QD View: Bubble trouble?

In his latest QD view, James Carthew looks at the impact of recent market falls on the technology sector, and Polar Capital Technology in particular

Polar Capital Technology’s amazing results

 
Polar Capital Technology (PCT) announced results for the 12 months ended 30 April 2024 on 17 July 2024, we covered these here. The numbers were great – up 41% in NAV terms and over 50% in share price terms – with the NAV hitting £31.54 and the share price £29.20. Given the size of the share price, the board is proposing to split the shares on a 10 for one basis.

Given the magnitude of the gains delivered by the trust, it seems a bit odd that it has not traded at asset value for four years now. However, that might have reflected nerves about valuations, in particular nerves around valuations of the AI-related stocks that have come to dominate its portfolio in recent years.
 

Shares slump

 
Then from about 10 July onwards, those fears seem to have been realised. The share price of Nvidia, PCT’s largest holding, has fallen by about a quarter since then. The second-largest position – Microsoft – is down 13%. TSMC, which is a top 10 position in PCT and the dominant stock in many Asian portfolios is off 17%. The list goes on.

This sounds like a disaster for PCT, but all it has done is brought the NAV and share price back down to the same levels that they were at on 30 April. Similarly, Manchester & London (MNL) which has a more extreme bet on AI, is back at levels last seen in May.
 

Magnificent seven

 
At the start of July, PCT’s manager Ben Rogoff highlighted that markets were being driven by a very narrow set of stocks, suggesting that was to be expected from the early stage of a new technology cycle. He noted that the magnificent seven companies (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) had been outperforming small and mid cap peers, and unprofitable but fast-growing stocks in June. However, Ben also pointed out that the magnificent seven have much faster predicted earnings growth than the wider market.

The largest companies seem to be throwing everything into the AI race. Ben talks about $170bn of capital expenditure by hyperscalers (the very largest cloud service companies such as Amazon and Microsoft). Much of this is going to buy the AI chips that Nvidia is producing, underpinning its spectacular revenue growth.

Ben was looking forward to robust second-quarter earnings figures from the six largest technology companies. However, he did caution that “volatility could resurface whether driven by macro (rates/inflation), geopolitics (elections/policy) and/or sensitivity to perceived negative AI datapoints.”
 

Are valuations too high?

 
On valuation, Ben’s manager’s report in PCT’s annual report was a tour de force, as always, you can read the outlook section of it in our latest economic and political roundup. He noted that technology sector valuations had hit 1.4x those of the wider market, at the high end of the range established since the tech bubble burst almost 25 years ago, but had since retreated to 1.3x.

Mike Seidenberg, manager of competing trust Allianz Technology, said on 7 August “Valuations continue to be elevated but not excessive and we believe there is the potential for upward revenue and earnings revisions should we see a better spending environment in the second half of the year.”

There is not much doubt then that these businesses are expensive. The big question is, is their sales and earnings growth going to justify those values?

Ben has talked before about how bad investors are at valuing fast-growing businesses. With AI, the pace of that growth comes down to how quickly will it start to disrupt existing businesses, creating new profitable companies while condemning others to obscurity.
 

Why did prices fall?

 
So, what triggered the share price falls? The answer is hard to pin down.

The earnings numbers that Ben was waiting for were not bad. Alphabet beat analysts’ revenue forecasts, but those analysts found fault with a slower rate of advertising revenue growth from the previous quarter. Microsoft, Amazon, Meta, and Apple also beat forecasts. Meta announced a 22% jump in sales year-on-year. However, news emerged that Warren Buffett had halved his stake in Apple. The only big casualty was Intel – not a magnificent seven stock, and not a holding in these trusts.

My best guess is that a bout of profit taking coincided with some market volatility associated with the unexpected Japanese interest rate hike that triggered a surge in the yen and a slide in Japan’s stock market. Early in July, Goldman Sachs warned that the vast capital expenditure devoted to AI was yet to create new sustainable business models. On 2 August, the FT reported that Elliott Management claimed that Nvidia is a bubble and AI technology is overhyped. In both cases, the public stance may suit their book, but Elliott also said that shorting big technology stocks could be suicidal.
 

Watch out for Nvidia

 
Nvidia’s next quarterly earnings statement is set for 28 August. If the numbers are good, we could see a rally and that may persist into September as investors return from their summer breaks and reason that the recent sell-off was a blip. Or, it could be bad news and the gloom will descend once again.

However, managers like Ben, Mike, and MNL’s Mark Shepherd would tell you that the AI story has a lot further to run. Mark has been buying the dip, adding to his already substantial stake.

 
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