Investing for better, not worse

When people marry in the UK, they traditionally vow to stay together: “For better, for worse, for richer, for poorer.” I thought of that vow recently when explaining our job to someone. 

We try to buy attractively priced companies that are getting better and to sell companies if they’re getting worse. I’m wedded to the process, not the stocks, so no pledges of fidelity there – we’re trying to help investors become richer, not poorer!  

It sounds an obvious investment tactic, but millions of investors don’t do this. Most passive investment funds have no concern at all about whether what they own is improving or deteriorating. Just one question drives what they buy and sell: how big is the company? 

If a company’s market capitalisation – the share price times the number of shares – is growing relatively, a passive fund will buy more. The rise of the tech giants and the AI boom have meant the biggest companies have been growing. And passive funds have added fuel to the momentum. 

If more people are shifting to passive investing – and they have been – then a virtuous cycle can build. The biggest companies get bought more heavily; their share prices rise; their market caps get bigger; and passive funds automatically buy more. 

So far, so good for passive investors. In the past five years, the top 10 stocks in the S&P 500 index have risen 380%, compared with 75% for the index¹.  

As a consequence of this golden period, more passive investor money is now in fewer stocks – and some of these are, in our view, on stretched valuations. The top 10 stocks in the S&P 500 have grown to represent 37.6% of the index². 

And that brings me to another important active investment point. We look for companies with an asymmetric risk profile – where the upside opportunity is significantly greater than the downside risk. That way, even if you’re only right half the time, you’re still likely to outperform over the long term. 

Valuations become important in this regard. A company may be getting neither better nor worse, but if its valuation has become stretched then the asymmetric risk balance tilts the wrong way. The opportunity for share price growth declines; the risk of a fall grows.  

So what happens if the tide turns on the mega-cap tech stocks that dominate the US index? What if the world suddenly decides these companies have got poorer and are overpriced? Does a virtuous circle turn into a cyclone – the perfect storm?

Mitigating the risks

It’s very possible. The net income growth for the Magnificent Seven – Alphabet, Amazon, Apple, Microsoft, Meta, Nvidia and Tesla – peaked at 57% at the end of 2023 but is expected to fall to under 20% during the third and fourth quarters of this year. The remaining S&P 500 stocks have seen their net income growth improve from negative territory in 2023 to estimates of 20% or more³. 

The AI investments that helped many of these big tech stocks to dominate the index means their cashflows are deteriorating. They are investing billions of dollars into research and development for a race in which there may be only one or two winners.

In June, Alphabet said it would sell $80bn worth of stock to fund its AI investments⁴. It also raised almost $32bn in February from a 100-year bond offering⁵. Alphabet and five other hyperscalers – Amazon, Meta, Microsoft, Oracle and SpaceX – are expected to spend around $800bn this year on AI⁶, building and running data centres, buying and financing AI startups.  

These companies are becoming capital-intensive. But are they using capital efficiently? What happens if they can’t monetise their AI output? We don’t believe in the ‘AI bubble’ narrative and we are bullish on the AI build out, but we don’t think all these players will be winners.  

As active investors, we don’t have to make bold binary decisions on these companies. We can dial down our holdings to mitigate risk and dial them up again if something makes us revisit our view. This approach has seen us run our winners and cut our losses effectively.

Applying this approach, our exposure to the Magnificent Seven cohort has changed considerably since 2023, following OpenAI’s release of ChatGPT, which ramped up investor interest in AI-related investing. We expect it to continue to change as we learn more about the spending plans and success of the investments.

We have been most bullish on Amazon, which has its AWS cloud business and is a big producer of CPUs (central processing units). We believe that leaves it well placed to win the AI arms race. That being said, we will continue to be active and dynamic in our exposure to these companies. 

Elsewhere, we were early to buy companies in the AI supply chain that benefit from this spending, such as Advanced Micro Devices (semiconductors) and Seagate Technology (storage). Some of these companies had a near-death experience after Covid but then suddenly found their supply-constrained products in high demand.

We are also revisiting oversold software companies where we’re seeing asymmetric risk – little downside left in the price but hefty upside potential as the market realises AI can actually benefit them. Increasingly, we’re looking at areas outside of AI that have taken a beating but are showing signs of recovery, such as healthcare. 

In other words, we’re looking for companies that are improving. We believe investing “for better, for richer” beats investing purely on size.