key in the way we invest and so the compelling levels reached lead to a pool of excellent disruptive businesses selling on very attractive valuations, in my view. While the consensus is that rates will remain higher for longer, I believe the Federal Reserve (Fed) will move in the opposite direction more quickly than expected. If that were to happen, the pendulum would likely swing the other way in terms of growth versus quality. Timing is always key and when the markets turn, they do so very rapidly. We saw this in 2008/9 when investors started to increase risk again, some of these companies went up 50-80% in very short order.
There are two triggers that we believe will mark a turning point for unprofitable tech. One is when the technical picture starts to bottom out. The other, in terms of fundamentals, is seeing companies deliver in spite of the economic backdrop. The thesis is that truly disruptive companies grow through downturns. For example, Amazon and Salesforce saw their share prices plummet in the last downturn, but their businesses barely missed a heartbeat. The market was probably too irrational on the upside two years ago but now it has become very irrational on the downside and is very macro driven. We need strong and clear proof that these businesses can grow through the downturn, which we will hopefully get with each quarter. We also need the macro decision to start to move back in favour of these assets, whether it be because they have underperformed so significantly or because there is a general view in the market that one can be more risk positive and less risk averse.
Chinese equities were down in 2021 and 2022 and despite starting the year reasonably well, they have now turned negative for 2023. Some Chinese equities look very attractive but currently a lot of investors’ decision making is macro driven, with geopolitical risk dominating fundamentals.
We believe the geopolitical axis is driven by a fear of competitive positioning in artificial intelligence (AI). There is a huge fear in the Western world that China has an AI lead and the West must catch up. Traditionally China has always been a fast follower but for the first time, because of the size of its data set, it is potentially a leader. We think this is the reason the US in particular is pressing so hard on the supply chain into China and why we are seeing a move towards the deglobalisation of manufacturing which, in itself, is an interesting thematic opportunity. This generational shift is going to drive big changes to the way business is done globally, in our view.
ChatGPT has reached a key tipping point – it can do more and in real time. As Moore’s Law has worked its magic, we have reached the tipping point where progress is dramatic. For example, AI can handle customer inquiries in real time, which it would not have been able to do relatively recently. ChatGPT is also powerful in that we are starting to see applications written on top of it that can project manage by handing out tasks to other applications within the ChatGPT universe. We have rapidly progressed from ChatGPT 3.5 to ChatGPT 4. The vast data set and amount of information available to the new iteration is billions of times more than the previous iteration; GPT 4 is using 80% of all stored data available in the world. As we move to GPT 5, we are going to need more data. Only 2% of data generated is stored in the world at the moment. We are going to start storing and using more data because it is economically valuable if it can be crunched fast enough. There are a number of related companies that will be benefit from this trend. For example, we believe we will see growth in cloud infrastructure generally. Another important aspect is to identify the companies in particular sectors that choose to adopt it versus those that do not.
Silicon Valley Bank
In terms of the impact of the collapse of Silicon Valley Bank (SVB), it has become harder for new companies to get funding at the bottom end of the venture capital world. SVB was known for having fairly low lending standards and it was a keen supporter of disruptive businesses. There is still plenty of money in venture capital for backing the right businesses. However, we expect there will be a tightening in lending standards more broadly that will restrict access to capital for many newer companies.
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