Riding the Wave of the Few – Mid Year 2024 Review
In his 2024 mid year recap interview, Cambiar President Brian Barish sits down to discuss a wide range of topics that have dominated the early parts of 2024. Brian offers insights on the recent A.I. and GLP-1 craze, healthcare challenges, and more.
Brian, looking back on the first half of 2024, obviously, tech has dominated. The market’s being carried by Nvidia and things like that. What are your thoughts on what we just witnessed?
In terms of the overall market, it’s very narrow and it’s gotten super narrow in the second quarter of 2024 with AI-related businesses and maybe the GLP-1 stocks really dwarfing the returns.
Within the S&P 500, the S&P 490 are doing very badly. It’s the top ten names in the S&P 500 that are dominating returns.
Breadth is not great. I don’t know if that is a signal of pending trouble or alternatively that there is a bit of mania going on in AI. It’s clearly very specific to a small number of names.
I would say that I have started to become a bit uncomfortable because it looks like investors are just lunging at AI without much knowledge or understanding of what this might look like. They just say, “Oh wow, this could be really big and pervasive, and there could be some really big businesses built here.” I don’t disagree with that as a basic sentiment, but at this point there’s well over $10 trillion of market cap riding on this actually being a big deal. You would think you’d want to have some actual real-world applications that people are paying a lot of money for to validate something that large.
As of yet, I don’t see it. I see better search query results on Google. I can see the daily usage of tools like ChatGPT. If I wanted to do an earnings summary of a stock after a quarter, I could tell ChatGPT to do it. It will spit something out, and it kind of sounds like a 22-year-old just out of college wrote it up. It doesn’t have much thoughtfulness to it.
I know AI will get better. I don’t want to pretend that it won’t get better, but is that really high value added? I’m just saying I’m unsure about that. What I am sure about is that you’ve got people lunging at this stuff that don’t really understand it, and those kinds of things don’t end real well usually, or at the very least, there’s a fairly violent snapback.
What potential catalyst(s) could lead to a broadening of the market?
Since late 2023, the market has been narrow and dominated by a few stocks. Parabolic moves in individual stocks or whole industry groups are not that unusual. They are typically propelled by a story about a big new product or market that does not have much history. Therefore, investors cannot place logical boundaries on market size, profitability, or competitive dynamics – many investors refer to these as “big TAMs”, or Total Addressable Markets. Investors/speculators have a long history of overestimating the long-term market size, potential profits, and level of competition in these big new TAM situations. We can look back at “broadband” stocks in the 1990s, “data warehouse” stocks in the early 2010s, stocks propelled by PD-1 anti-cancer molecules in the mid-2010s, and autonomous driving stocks and EV battery stocks fairly recently. All are examples of legitimate new end markets that were overestimated in terms of size and profit potential. Once the overestimation reveals itself and the aggressive projections are scaled back – the losses as reality sets in can be sharp and rapid. There are exceptions. Apple’s massive success with the iPhone, or Google’s success with search and related advertising revenue would be examples that most people are familiar with. The TAM just kept getting bigger, and competition has never seriously dented their positions/profitability.
What’s unusual in 2023-24 is the concentration of parabolic moves among the very largest stocks in the market. It’s led to overall market concentration statistics that nobody alive has ever seen before (the top 15 S&P 500 stocks are currently 43% of the index, and the top 30 stocks are 53% of the index). Very large cap stocks have often been penalized over history in terms of valuation because it’s hard to grow such large businesses, and they are often not fountains of innovation. So this is, in a historical context, very unusual.
Most successful long-term investors are disciplined, among other things. Holding on to entire positions that experience a parabolic move is generally not considered to be “disciplined”. Why? Because parabolic moves in individual or groups of stocks, when they do break, they tend to break decisively, meaning they don’t correct by going sideways peacefully. Some profit-taking is the normal, disciplined thing to do. That is what we would counsel at this time.
We do not suspect the S&P 490 stocks have any special tricks up their sleeves that will make them relatively more interesting. These stocks by and large do not participate in big new unpenetrated TAMs, and are more bound by broader economic factors and competition. They are a bit more boring, so to speak. Given the stark divergence in aggregate stock market performance this year, S&P 490 multiples have declined in varying degrees. From a valuation perspective they are, on balance, more interesting than earlier in the year. Part of the art of value investing is investing in good businesses when there happen to be unthoughtful sellers about. Boredom and lack of sexiness are not great fundamental reasons to sell stocks, but if we are being honest, people sell them for reasons like this all the time.
There is no bright-line formula for how markets may broaden out from here. At the moment, it seems more logical that these big limitless TAM themes prevalent in the S&P 10 stocks might evolve in ways to appear more limited in investors’ eyes. In some cases, growth simply decelerates, earnings stop beating “whisper” numbers, or margins stop rising, revealing functional limitations. In other past circumstances (such as the early days of internet stocks) there can be a “where’s the beef” moment leading to a sharp change in sentiment. I kind of wonder how well people will “trust” certain functions to AI, given how untrustable things like Google Maps can be for traffic directions. Hard to say. Markets can and do go to extremes, but are also decent at sniffing out when things are just out of hand, at least after a bit of time.
Finally, one other (plausible) catalyst for flipping the script: you run out of buyers! I would think every thematic/growthy fund in the world owns AI and GLP-1 to the gills so to speak. And individual investors too. You have to figure the exposures are enormous. At some point, you just run out of buyers, and stocks stop reacting to good news. The same happens with the unloved stocks – they stop going down because there is nobody left to sell.
There was a lot of talk at the end of 2023, predicting the number of rate cuts in 2024 and potential market moves, none of which has panned out. What does this all say about act of forecasting?
It says that you don’t want to filter stocks through a macroeconomic lens most of the time. There have really been two macro episodes in the last 20+ years, during which the macro has overwhelmed everything else. That was in 2008 and in 2020. Beyond that, stocks perform or don’t perform based on their own company specifics and narratives within the market. Big picture macro usually isn’t the dominant driver.
If you remember, back at the beginning of the year, people were pricing in six Fed rate cuts. You can look at rate futures and say, “Yes, that is in fact what is priced in.” These are big liquid markets, and now you’re down to one, maybe two, and we’re halfway through the year. There are only so many cuts that could possibly happen. You would’ve thought markets would not do well if you were driving with a macro lens based on all these rate cuts being priced back out of the market, and yet the stock market is up about 15% (at least for the S&P 500, maybe not for the average stock) as we’re talking.
A lot of comparisons have been made between Nvidia and Cisco of the 2000s. Both are early dominant players in their respective segments of technology, and both stocks having meteoric rises, etc. What are your thoughts on this comparison?
I know the Cisco analogy super well. I was there in the middle of it in the late 90s.
I do see similarities. Cisco was the dominant name in routers and switching, and people could see the internet was going to be a big thing. You would need to build a lot of infrastructure in trunk networks, server rooms, and things like that. What was interesting about Cisco vis-a-vis Nvidia is that Cisco controlled certain standards for how you set up a router.
With Nvidia, there’s a language called CUDA that the current large language model AI is written in, and CUDA is an Nvidia-specific set of protocols. By default, people have been buying Nvidia chips because they work well with this language.
Is it possible, however, that the future will not be so monolithic? That’s really the basic question. The answer for Cisco was that the future was (eventually) not so monolithic. They still make routers and switches, and they still earn a decent profit on them, but the rest of technology has run by. To some extent routing and switching capabilities have become commodified.
From what it looks like to me, they (Cisco) are now trying to buy their way into other relevant markets. We don’t like that as an investment characteristic and are not attracted to the stock even though it trades at a low multiple.
Nothing of the sort has happened with Nvidia yet; let’s be clear about that. However, I could easily see a situation where one or several of their big customers (Microsoft, Google, Amazon, Meta) were to find some other way to build LLM AI systems or maybe design AI chips for themselves. That could be quite a reset of current expectations.
That is how the Cisco movie played out. It looked like a surefire bet on internet infrastructure, and it wound up being that that infrastructure became somewhat commodified.
If AI is going to be as big as some expect, do you really think there’s going to be a monopoly supplier of CPUs, essentially, that are specific to AI? Or do you think this will be a more diversified type of situation? At the moment, no one knows, but history says it is probably more diversified.
Turning our attention to the Fed, what do you make of their lack of action?
I don’t know what the Fed is going to do; I think the Fed themselves don’t know what they’re going to do. What I do believe is that the Fed doesn’t want to do a “start-stop”. They don’t want to cut in, let’s say July, and do nothing until December, then do something in January, and then do nothing again for four months. That will amplify confusion, mixed messaging, and so forth. Once they decide to cut, they probably want visibility towards doing three or four. You may need more profound economic weakness than anything we’ve seen at this point in the last two years for them to actually be willing to do it.
I think that in their mind, “once we cut, we’re going to do this several times.”
In the past, you’ve mentioned the importance of tracking interest rate volatility. Can you remind some of our newer clients why this is an important variable?
If you actually look at when equity markets performed poorly, it’s quite interesting. They didn’t perform poorly based on the absolute level of interest rates. They performed poorly when interest rate volatility was high and expected future volatility was also high. I find this fascinating personally.
In other words, let’s say that we are correct that the low interest rate environment is never coming back, it’s going to be a sustained 3-4% inflation with sustained 3-5% interest rates as we go through this.
Is that so bad? Well, the stock market says not really, actually. We’ll have a little higher nominal growth, and funding costs will be a bit higher, but are rates higher in real terms or do we just kind of reload the deck upwards for a little higher rate of inflation and go our merry way?
I don’t know how this is going to go. I don’t think Jay Powell knows how this is going to go, but they want to be predictable. They care about that kind of thing. If the Fed is predictable, then that suggests interest rate volatility will stay low.
There’s a big question that inquiring minds might want to ask: Can they really be so predictable? Is that for real? I don’t know.
How are you measuring rate volatility? How do you quantify that?
There are a lot of different markets that you can look at to measure rate volatility. One is simple, which is a daily change in rates or weekly change in rates. Another one is Euro-Dollar futures. If I want to swap Dollars for Euros in the future, how much do I have to pay if there’s an interest rate differential? Back in 2022, those Euro-Dollar futures were all over the place. Actually, some of the gaps were much larger than in 2008.
You don’t see too many volatility measures of anything higher than 2008. That almost never happens. But (in 2022) people had no idea what the Fed was going to do, when they were going to do it, and what their modus operandi to some extent was. Those futures really, really gapped out and that drove a lot of multiple compression in the United States. Once it became evident that inflation had peaked, which was in late 2022, that’s when most stocks around the world bottomed.
What we’ve seen subsequently is that these big digital platform businesses have not been affected on a fundamental basis by higher rates. In some cases, their multiples are lower today than they were back in early 2022 before this whole process began, so they are reflecting if you want to think about it in an academic finance type of way, higher for longer, higher into perpetuity. Their overall businesses haven’t been hurt.
What about your thoughts on healthcare? Obviously, similar to tech, it’s GLP-1 instead of AI Do you have any other thoughts regarding that?
Healthcare has been a bifurcated space in the last two years with GLP-1 stocks just marching onwards and upwards to spectacular valuations and everything else is kind of withering on the vine essentially.
We remain constructive. We’re currently looking at some additional names across our strategies. I do think there are a few cross-currents that you need to be aware of.
One of the negatives for pharmaceutical stocks has been the Inflation Reduction Act. The Inflation Reduction Act was legislated via reconciliation, meaning that they needed to find pay-fors to pass the IRA. One of the pay-fors was compulsory “negotiation” of drug prices for certain big blockbuster drugs. Well, when you think about that, it reduces the business value of some of these big drug companies.
I’m not personally convinced that this is constitutional. It is not much of a “negotiation”. The Federal government just kind of tells you what price they plan to pay. That has been an out-and-out negative for some of the big pharma companies.
I think one of the other problems, frankly, is the lack of R&D productivity by big pharma companies. You’re seeing pharma companies of all sizes engage in M&A to buy pipeline assets, and in some cases at pretty exorbitant prices where it’s hard to see the return on investment ever being anything better than mediocre, on numbers as big as these companies are spending. I think that’s soured a lot of investors to the space.
There’s a flip side to this. Let’s say AI is a really big deal and it does a better job of evaluating certain pharmaceutical paths, certain molecular mechanisms of action. Maybe drug discovery will get better, and people shouldn’t be so negative here, but that’s a very speculative thought in and of itself.
Are there any stocks you want to highlight? How has portfolio activity been in the first half of the year?
We’ve been quiet in the second quarter. We bought Delta Airlines in the first quarter. It is an example of the world perhaps changing a bit. In the past, legacy carriers were terrible investments for a long time. As an investor, you wanted to own low-cost carriers like Southwest, and in Europe, you have Ryanair.
What we’ve seen post-COVID is that the low-cost carriers are having a hard time. Essentially, costs are going up faster than they can be priced.
It does so happen that Southwest, Ryanair, and some other low-cost carriers tend to rely heavily on the 737 airplane. Boeing has its problems producing 737s, so that’s affected their fleet plans.
We believe it’s (relatively) better to be a legacy carrier and have more fixed costs in an inflationary environment. That is what we’re seeing thus far. We’re monitoring this closely, and it looks like it might be a fairly durable thesis.
Are there any other areas of the markets that you find interesting?
When you’re dealing with the kind of parabolic moves we’re seeing in AI and GLP-1 stocks, you just have to be careful about taking the other side of that. It needs to be done maybe in pieces rather than super aggressively.
Energy stocks have not done a lot, basically since the middle of 2022. They’ve been up and down. Our view is that oil will lean tight relative to a logical range. That logical range is about $60 on the low end and $85 on the high end. Oil prices have spent about 98% of days since early 2022 above $70+, and probably more than 50% of days >$80. Our thesis has been holding together.
There’ve been two interesting things happening in the energy space recently. First, there’s been a lot of M&A. It looks like in the Permian, you’re going to have no more than six or seven companies by the time this is over with, and that probably means more disciplined production.
There’s really no incentive to try to outgrow the next guy. To do what? What does that accomplish? We think that will be, generally speaking, better for returns.
Secondly, there’s a rule of thumb if you’re following energy stocks: “Watch what the Saudis do.” The Saudis did something very interesting early in the year, which was to take down their capital budget. They had a big program to take their nameplate capacity from about 12 million barrels a day up to 13 million barrels a day.
The Saudis have decided it’s not worth it to spend the money to take their capacity up to 13 mm bpd. In other words, if the world really needs that capacity, the world will have to raise prices and get oil from other places. I thought that was interesting, the most important OPEC country tapping down on how much it cares to produce in the future.
As a general rule, though, I like to have some energy in the portfolio because you don’t know when you’re going to really want this. You’re not going to be able to predict in advance global geopolitics and when energy is going to matter.
There are other sectors, like the military side of aerospace and defense, that are starting to look a bit more interesting. There’s not a lot of interest in defense right now (they’re not exactly AI stocks). There are some more defensive healthcare names that are extremely acyclical that no one cares about at the moment that look pretty interesting to us too. That’s where our noses and our QPD process are taking us.
Shifting across the pond, what are your thoughts on the recent French Elections?
French elections saw both the right-wing party gain a substantial number of seats, but not enough to control the French government. A far-left and center-left coalition has prevailed, but it’s not clear if they will be able to legislate very much given sharp ideological divides within this coalition. France has “leaned left” most of the post-WW2 time period. I don’t think we can draw many inferences with respect to upcoming U.S. elections in November from French (or U.K.) elections other than a disdain for the incumbents.
Based on these French election results, does anything change in terms of how this may affect the French positions that we own currently or are you in a wait-and-see with a lot of those names?
We have leaned in to the French sell off a little bit and added to a couple positions.
If you look at risk measures in Europe, investors typically look at sovereign risk pricing (how much more yield you have to pay on French bonds versus German bonds – German bonds are the European standard).
French bond yields widened by 40 basis points and went up to the low 3% range from the high 2% range. Compared to past European electoral disturbances, that is not much.
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