Bottom-up builds better portfolios for your clients
A balanced, diversified multi-asset portfolio is one of the best protections your clients can have against economic and political upheaval. In fact, those who diversify sensibly across bonds, cash and equities, both locally and offshore, will not have batted an eye as the South African ruling party crashed to 40% support, or the immediate past-President of the United States (US) was convicted on all 34 counts in the so-called hush money trial.
Building a portfolio from the bottom-up
Absolute returns, diversification and the outlook for selected offshore equities were among the topics introduced during a recent presentation to the Allan Gray Investor Conference. Rob Perrone, an investment counsellor at Orbis Investments, reminded the audience of the merits in building a portfolio from the bottom up. He argued for selecting those bond and equities that showed the most promise rather than simply adhering to a central asset allocation decree. “We are bottom-up investors,” he said. “Our focus is on which individual stocks and bonds are most attractive globally, and how can we combine those to build something better for our clients”.
Perrone used his 20-minte slot at the client-facing event to explain the value-focused portfolio manager’s ‘big picture’ financial markets view. “I will show you how an understanding of individual companies can feed into big picture views,” he said, proposing to talk about opportunities in energy transition and semiconductors in the context of global debt, deficits and inflation. But first, Perrone observed that world stock markets were, in aggregate, fairly expensive. “The US has dragged world markets higher, pushing aggregate valuations,” he said. And the reason: “About 40% of the US market is in technology related sectors”.
Artificial intelligence (AI) is the standout story of late 2023 and early 2024. According to Perrone, the financial media thinks of the AI boom in terms of two shares, Nvidia on the chip side and Microsoft on the services side. “AI is going to change the world,” they scream. “And these two companies are going to grow to infinity”. Yes, AI is a big deal, and shares exposed to this technology have the potential to grow. But there are certain subtexts that investors must accommodate. For example, Nvidia’s revenues are closely correlated to Microsoft’s expenses. The interplay between chip designers and AI service providers was intriguing.
Nvidia needs Google, Meta and Microsoft to spend big
The portfolio manager illustrated how the aggregate capital investment for Google, Meta and Microsoft represented about half of Nvidia’s total sales. Putting Wall Street consensus estimates on future chip demand, Perrone offered one of two future scenarios: “Either Nvidia will struggle to grow as quickly as the market expects it to, or we should expect higher costs for the other tech giants; this calls for tempering expectations for the returns of these shares,” he said. Fortunately, there are other ways to gain exposure to the AI trend.
One possibility is to shift attention from Nvidia, which does not actually manufacture chips, to Taiwan Semiconductor (TSMC). The argument here is that if Nvidia grows, so does TSMC; but you do not have to pay nearly as much in terms of the price-to-earnings valuation to get exposure to the latter. Another possibility is to find another critical component in the AI field. “AI processors are much more memory intensive than conventional processors are, which is likely to be a big tailwind for memory makers like Micron or Samsung,” Perrone said.
It turns out once you strip the world into US and ex-US, you find plenty of reasonable value opportunities in places like Europe, Japan, Korea and the United Kingdom (UK). As Perrone explained, Nvidia was “way, way more expensive” than the trend-linked companies in the Orbis value-focused portfolios. “If you are active and you follow a bottom up process you can participate in these big growth trends without paying over the odds to participate,” he said. “This is a much more rewarding approach”. He then shifted focus to how the energy transition and AI-related investments overlapped.
A tale of nuclear-powered data centres
What followed as another fascinating narrative that included how Amazon was setting up a data centre alongside a nuclear plant because of the vast amounts of energy needed to power AI-backed data solutions. Need more convincing? How about the fact that none other than Meta CEO, Mark Zuckerberg is on record saying that energy rather than chips or data storage will be the limiting factor in the global rollout of AI. “What excites us are the boring bits of the electricity grid that are no less essential to allow increased demand growth,” Perrone said.
Gas-fired peaking plants, grid-level energy storage and transmission infrastructure are thus seen as non-negotiable components of the global transition to cleaner energy. Orbis backs the likes of AES and Siemens to get exposure to battery storage farms, and DRAX for its pumped hydro storage electricity price arbitrage capabilities. These companies are listed on the New York, Frankfurt and London stock exchanges respectively. And finally, a Milan-listed cable manufacturer called Prysmian Group.
“If we are moving from a system of compact plants located close to the demand, to vastly dispersed plants located far away from demand, it seems obvious that we are going to need more cables, including the high voltage undersea cables made by Prysmian, which we hold in the funds,” Perrone explained. As an aside, the company boasts a full order book, having secured sales for eight years of manufacturing output. Energy demand will also be driven by the ongoing shift to electric vehicles and attempts to make energy intensive chemical processes, such as cement manufacturing, greener.
Old-fashioned is where the money is
Restated with a value investor skew, you get: “We are going to have much more power, travelling much greater distances in many more directions, with much more intermittency; all of that points to greater demand for good old fashioned cables and substation equipment”. The important investment methodology explainer is that your portfolio manager should not simply plough into the market on the basis that the energy transition is a big theme, but rather on a bottom up assessment of the price and prospects of selected global companies. For another curveball, the presentation dipped into the current deglobalisation trend, also called nearshoring.
Governments are not only ploughing billions into the green energy transition they are also cottoning on that they need a secure supply of AI chips. “Governments from Japan to Germany to the US are paying chip companies billions of dollars to build factories on home soil, not because they think it is going to be cheaper, but because they do not trust foreign supply chains anymore,” Perrone said. He used this to segue into a discussion on US debt-to-GDP rising to as much as 150% over the coming years. As debt servicing costs mount, US inflation is likely to peg at 3% or higher over the longer-term.
The bond to equity correlation ‘chestnut’
One of the big concerns is that bond and equity returns could correlate, as they did in the 1980s and early 1990s, posing significant challenges for multi-asset managers that hold the bulk of their portfolios in these two asset classes. The closing refrains was that an active, bottom-up methodology would help asset managers through the pinch. “Over the long term, we think our bottom-up security selection will drive our performance,” concluded Perrone. “Over the next decade we expect a much more rewarding environment for the strategy”.
Writer’s thoughts: The fascinating thing about value methodology presentations is that the fund managers always make a compelling case for the companies they own; but the historic performances often disappoint. Do you still push value focused funds on your clients, or do you prefer going all in on growth or momentum? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
