Positioning global portfolios for the next generation of opportunities - Angles & Perspectives Q2 2024

Positioning global portfolios for the next generation of opportunities

Investment opportunities and outcomes tend to be a function of fear and greed over the short to medium term. Over the past year, both global equity markets and sectors have diverged to such an extent that we are observing high levels of greed in some areas and extreme levels of fear in others.

Our 3M investment process leads us to embrace fear, as there is naturally less competition for assets when selectively investing into areas of which the market is fearful. There are higher odds of buying at a wide margin of safety, and there is the potential to realise outsized returns once these fears subside.

By contrast, areas of the market dominated by greed tend to be crowded with many participants and see reduced odds of finding mispriced securities.

We are observing high levels of greed and complacency in US and tech stocks
We are observing high levels of complacency in US stocks with the S&P 500 Index having returned 36% over the past 12 months to 30 September 2024 (vs a long-term average of ~11% p.a.), and trading at a price-to-earnings (PE) ratio of 30 times compared to its long-term average of 16 times. The CBOE Volatility Index (VIX, commonly known as the fear index) currently trades at historically low levels, after a brief spike in early August, and the US economy, while slowing, is expected to come in for a soft (or no) landing – i.e. avoiding a recession.

It is now well known that US stocks generally, and technology stocks in particular, have been the winners over the past decade. This outperformance has resulted in current global index concentration surpassing previous periods of exuberance, with the United States now accounting for nearly 70% of the MSCI World Index.

Furthermore, index concentration at a sector level has reached historically extreme levels, with the recent rally in AI-related stocks driving the Mag 7 (Magnificent 7 stocks including Microsoft, Nvidia, Apple, Amazon, Alphabet, Meta and Tesla) to account for over 30% of the S&P 500 Index.

At a global level, contrasting the weights of the energy and materials sectors with just the three largest companies of the Mag 7 yields interesting results.

Apple, Nvidia and Microsoft (let’s call them the Mag 3) made up 3% of the MSCI World Index 10 years ago. This has risen to 13% currently. Meanwhile, the combined energy and materials sectors account for 8% of the MSCI World Index, compared to 13% a decade ago.

Rising expectations of Nvidia
Nvidia is a great company and has been a key driver behind the market’s returns over the past several years. It has built a formidable moat in advanced graphics processing units (GPUs) and the company is a prime beneficiary of the move towards AI (artificial intelligence). Nvidia compounded its revenues by an impressive 27% per annum over the 7-year period from 2016 to 2023. Back in March 2023, Wall Street sell side analysts expected revenues to grow by 13% in the 2024 financial year (January year-end) followed by consistent 20% annual growth over the subsequent years. How it has blown away expectations since!

Instead of the expected US$31 billion in revenues, Nvidia recorded sales of $61 billion in the 2024 financial year, growing by a whopping 126% year over year, while estimates for subsequent years have risen sharply driving an expected revenue compound annual growth rate (CAGR) of 68% from 2023 to 2027. The latest revenue estimate of $216 billion in 2027 compares to the $54 billion estimate a mere 18 months ago. This fourfold increase compares to Nvidia’s share price rising sixfold over this period.

While we are open-minded to what may happen in the future, the fact that Nvidia is generating record-high margins, whilst being the prime beneficiary of training capital-intensive AI models, leaves the stock vulnerable should these rising expectations not be met.

It is important to take note that Nvidia’s revenues are its customers’ capex spend, and these customers will want to see a decent return on these large investments at some point.

Furthermore, as outlined in the article China: geopolitical risk and your portfolio, we believe that the market is strongly underestimating the importance of geopolitical risk when it comes to some of popular mega-cap shares listed in the US, and investors are not being appropriately compensated for the geopolitical risk they are taking on.

All in all, we would argue that investors, and especially those allocating funds towards passive strategies, are largely complacent when investing into US stocks.

Underestimating inflation risks
The four decades from the early 1980s to 2020 have been characterised by falling and low inflation and bond yields, with the period of secular stagnation post the Global Financial Crisis (GFC) being the most extreme. The pandemic-induced fiscal stimuli and supply chain bottlenecks, coupled with increased geological fractions, saw an end to this 40-year era of relative calm, which caused inflation rates to spike to levels not seen since the 1970s. While major economies’ rates of inflation have retreated towards central banks’ target levels recently, we are of the view that we are entering a new era of a more capital-scarce world with higher long-term interest rates and likely higher and more volatile inflation.

Factors such as governments’ embrace of fiscal spending, high and rising developed market debt levels making the current fiscal paths unsustainable (the US fiscal situation is particularly troubling), rising geopolitical competition and the historical underinvestment in the real economy, are just some of the dynamics behind this inflection.

Yet, when we consider the market’s pricing of expected inflation, it is back to pre-Covid levels. In other words, the market is once again pricing assets for a period of low and stable inflation and, as a result, is likely not appropriately positioned if higher and volatile inflation resurfaces.

While history may not repeat, it can rhyme, and as we saw in the 1970s, one would be foolhardy to ignore the prospect of a second wave of inflationary pressures. We saw a preview of what can happen to asset pricing in late 2021 and 2022, should this occur.

Fearful of international markets and commodities
In contrast to US markets, the past decade has been tougher on stocks in markets outside the US, such as the United Kingdom and Europe, and emerging markets such as China, South Africa and Brazil.

Unless one is an investor in the likes of Apple and Nvidia, where investors appear to ignore risks around China (read more in Kevin Cousins’s article), the Chinese equity markets, once the posterchild for emerging market growth, have become uninvestable to many. Potentially fortuitously, in the September Bank of America (BofA) Fund Manager Survey, published just days prior to China announcing monetary and fiscal easing measures, investors expressed extreme bearishness on the Chinese economy, which coincided with stocks trading at multi-year lows, before rallying sharply in late September.

Related to the bearish China theme, investors have become increasingly fearful of commodities (including energy and materials), and recent survey data suggests investors are positioned the most cautiously since 2017.

While it has not paid to own assets outside the US over the past decade, the decade from 2004 to 2014 tells a different story, when emerging markets significantly outperformed developed markets. This is a reminder that investors should keep an open mind when considering potential future outcomes.

Importantly today, global indices such as the MSCI World Index and the S&P 500 Index, in addition to many large actively managed funds, are largely positioned for historical conditions to persist.

Positioning our funds for the next generation of opportunities
To protect and grow capital in a changing environment, we are positioning our global portfolios in areas where people have become more fearful, catering for a multitude of potential future scenarios and away from areas where (potential) greed has gotten the upper hand.

• Off-benchmark exposures: Investors willing to search for opportunities outside of the large mega-cap stocks are spoilt for choice, with an abundance of opportunities available at low valuations and low expectations.
• International markets outside the US: Significant exposure to UK, European and Japanese markets, trading at multi-decade high valuation discounts to US stocks.
• Emerging markets: Compared to developed markets, many emerging markets are acting more maturely in relation to fiscal restraint and reform agendas. Our funds have large indirect (e.g. Anheuser-Busch, Prudential plc and commodity stocks) and direct exposures to emerging markets (China, Brazil and South Africa).
• Real assets (including materials and energy): The historical underinvestment in supply and under-representation in indices, coupled with a resource-intensive ‘energy transition’, support a highly constructive long-term outlook. Additionally, commodity stocks offer cheap inflation protection and high shareholder returns (dividends and buybacks), and mitigate against geopolitical events.
• Index protection via puts in PSG Global Flexible Sub-Fund: It is prudent to purchase insurance when the cost to do so is cheap, especially at a time when overall index levels and valuations appear elevated.
• Cash: Valuable dry powder, as equity markets can be inherently volatile.

To practically illustrate this, the PSG Global Equity Sub-Fund can be segmented into four broad buckets:

• 28% of the fund is positioned in long-term secular winners which have significant exposures (direct and indirect) to emerging markets including South Africa, China and Brazil. The market is currently underappreciating their medium- to long-term growth prospects resulting in attractive valuations.
• 30% is invested in mispriced value opportunities spanning areas such as European defence, global reinsurance, European telecoms, global capital goods, discount retail and real estate.
• One-third of the fund is exposed to companies operating in real asset industries, providing cheap inflation protection and diversified exposure to miners, energy producers (oil, coal, natural gas and uranium), energy services and shipping stocks (dry-bulk and tankers).
• 9% of the fund is exposed to precious metals companies including gold royalty, gold miners and platinum group metals (PGM) producers.

While these buckets have underperformed the index dominated by mega-caps and US growth stocks over the short term, the opportunity set in areas where the market is fearful are trading at bear market valuations, thus offering a wide margin of safety, and we are confident that value will be recognised. This differentiated positioning may play a crucial role in investors’ portfolios given current consensus views on risk and the exuberance currently seen in areas dominating global indices and most investors’ global holdings.