Mid-Year Review – AI, Banks, & More
We look back at the first half of 2023 and examine the AI craze, the stability of banks, and the strength of Chevron and JP Morgan.
- There is a recession obsession. It is tough being a Wall Street Strategist right now. It’s best to turn off the noise and invest with humility.
- We are in the excitement phase of AI. However, there is a bit of a hype cycle going on now.
- Markets are going through a major rotation – moving swiftly into what is working in the short term.
- Slow & steady can win the race in certain areas of the market.
To learn more about the strategy and performance mentioned in this episode, please click below:
Hi everyone, this is your host, Kyle Helton. Before we get started on today’s show, I just want to send a quick reminder to please hit the subscribe button to stay current on our show. When we first came up with the idea, we anticipated that it would be a limited series touching on a few timely topics, reaching a handful of our biggest clients, and then quietly fade away.
However, over the course of a year and a half, we’ve received a ton of positive feedback and have been humbled by the growing support from our listeners. Thank you to everyone who has tuned in and I’m looking forward to bringing you more engaging conversations and timely investment topics. Without further ado, let’s get to the show.
I’m having fun with this. I mean, you can almost see the plays developing in sports type of analogies before the shots are available, before the receiver is wide open. You can see it coming, and it’s really fun when it feels like that as a portfolio manager.
Hello, and welcome to the latest episode of the QPD Podcast. In the blink of an eye, we are nearing the midway point in an already busy year. From the collapse of a few regional banks, inflation and interest rate uncertainties, recessionary fears to major market indices touching yearly highs off the recent AI craze, and everything in between, I felt it was a good time to bring back Cambiar president and chief investment officer, Brian Barish, to make some sense of what’s going on in the markets. Brian, welcome back to the show.
Thank you Kyle.
To get things started, how would you describe the first half of 2023?
Well, it’s been a recession obsession. It has been the overarching narrative and within the stock market itself, it’s been highly rotational, is how I would describe it. I would also say that I have never seen Wall Street strategists look this bad in my entire career. They’re all out there trying to make big, bold predictions. I just don’t know how you can do that. So, my keyword is humility for all of 2023, really. There are so many non-linear economic trends and forces at play and that have been impacting the economy and business results for basically the last three years, starting obviously with the pandemic, that I don’t know how you make big, bold predictions out of this.
Most economic models assume linear trends that you can extrapolate and create equations about, and that’s just not possible with what’s transpired over the past three years. So, that’s what it’s been like up to now. Turn the soothsayers off, they are not helping you.
You mentioned rotations. There’s been some rotations in and out of certain sectors. A lot of healthcare names have stumbled early this year, while tech has led returns, albeit from a relatively narrow group. Any thoughts around these rotations?
Year to date, it’s been a very narrow stock market. You’ve had 10 big stocks that have basically been almost all the return in the S&P 500, for instance. Most of those are FAANGs and digital platform, big tech businesses. They did get killed last year. They’re still, in most cases, well below the highs that they reached in 2021. There’s been a rotation back into them at this point. So why have there been these violent rotations? I don’t have a great answer for you.
The market does know in its own weird way that we have all these non-linear drivers in the economy and the financial system and it’s hard to have a lot of conviction in any conclusion. So, investors are consequently just rotating through sectors and piling into what’s been working lately. We saw that in late 2022 with energy and healthcare outperforming.
Ironically, one of those is cyclical and one of those is not cyclical, and this year, they’re lagging very substantially. Another subtext that I wanted to expand on a little bit is something that we call it at Cambiar the Shallow Market Hypothesis. So, this is the title of a paper we published about four years ago. This was before the pandemic, so back in the Jurassic era, essentially. The Shallow Market Hypothesis basically says that with passive and quantitative strategies holding more than half of all stock market cap, there is correspondingly very little money that is actually engaged in price discovery on a daily basis.
So, the market and individual stocks are vulnerable to out-sized moves and price dislocation on seemingly very little information, or in some cases, no information. There’s a big irony in this, which is we’re in the information age, and I’m saying that stocks contain less information than they did 20 or 30 years ago, if you follow this logic. So, we have to treat the efficient-market hypothesis with more suspicion than before because the information embedded in prices is either reduced or of lesser quality given the market structure.
So, with the Shallow Market Hypothesis as a backdrop, this year’s big swings in favor of big tech and internet names is probably mostly sourced from money coming out of wherever it was over-concentrated last year. So, does that mean that we have good information contained in the price signals that these are giving us today in 2023? Was that information in 2022 good, or was it bad given that these stocks are underperforming now?
I can’t tell you in any convincing fashion that I have an answer to any of that. I don’t know. It’s entirely possible we’re just seeing momentum swings, they don’t really mean a lot and it’s just basically money sloshing around and chasing whatever thesis sounds good at the moment. So thankfully, we’re not momentum investors. We tend to rotate a little bit against the grain, and it’s certainly working for us in 2023 in a lot of strategies.
I was noticing this morning that the S&P 500 was up give or take 13%. The Equal Weight S&P was up give or take 4% over the last week. However, the Equal Weight S&P has slightly outperformed the cap-weighted index. Do we see a broadening of returns in the marketplace moving forward this year or should we expect a more narrow market in general?
I don’t know if it can get any more narrow than it’s already been. It’s hit various historical extremes, so I would think some broadening out is feasible. It was in the Financial Press a few weeks ago, the market cap of Apple now exceeded the entire market cap of the United Kingdom, and the UK is a big stock market outside the US, a lot of multinational businesses. It’s incredible. If you just have a lessening of interest in these FAANG and related type of companies, it likely follows that you’ll have a broadening out, I think, of breadth in returns.
Sure. So with that being said, what are your thoughts on the recent craze around AI? Is this another hype cycle? Is this a long-term value creator?
Well, I got a lot of thoughts on it. The short answer is yes, this does sound like a hype cycle, but I do find it interesting, Kyle. We’ve all had AI in our lives up to now. This isn’t new. If you have spell checker on your Word app, that’s a form of AI, and so are targeted ads on the internet.
What we’re talking about now is AI that seems more human and it can respond to natural language inputs and give natural language outputs. That’s basically what ChatGPT is, and that’s got people very excited, because they haven’t seen that before and they’re lunging at the obvious stuff. So, that’s high-end chips, you’re going to need those. There’s some business software that could probably add some AI modules and get some improved pricing for that. It does seem like there would be some clerical type of tasks that can be automated with AI, but that’s not new.
We’ve been automating away back office tasks for decades. There’s also a lot of AI things that people have been excited about for at this point, quite a number of years, like autonomous driving, that we’re still waiting on this. The AI, it needs to be supremely reliable and supremely human-like to actually be implemented in something like autonomous driving. So far, it’s still not up to the task. So, I’m going to go on a little tangent, if you’ll bear with me.
This is fun stuff. So my educational background is I studied philosophy and economics. I was a double major in that. The philosophy side of things, it’s scarcely relevant to finance. It’s just entertaining stuff that occasionally, I can tap into. As it happens, AI and what constitutes thinking and what does it mean to be a human being, that gets a lot of attention in 20th and 21st Century philosophy.
There’s philosophical courses devoted to this these days. One of the big differences between a human being and a computer is that humans have intentions and they make decisions based on those intentions. These intentions, they reside in a human physical and emotional landscape. So, I intend to drive to the store and buy food for dinner. I intend to take the shortest route.
I intend to pick up my kid on the way back from the store. A computer doesn’t really care the way a human would about any of these concepts. It has no ability to relate to them. So it can’t have plans as intentions. It could only do what you tell it to do, basically. So, here’s the interesting question. Can ChatGPT or some future version of this, could they possibly have intentions the way a human would?
So I’m going to say I don’t know, because I really don’t. I’m not trying to be falsely humble here. I watched a very interesting movie, just happened to watch it a couple of weeks ago, called Her, I don’t know if you’ve ever seen it, it’s with Joaquin Phoenix. It was out 10 years ago, but it’s remarkably prescient, so if you did not ever see this movie, basically he gets an operating system computer that has AI.
It sounds like a woman, has a very interesting personality, and he falls in love with it and it falls in love with him. They have this romance that’s entirely non-physical, and it goes on and on. At some point, he actually gets dumped by his operating system and it turns out that she’s having some relations with thousands of other operating systems, and is in love with 173 of them, which is a really interesting take on what a human experience would be for a computer that can obviously work much faster than a human being can and is not bound by the physical realm.
So, I think the irony here is that operating system seemed to have human-like intentions and emotions until it didn’t at all. Just an interesting food for thought about all this. So, let’s get back to investing. My job as a value investor, particularly as a relative value investor where I’m not as conservatively bound by things, is to fade the hype but also look where you might have companies that provide key components where you’re not paying a lot for an opportunity. Right now as I see it, yes, we are going to need more chips, semi-cap equipment, that remains relevant. Business software, that’s also relevant and you’re not really paying for the hype. So, we like those right now.
Where are you currently finding opportunities for our large cap value portfolio? So far you’ve added value year to date via security selection and financials, industrials in which we have a pretty material overweight relative to the index, as well as consumer discretionary.
Sure. Well, let’s start with banks at a high level. So when you’re looking at stocks, it’s useful to have a base case and then you have an upside case and a downside case. Your upside case and your downside case, they could involve what they call tail risks. Left tail risks being things just go even worse than you could’ve possibly imagined. Right tail risks being things go better than you could possibly imagine.
Well, banks are unusual businesses that there’s no such thing as a right tail. Can you imagine a bank saying, “Hey, guys, guess what? Our customers are so happy with the loans that we gave them that they’re going to pay us back 120% of what they owe us.” That’s never going to happen. All you have are left tail risks of, “Guess what? We underwrote some really bad credit. We lent some money to some office tower projects that look like they’re going to need to be meaningfully recapitalized.” Things like that.
So, that’s one of the reasons why we’ve stayed very bashful in the banks, but there is actually one bank out of all of them that has right tail risk, and that’s JP Morgan, just because there’s so ridiculously well-capitalized, that wound up being exactly what happened. They bought First Republic for nothing, and their losses are going to be substantially subsidized by the government and it’s all going to work out.
Now at the end of the day, the amount of earnings per share that JP Morgan can add from First Republic is quite small, because JP Morgan was already fairly enormous. But it’s just a remarkable feat of positioning.
Index investing has been so popular for so long, people have forgotten some of the positive points of active investing. One of the positive points is abstention. You don’t own by definition everything in an actively managed portfolio. We have not owned a lot of banks. We had our own reasons for not owning them. We just felt like the risk/reward wasn’t particularly favorable with higher rates and credit risks likely to manifest over the course of 2023.
We certainly didn’t imagine what happened with Silicon Valley Bank and First Republic Bank blowing up on interest rate risk mismanagement, but it just shows you there’s ways to add value through abstention. The way I’m looking at it right now is we are in a low conviction rotational market and there are pockets of overvaluation that are a direct consequence of capital costs being near zero for over a decade prior to last year that will deflate and continue to deflate as this process keeps going.
So, we want to avoid getting smoked by those. I think what’s happened to the banks is somewhat a consequence of that, but also take advantage of opportunities. So, two of the out-performers from last year, healthcare and energy, they’ve been big under-performers year to date, and we’ve taken an opportunity to add names in both of those areas. Healthcare as a sector, people think of it as defensive. You need to actually sit at a portfolio manager’s chair and live this for a while to realize it is nowhere near as defensive as you might suppose.
It’s true, it’s not correlated with the economy. That part’s true, but whether it’s hospital stocks, drug stocks, distributors, healthcare insurers, they all have really idiosyncratic drivers that can easily hurt you when you’re not expecting it. So, be that as it may, valuations have come down, I think it’s just this rotational market.
I don’t think it’s a lot more complicated than that. That’s created some opportunity. There was a narrative around healthcare spending by the government going into this debt ceiling business that has all concluded now, that really didn’t materialize into much of anything. Energy is a very fascinating narrative that we could probably spend 45 minutes on. Our house view is that the green transition, yes, we’re trying. There’s lots of money being spent on that, but it’s going to be very difficult to migrate away from hydrocarbons in the visible future. Meanwhile, we’re not investing a lot upstream especially.
So, it’s creating a market that leans tight. It’s creating a market that OPEC can easily influence and they’re clearly trying to do just that. That’s interesting to us. There’s lots of other examples of some fairly old industries, whether it’s railroads, lumber, those are just two that popped to my head immediately where you have capacity constraints for other reasons and you’ve had very favorable investor returns as a result. So that’s an area that we’re looking at closely.
You mentioned a couple areas where we’ve found opportunity Energy, where you added Chevron and Synovus in Q1. Are there any nuggets about any or all of those businesses that you would care to share for our listeners?
We bought Chevron in the first quarter very recently. We bought Conoco. Those are two energy companies that I would say also have right tail risks when the rest of the market has left tail risks. So in energy, it’s a long story, but there’s been a bad history of capital stewardship and corporate governance, particularly among producers. They’ve chased growth without regard to cash returns for investors. It’s been disastrous. A lot of that has changed, but it’s hard to imagine it’s been completely exorcized from the space.
Now, ironically, when the chips are down, these better capitalized oil producers that operate in multiple regions, they have A, AA, or even better balance sheets, they’re able to buy producible reserves, outright reserves that are in production or some combination thereof at deep, deep discounts. So as it happens, we bought Chevron in the first quarter. The second quarter they bought a company called PDC, which is based not far away from us here in Denver.
They produce in an area called the Denver Julesburg Basin, which is one of two growing basins in the US. The other being the Permian. The rest are all in decline already. Conoco, likewise, is about to obtain some assets in Canada, which we happen to Canada as a producing region just because there’s very long duration assets.
We’re trying to find areas of the market where even if the economy is worse than I have suggested I think it’s going to be, we might wind up benefiting notwithstanding. I don’t want to get too high on that as a thought, but if you can do that, it certainly helps at the margin.
Yeah. So based on your comments about both Chevron and JP Morgan, are we witnessing a shift from a run for growth to a run to stability?
Possibly. That’s possible. I’ll share another anecdote with you, Kyle. So I was an emerging markets bank analyst back in the 1990s, and when I became an emerging market bank analyst, I was drafted to do this. It wasn’t something I really knew a lot about or was necessarily very interested in, but the company I was with at the time, they had a lot of investment banking business with banks in Latin America primarily and also in the Middle East that were looking to raise capital.
They got a 25-year-old Brian Barish to go in there and figure out the financials. So they sat me down with a domestic US banking analyst who was a grizzled veteran. He walked me through how to build my models and everything. At one point, we had this banking client that was growing very fast. They had more capital, and this fellow who was my mentor essentially in this space was saying to me, “Brian, I’ve been doing this for a long time. When banks grow rapidly like this, it’s almost always catastrophic. It’s just really bad. It’s because they’re accumulating risks faster than they can really process them, mitigate them,” et cetera.
I’ve always remembered that. If you look today at what happened in 2023 with both First Republic and Silicon Valley, that is a completely appropriate conclusion. They grew too damn fast. They accumulated risks faster than they could really handle them, and it blew them up. You see similar things in other industries. I just talked about that with the oil and gas industry, slow and steady wins the race in certain industries. In tech, no, not necessarily.
You want to get out there, get ahead of everybody else and develop a chip or a type of code or an app or whatever that gets ubiquitous as fast as possible. But that’s the wrong analogy for other kinds of businesses that reside more in the physical economy. So it’s just something to keep in mind. The growth investor mentality may be just flat out wrong for certain industries because of the way those industries work.
Maybe shifting gears from the portfolio manager hat that you wear to being the business steward that you are, we’re celebrating our 50th birthday coming up in the fall. Can you talk a little bit about what this milestone means to you?
It means a lot. Asset management companies don’t last for any particular length of time, and a lot of them don’t last very long at all. So, longevity does mean something. My proudest accomplishment is not a specific moment in time. It’s really the achievement of a strong and very positive company culture. I’ve always felt that there was a reason why Cambiar endured. There’s a reason why Cambiar had a lot of really loyal employees who cared about this place, and it was that culture.
So, that’s really my proudest thing. There’s certainly some moments that stick out. Getting our firm bought back, we were owned by a different corporate entity back in 2001, was huge. Seeing certain products get to scale that were brand new, they were incepted since I became president of the company, that also was a very big accomplishment. But I still think our proudest moment is out in the future. I’m not sure what that means it will be, but I think it’s out in the future.
If you could hop in the DeLorean with Doc Brown and go back to the day that you took the firm over, what would be a piece of advice that you would tell the younger version?
I got a few pieces of advice. It’s not one, I think one is to be decisive. That’s always important. Trust your instincts when it’s clear that you have a strong conclusion that is not emotionally driven. I think have a very clear inclusion and exclusion criteria. I wish I had understood the value of that 20 plus years ago, it would’ve saved me a lot of aggravation over the years.
From a people point of view, you want people that believe in the totality of what we’re doing and understand mentally and philosophically what we’re doing and make sure you bet on those type of folks. That’s the advice I’d give myself.
How about a piece of advice for younger investors? I mean, we have an entire generation of people, for instance, who’ve never seen rising rates. Is there any advice that you’d offer them?
Oh, I’d offer them a lot. Sure. Read a lot, learn accounting. There’s a lot you can learn just from trying to understand a handful of stocks, some that are in new industries, but that are in old industries. You can learn a lot about stocks that are far removed from those, just by understanding how a modest number of stocks work. Develop a framework for investing. Have a way that you go about this. Don’t just be snookered in by something that sounds cool in the moment.
That’s the wrong way to approach this. Make unemotional decisions, do your research, and then once you make a decision to commit capital, write down, and it could be just bullet points, why you’re doing what you’re doing and what you’re anticipating will happen. Whether your stock works favorably or poorly, write down what happened. Was your expected narrative total garbage, or actually pretty solid? You do learn a lot. It’s very easy to have selective memories in this business, and writing things down is a good way to prevent that.
Thank you. Brian, you’ve shared a ton of wonderful insight. I know our listeners are going to find a lot of value out of this conversation, so I appreciate your time today and look forward to chatting with you later this year.
Thank you, Kyle.
Thanks again to everyone who’s tuned into the show. I’m your host, Kyle Helton. Until next time, take care.
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