Managing money is a curious profession. If I managed a portfolio full of semiconductors, I'd probably be dancing in the streets right now. But I don’t and I’m not. As with many equity income fund managers, my strategy is inherently contrarian, frequently involving buying assets others are only too willing to sell.
Fund managers who invest in companies nobody else wants to own tend to have a certain resolve, knowing we often face the darkest hour just before dawn. I was recently reminded of a comment the former chief executive officer (CEO) of Citigroup, Chuck Prince, made to the Financial Times in July 2007.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We are still dancing,” he said. Just days later, the financial crisis hit and Citigroup’s exposure to toxic mortgage debt brought the bank to its knees.
Many investors continue to fall over themselves to allocate more capital to the AI theme – either actively or passively. There is no doubt that AI is a truly transformational technology that will change all of our lives in many ways. AI will likely become ubiquitous – we will use it in everything we do. However, that does not necessarily translate into profitability and high returns.
With hyperscalers spending money like there is no tomorrow to win the AI race, overcapacity is almost guaranteed. The AI capex boom is getting longer in the tooth, and we view it as ‘just another cycle’. At some point, the cycle will end, the music will stop and the dancefloor will clear.
And all the while, and perhaps more profoundly, we are entering a brave new world – transitioning from a secure, low-inflation, globalised era to one marked by greater uncertainty and rising inflation.
The developed world has to reinvest to re-establish strategic autonomy, re-establish closer supply chains, and re-establish security autonomy. This means the outlook for the future will be significantly different from the past, with capital likely to flow to different areas than before.
These gales of creative destruction are intensifying, placing greater emphasis on businesses that show resilience and robust long-term value in the face of disruption, while many others are left by the wayside.
Another consequence of this new environment is a structurally weaker US dollar. With rising interest rates, higher bond yields and elevated government borrowing, ongoing currency debasement is likely.
To capitalise on and adapt to the reordering of the global economy, we are spreading the net a little wider, considering a broader range of assets and exposure to different geographies.
A recent addition to the portfolio, SLB (formerly Schlumberger), the multinational oilfield services company, which exemplifies the robust business model suited to this environment.
Geopolitical tensions in Iran underscore the need to diversify hydrocarbon sources amid reliance on chokepoints such as the Strait of Hormuz, driving increased investment in oil and gas exploration. SLB stands out as a high-quality asset with a strong track record of returns.
Vinci, France’s largest private toll-road operator, is another example of casting our net wider. Its toll roads provide reliable cashflows, while its construction business stands to benefit from developed economies’ renewed focus on infrastructure that supports strategic autonomy.
We have also reduced our dollar exposure – as the US potentially loses ground, we see opportunities beyond traditional markets. For example, investing in the Brazilian stock exchange B3, though unconventional for some global income strategies, reflects our conviction that emerging markets will benefit from these evolving macroeconomic trends. Likewise, we have made a new investment in AIA, Asia’s largest insurer.
Despite widening the net, we remain steadfast in our fundamental approach to investing in overlooked quality companies that offer strong value. The recent addition of LVMH exemplifies this contrarian style. The stock has fallen so far out of favour that we believe it now offers significant value, prompting us to initiate a position for the first time.
Quality stocks have been left behind in the wake of the AI frenzy. Many, such as Unilever, Pernod Ricard, LVMH, Diageo and PepsiCo, trade at the lower end of their 10-year valuation ranges, in part because of current pressures on consumer spending.
While the exact catalyst for a turnaround in their fortunes is unknown, whether a decline in oil prices or another market event, the fundamental rationale for holding out-of-favour, high-quality companies with a competitive edge remains strong.
And here’s the odd thing. You can rarely have good news and good prices. Right now, quality-laden portfolios carry their share of bad news but also significant value, unlike others where optimism prevails but valuations are stretched.
Investing is both an art and a science, but no one knows when the AI cycle will reverse. Rather than trying to call the AI peak, our focus is on identifying businesses positioned to succeed regardless of prevailing trends. For us, this means holding high-quality companies at attractive valuations.
Numerous indicators suggest that markets are currently overextended. High levels of concentration, correlation and valuation are prevalent among the best-performing funds, with many following a single trade.
When that trade turns and the music finally stops, being an investment wallflower may prove to be valuable.
James Harries is co-fund manager of the STS Global Income & Growth Trust. The views expressed above should not be taken as investment advice.