When reflecting on this quarter, we are pleased by the strong performance and the positive impact that it has on our clients’ portfolios. However, our optimism about the future is tempered by a heightened sense of caution. While the U.S. economy appears strong, we see that, beneath the surface, fragility could be growing. Some of our concerns include exhausted consumer excess savings, rising delinquency rates, normalizing job openings, and increasing fiscal overhang across developed markets.
Our “constructive but cautious” outlook will likely not come as a surprise to readers who have been following our commentaries in recent years. We continue to keep an eye on the Fed and the potential for politics to get in the way of effective monetary policy, and on the potential impacts of a narrow rally on systemic volatility. However, the constant for Verger is a continuous examination of our positioning, a strong conviction in our philosophy, and a focus on client outcomes.
Source: Bloomberg
It is quite clear that AI has been (and continues to be) a key driver of U.S. equity returns over the last few years. Per JP Morgan Asset Management, 41 AI related stocks have accounted for 75% of S&P 500 returns, 80% of earnings growth, and 90% of capital spending growth since ChatGPT launched in November 2022.
We have no doubt that AI will impact, perhaps in a profound way, the way we all work and live. Nevertheless, from an investing perspective, there are a few areas of potential concern. First, many of the large technology companies (e.g., Amazon, Google, Microsoft, Meta, and Oracle) have been long admired for their strong free cash flow and asset light business models. However, as noted in the graph below, an ever-increasing share of their cash flow is being allocated to (mostly AI related) capital expenditures – building data centers, buying specialized chips, and expanding infrastructure. A key question is whether this increased spending will lead to declining profit margins.
Source: Bloomberg, Apollo Chief Economist
Second, another potential risk involves AI companies extending credit or prepayments to chipmakers and equipment suppliers to help secure capacity. While securing a reliable supply of inputs vital for the development of AI technologies is (understandably) top priority for these companies, we wonder about the associated financial and operational risks of extending multi-year credit to manufacturers producing rapidly evolving technology (that, in turn, could become quickly obsolete). What’s more, this practice of extending credit has resulted in a variety of circular relationships among these companies, as demonstrated by the visual below. Given the size of these companies, their debt obligations, and their relationships to each other, the risks they are taking on could lead to broader risks for the economy and the markets.
Source: Bloomberg News Reporting
And we’re not the only investors taking note. For example, after Oracle’s stock jumped more than 20% following news of a major, multi-year contract with OpenAI, JP Morgan’s Michael Cembalest pointed out that Oracle, which already has a debt to equity ratio of approximately 500%, would need to take on increased borrowing to implement this deal. This promise of $60 billion a year from OpenAI is “an amount of money OpenAI doesn’t earn yet, to provide cloud computing facilities that Oracle hasn’t built yet, and which will require 4.5 GW of power (the equivalent of 2.25 Hoover Dams or four nuclear plants),” he said.
Once again, while we expect AI to have a notable impact on all our lives, we continue to be concerned that there are some potential risks in the space that are being overlooked, especially given the backdrop of U.S. equity valuations at or near all-time highs.
While our portfolio has exposures that will likely benefit from continued development of AI (e.g., U.S. large cap growth stocks, data centers), we also strongly believe that there are other compelling investment opportunities that can be additive to an overall portfolio, slightly off the beaten path, where valuations are much less demanding.
Last quarter we mentioned “non-large cap” U.S. stocks as an interesting opportunity within equities. This quarter, we’d like to highlight another equity segment – international small cap value stocks. As you can see from the chart below, this segment has been the top performing major equity style over the last five years.
We have had an allocation to non-U.S. small cap value stocks for a long time (well over five years) and have been pleased with its contribution to our overall results. Going forward, we continue to see the benefits of such an allocation, due primarily to: (1) much more attractive valuations compared to the U.S. market, and (2) a higher likelihood for our managers to outperform, due to less coverage of these markets by other investment managers and bank analysts.
Separately, more and more companies are facing pressure to restructure their debt, as the era of near-zero interest rates has faded and refinancing costs have risen sharply. Loans and bonds issued during the low-rate years are now maturing in a much higher-rate environment, meaning that rolling over or servicing this debt significantly increases interest expense – pressuring cash flows, profit margins, and, in some cases, solvency (as shown in the chart below). Our managers are finding opportunities to restructure over-levered, often private equity (PE) companies, where expected returns are attractive for lending at the senior part of a (restructured) balance sheet. And yes, these restructurings are now called “Liability Management Exercises (LMEs).” Doesn’t the term make things seem much more benign?
Finally, we see compelling return potential in other, less popular market segments such as closed end funds (attractive discounts) and biotech / pharma stocks (scientific advancements; favorable valuations; increased M&A as big pharma addresses patent cliffs). We will continue to search for opportunities in areas that may be overlooked by investors focusing primarily on AI and related technology.
As previously mentioned, we have high conviction in our long-term focused, disciplined approach, and feel we are well prepared to continue steering through any market environment. It is our (perhaps slightly contrarian) view that a commitment to discipline is just as important when markets are jubilant (as they are now) as when markets are experiencing extreme turbulence. Many market commentators are currently referring to markets as “priced to perfection,” or, in other words, embedding expectations of continued resilience. On first blush, this may sound like a good thing. But we know that the illusion of perfect resilience leaves little margin for error and leaves markets more vulnerable to surprises and bad news.
As always, we will continue to keep our eyes open to a wide range of potential market outcomes, while focusing on constructing a portfolio that can have upside participation when markets are performing well and downside protection during more challenging environments. This requires staying prepared for bouts of volatility, guarding against the behavioral pitfalls of complacency, and searching for investment opportunities off the beaten path. We strongly believe this is the best way to generate attractive long-term results for our non-profit investors over full market cycles.
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