Quarterly Insights: July 2024
The U.S. economy keeps growing even in the face of high interest rates. Consumers are spending, businesses are investing, and the labor market is strong. Though these conditions have shown signs of slowing, they’ve supported a white-hot stock market: the S&P 500 was up over 40% in the eighteen months trailing June 30th.
All eyes have been on artificial intelligence (AI), an investment theme that has split the market in two. Seemingly anything that can be tied to AI has raced to the front of the field, led by none other than chip designer Nvidia, which recently eclipsed $3 trillion in market value.
There are two instinctive ways to react to this market. The first is to chase what’s been working, a response we can appreciate as an investment in AI feels like a vote for the future. The other is to sit out the market altogether because of that familiar feeling that a bubble is brewing (or worse, that it might already be here) and that pain is coming.
We think the right approach is more nuanced than either of these options.
To begin, we caution against chasing the most eye-popping names. Shiny new objects have a way of creating unrealistic expectations. To be sure, we are excited for technologies that enable us to work smarter and that improve living standards; the dynamism of the American economy never ceases to amaze us. But there are early indications that AI investments may fail to increase business productivity. Some executives are finding that the benefits of AI remain elusive with fewer use cases than first believed, a notable setback being McDonalds’s decision to abandon their trial with AI at the drive-through window. These are still early days, so it’s hard to know what path the AI landscape takes from here. But we suspect it will be fraught with surprises. Who will be left standing when companies shift their attention from model experimentation to the mass deployment of AI engines, bringing hardware and operating costs into greater focus? What will happen as Nvidia’s most important customers – among them the most valuable companies in the world – continue to pour billions into developing their own chip solutions?
It feels like investors have been too quick to anoint the winners of the AI economy and that our robot future may be further away than many assume. Yet, even if one believes that the market has gotten ahead of itself, the temptation to exit the market can be dangerous. History tells us that sell-offs are incredibly difficult to time. As the adage goes, more money can be lost waiting for a correction than in the correction itself. Importantly, our internal diligence suggests that when excluding AI-related companies, the market looks far more reasonably priced in the context of historical valuations. Among the market’s laggards are fantastic businesses that have been overlooked for lack of gratuitous buzz in their marketing. These include healthcare companies that use data-centric tools to improve patient outcomes, and logistics companies with rich insights on how to move goods through the world’s increasingly complicated trade lanes. Worth noting is that many of these companies rely on the efforts of skilled, hard-to-replace workers who have gone underappreciated as investors dream up a future with sentient machines and human-less factories.
In today’s market, we recommend staying the course while being cautious. This means putting money behind companies with durable advantages and bright futures but being disciplined about the price you’re willing to pay. Winning businesses come in all shapes and sizes but they tend to have well-entrenched customer relationships (leading to resilient cash streams) and can succeed in most, if not all, environments. That is, against a difficult backdrop, while their competitors may fight to keep the lights on, the best companies tap strong capital positions to invest for the future. Later, these companies are rewarded when their investments bear fruit, lifting intrinsic values through a wonderful process called compounding. Today, our favorite holdings exist in overlooked areas of the market and can be uncovered by (1) paying attention to business fundamentals over stock price (remember, fluctuating prices often create false signals about a company’s prospects) and (2) having an understanding of industry cycles, which reveals instances in which company setbacks are only temporary and worth looking past.
Our recommendation to stay the course by no means implies that we know where the economy is headed. Certainly, cracks are beginning to show: pandemic-era savings have been spent down and there are swaths of the market where problems have been brewing (private equity and commercial real estate, to name a few, especially with how high borrowing costs are). Thankfully, successful investing doesn’t require a near-term crystal ball. If a recession does take hold, we should remind ourselves that they are a perfectly healthy part of the economic cycle. Amid calamity, long-term investors should look forward to emerging on the other side of the valley intact, provided they’ve sown seeds in the right places and have liquidity available to put money towards the right opportunities as they appear.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.
