The tone on the sidelines of Morgan Stanley’s investment gathering this month was one of pending doom. A week prior, markets were fairly confident we were either at or near peak interest rates. But a monthly inflation surprise, a reset to the minimum wage and hawkish rhetoric unsettled wealth advisers and fund managers about where we’re heading.
One healthy distraction, however, was a debate about Wall Street’s hottest stock, Nvidia, the chipmaker that this month joined the trillion-dollar club.
In May, Nvidia CEO Jensen Huang unveiled a new batch of products to capitalise on the interest in artificial intelligence. Bloomberg
Nvidia has its roots in manufacturing graphic processing units, or chips, for video games. But those chips, which accelerate computing speed, are now a vital component for data-rich companies to harness artificial intelligence.
The ramp-up in sales, as companies add the GPUs to their servers and data centres, led to a spectacular beat and upgrade in revenue guidance, and added $US184 billion ($268 billion) to its value in just one session. That is the equivalent of the combined market cap of Commonwealth Bank and Westpac.
That has analysts debating whether Wall Street’s hottest stock is too hot, given its seemingly exorbitant valuation of 37 times sales.
History suggests that when stocks hit such lofty multiples, they might keep going for a while before there’s a painful reversion to some sort of normality.
There are a few cautionary tales relating to buying stocks on double-digit multiples to sales. One comes from Sun Microsystems co-founder Scott McNealy. In 2002, when his company was trading at 10 times sales, McNealy noted investors would only get their initial investment returned over the next decade if the company had no input costs, no expenses, paid no tax and invested nothing in research and development in that time.
Game on for chipmakers
At the Morgan Stanley event, strategist Gerard Minack used a variation of the same theme and recounted how Cisco, a darling of the 2000 tech bubble, delivered two decades of high returns while the wildly bullish estimates on computer adoption were too low. Yet, Cisco stock has still been unable to get anywhere close to its peak price of $US80.
So, can Nvidia’s valuation be justified? Divisive growth investor Cathie Wood has never been one to shy away from owning exorbitantly valued stock. But it appears that price does come into consideration in her investment process. She was ridiculed recently for selling out of Nvidia just before the 22 per cent pop in share price – after owning it for years. But she fairly pointed out that her analyst Tasha Keeney picked up as far back as 2014 that Nvidia was far more than a bet on the growth of video gaming, and her Ark Innovation fund piled in at $US5 a share. The stock has been the fourth-biggest contributor to the fund’s performance.
Her view is that Nvidia’s competition is being underestimated as large tech companies will manufacture and use their own chips, while there are cheaper AI bets with far more upside potential.
“We think Nvidia is going to meet our minimum hurdle of a 15 per cent compound annual rate of return over the next five years. It’s just stretched, and it’s got a lot of this good news in it,” she said earlier this month.
Munro Partners, an Australian-based growth investor, have also been believers in Nvidia for some time. They disagree with Wood, still hold Nvidia – and if anything, still regard it as a solid buy.
In January 2022, amid a rout in tech stocks as long-term interest rates drifted higher, Munro’s Nick Griffin called out the stock as having “had the potential to be the largest company in the world”.
The premise was that with artificial intelligence we were entering the fourth phase of the computing age, in which every organisation would attempt to harness the data they have to get “smart outcomes”.
That was a good call and one that the market has now clearly bought into. But Munro doesn’t appear to be cashing in. The fund’s analyst, Kieran Moore, was brave enough to pitch the stock at the conference, fully aware most in the audience would have believed that it had done its dash.
As he pointed out, the stock is up 150 per cent this year alone and was trading on 50 times next year’s earnings. Not only that, it’s a stock that has the rare distinction of being too expensive for even Wood to own.
But logic in owning Nvidia is predicated on an exponential take-up by data centres to add accelerated computing, which would require products such as the ones produced by the company. This is the Munro math on the valuation: if the penetration of accelerated computing increases from 14 per cent today to 45 per cent in 2030 while Nvidia’s market share slips from 80 per cent to 65 per cent, that will result in $US100 billion of data centre revenues. In turn, overall revenues will be in the order of $US130 billion.
That revenue should deliver $30 per share in earnings, almost 10 times the $3.30 per share reported in fiscal 2023. If those earnings are on a 35 times multiple, it implies a share price of over $US1000.
A bearish scenario, he said, is if penetration of accelerated computing only reaches 30 per cent, and its market share falls to 60 per cent. That would generate $US100 billion in revenue by 2030, or $21 of earnings per share. On a 20 times multiple, that is higher than the current $US400 share price.
The new value stocks
We’ll have to check back in 2030 to see if they got that call right. But what we can say with confidence now is that growth investing, which fell so spectacularly out of favour, is making a bit of a comeback.
That’s surprised some macro traders, given high-growth stocks have proved in recent times to be highly sensitive to interest rate movements.
While the market appeared confident in January that we were past peak inflation and near peak interest rates, that has proved not to be the case.
The outlook for both near-term and long-term bond rates is as uncertain as ever, while equity strategists point out that if discount rates are lowered, it will be because the growth outlook has cratered.
Another takeaway from the conference is that tech stocks may in fact be the new value stocks. One offshore tech investor said that valuations in the sector had never been more compelling as firms cut costs while also lifting prices, and cited Shopify as an example.
But all investors agree that any definitive sign that interest rates have peaked is the true signal to buy up stocks with confidence.
On that note, it is worth revisiting an interview with Edinburgh-based stockpicker Alan McFarlane from 2021. The discussion turned to Paul Volcker, the Federal Reserve chairman of the late 1970s and early 1980s who is synonymous with slaying inflation. He is the man this vintage of central bankers are hoping to emulate.
McFarlane’s take is that his legacy as an inflation buster got a helping hand from two sources. One is that the power of OPEC, the oil cartel, began to fade, bringing down energy prices. The other, he says, was a technological advancement. “He didn’t know that the Intel 8088 chip’s pervasive expansion [as personal computers became ubiquitous] was going to change the world,” McFarlane told this columnist at the time.
Are central bankers about to get lucky with the deflationary power of Nvidia’s chips? Probably not. But it’s worth being open-minded as to the range of possibilities that lie ahead.
This article was originally posted by The Australian Financial Review here.
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