Separating dreams from reality

From our office windows we have a wonderful view of the Scottish Highlands, at least on clear days. However, lately, we have been surrounded by grey mist and rain. To be honest, poor FTSE returns, recessionary GDP figures and “dreich” (Scottish for dull or gloomy) weather has led us to dream of sunnier parts of Europe.

Markets have behaved in a rather dreamlike manner, with the Nasdaq, S&P 500, TOPIX, cocoa, uranium, gold and Bitcoin all reaching all-time highs. This strange mix might suggest that speculation is rife. From an investor’s perspective, waves of innovation often pave the way for speculative conditions. But so far equity returns have largely been driven by earnings surprises.

To a large extent, this is due to the fact that FAANG stocks, along with Microsoft (NASDAQ: MSFT), have cash flow margins approaching 30%, whereas growth stocks hover around mid-teen cash flow margins, and the rest of the market sits below 6%. Incremental top line growth is driving significant operational leverage, leading to sizeable upgrades that almost explain the full extent of many share price moves.

The most graphic example of this is NVIDIA Corporation (NASDAQ: NVDA). Its 2025 forecast earnings estimate has gone up 5x, whereas its share price has “only” risen 3x since June 2023. This indicates a significant de-rating of NVIDIA’s shares.

The sustainability of top line growth will of course be important, and the development of AI Infrastructure is a potential bubble in the making. But in the meantime, AI stocks are not trading anywhere near the peaks seen in previous technology bubbles, like those observed in prior technology advancements (e.g. the mainframe, PC and Internet eras). The challenge lies in monitoring the pace of adoption and ensuring that those involved are generating economic value.

In the meantime, we are in the early stages of a boom in the development of AI Infrastructure, with little indication to date of market saturation. Over time this investment will result in the transformation of just about every industry. Naturally, identifying which industries and companies stand to benefit the most is a primary focus for us.

If AI is to have the effect that many are predicting, it will likely manifest in the earnings of a wide range of corporations and could theoretically offer outsized boosts to productivity, margins and profitability. This phenomenon is still confined to only a small number of companies, but the market is starting to identify second and third-tier winners in the AI space. This includes providers of electrical equipment, server cooling expertise and energy management, reflecting the scale of the energy requirements as AI and data centre expansion progresses.

CEOs of these companies, such as our own portfolio company Schneider Electric SE, are already highlighting an acceleration in top-line growth and expansion in their total addressable market. This has not gone unnoticed by investors. The strength displayed by industrials is unusual and certainly noteworthy.

Dreams have a place in the world. However, in stock markets, cashflows often serve as gravity when share prices display dream-like behaviour. We do not think we are in a bubble yet, but we could be on our way there.

Fortunately, our Future Quality philosophy, coupled with our consistent process of reviewing the portfolio and ranking stocks, will help us separate dreams from reality. As a result, the portfolio is performing well, especially due to stock selection outside of AI and across all sectors. This includes specialty Financials such as Palomar Holdings, Progressive Corporation and Ryan Specialty Holdings, as well as Healthcare stocks such as Encompass Health, Cencora and Masimo Corporation. Each of these companies have delivered robust results and strong performance in the first quarter.

The Global Equity team will continue to focus solely on one thing — Future Quality — that is, companies with robust balance sheets, proven management teams and the ability to grow returns. We believe that stock picking remains key in today’s market. The divergence within the “Magnificent 7”, driven by underlying cashflow returns, in our view demonstrates the importance of investing in Future Quality companies. We remain convinced that this approach will deliver above-market returns for our clients.

The Yarra Global Share Fund is substantially invested in the Nikko AM Global Equity Fund, a sub-fund of the Nikko AM Global Umbrella Fund, managed by the Global Equity Team of Nikko Asset Management Europe.

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