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Beware the ‘aggressive optimism’ around overvalued tech stocks: Atrium
Inflated prices attached to US technology stocks may have put wind in the sails of portfolios around the globe, but those same valuations can pose a ‘hidden risk’ to quality investors looking for a safe haven in their global equities sleeve according to Atrium Investment Management.
The performance of top-end tech stocks, led by the ubiquitous MAMAA cohort (which is the latest incarnation of the FAANG group, now including Meta, Apple, Microsoft, Amazon, and Alphabet), has been hard to fault over the last decade. Despite hitting a wall in 2022 – and shedding Netflix – the group dominates the S&P 500 with over 20 per cent of its value, worth around USD$30 trillion.
It’s these lofty valuations, however, that give Atrium Investments’ senior portfolio manager Brendan Paul cause for concern. Especially when you add the latest big US tech stock, chip maker Nvidia, into the equation.
“When you look at the stocks that are driving returns and ask, ‘Where are those returns coming from?’ a lot of it s around this AI narrative,” Paul said during a recent televised interview. “This generative AI is being priced in, and Nvidia is a great example.”
Nvidia is the fourth largest stock on the S&P 500 by index weight, behind Apple, Microsoft and Amazon. The integrated circuits (otherwise known as ‘chips’) it produces are used in devices around the world, and are pegged as a leading supplier for the next generation of large language, generative AI tools such as ChatGPT.
While other big tech stocks are having their valuations inflated by the promise of AI, none have as much positive momentum as Nvidia – which is a red flag for the Atrium Investment team.
“We looked at Nvidia and we said ‘so currently [it’s] trading at something like 24 x the next 12 month’s revenue,” Paul revealed. “Not earnings, but revenue.”
The Atrium team looked asked “what you really need to believe” to invest in a stock at that kind of an elevated multiple, he said. In other words, what kind of growth would it take to make the investment profitable?
“If you go out ten years and say ‘That stock is going to grow its revenue at 30 per cent per annum because AI is real and it’s going to generate sales’, that will still only get you a return of about 20 per cent over that timeframe,” he said.
“Now that sounds fantastic, but what you need to consider is that there’s only been a couple of stocks in history that have ever actually achieved that sort of growth for that length of time, and that’s Microsoft and Salesforce.”
Companies that can sustain the kind of growth those two have shown are incredibly rare, he noted. Nvidia might have incredible return potential, but a lot of that is likely already included in the price. For Nvidia to bank a return for investors, it would have to go a long way to maximising its potential.
“You want to be very careful of what’s being priced in,” Paul said. “It’s a very, very aggressive optimism in some of these stocks.”
Atrium’s wariness doesn’t preclude them owning the stock, Paul clarified. But it does mean they’re realistic about the inherent value of the company.
“We think that underneath some of that optimism is possibly a little bit of a gap to reality,” he said. “And we’ve seen that before, in the late 90s, with a number of these stocks proving not to be the next Microsoft and therefore, over a long term generating a negative return from these elevated valuations.”
