By Chris Miles, head of financial intermediaries UK at Capital Group
We are seeing the early signs of a market rotation from a narrow set of growth leaders to a broader array of companies. While investors are not bailing on big tech, many are concerned about concentration risk and excessive exposure to these companies in market-cap-weighted indices.
It makes sense – investors should have exposure to the incumbent technology giants that have driven so much of the growth in the US economy, but also a broader set of companies and industries that have strong business models and potential for a long runway for growth ahead.
The big are getting bigger
Scale has historically been an impediment to growth, but that is not the case with the big tech companies as they are generating returns on very low incremental investments. Capital investment in these industries is focused on hardware and software, which are sunk costs. Then, as the business grows, margins will expand while volume increases.
Nvidia expanded its video gaming semiconductor franchise into AI, opening up a burgeoning market with little additional outlay. It has a huge advantage through its expertise in graphic processing units (GPUs) for large language models. Nvidia’s sales are projected to catapult from $11bn in 2020 to $125bn in 2025, according to consensus estimates. However, these companies will not have big additional costs.
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After all, tech companies are expected to spend about $30bn per year on building and powering data centres needed for semiconductor chips and other AI-related hardware. And if geopolitical imperatives lead to both the design and building of semiconductor chips in the US and Europe, that could result in additional expenditures that may be partially subsidised by governments.
A broader ecosystem benefits from big tech
The phenomenal businesses that the Magnificent Seven and other large-cap companies have generated is undisputed, and value continues to accrue to these companies, with market caps ballooning to trillions of dollars for many.
But beyond the companies themselves, there is a broader ecosystem of firms that supply their parts or provide infrastructure critical to the success of the mega-cap companies. In some ways, these firms provide avenues to access growth opportunities that we view as more probable and durable.
Prominent examples of this trend are companies all along the semiconductor value chain, including designers of chips such as Avago (Broadcom), manufacturing foundries such as TSMC, semiconductor equipment manufacturers such as ASML and Tokyo Electron and Applied Materials, and silicon wafer design company Synopsys.
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Companies involved in meeting the increasing need for data centres and power generation, such as utility providers, may benefit as well. At the other end of the spectrum, early AI adopters could see greater interest from investors. Drug innovation is one example, with many pharma companies now talking about AI.
So far, AstraZeneca and Roche are doing the most to leverage AI tools for drug discovery and supply chain management.
High barriers to entry and big moats
Beyond the technology space, we look for industries and companies with strong moats — that is high barriers to entry, irreplaceable assets and growing demand.
The industrial sector is vast and diverse, yet we are seeing companies with considerable industry dominance, solidifying and expanding their footprint in areas poised for long-term growth.
Industrials are benefiting from multiple tailwinds – the energy transition in the US, energy security in Europe, the reshoring of supply chains and increased defence spending. These multi-year trends are setting the stage for a capital investment super-cycle that could drive opportunity for a range of companies.
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Renewable energy providers AES and NextEra are examples of companies that already have an advantage due to their extensive power infrastructure. Both are developing next-generation power-efficient solutions to meet global energy demands; they will also play a critical role supporting AI-driven data centres.
Aerospace and defence (A&D) is another segment of the industrial sector that stands to benefit in the near term from government orders and ongoing geopolitical conflicts. The UK, France and Germany have all boosted their defence spending, potentially spurring technological innovation in A&D-related products.
Global military expenditures rose for the ninth consecutive year in 2023, reaching a total of $2.44trn — a 6.8% increase and the steepest year-on-year rise since 2009.
Multiple levers of growth
This is an industry that long-term investors cannot ignore. In 2022, health care spending in the US reached $4.5trn or 17.3% of GDP, according to the Centres for Medicare and Medicaid Services.
Broader advances in technology such as greater connectivity and AI are turbocharging the development of therapies. We are in the early days of a third major wave of innovation in biotech and drug discovery. In the first wave, old-line chemical companies treated disease. The second wave was the emergence of protein-based therapeutics that were more targeted, harnessing the immune system to treat disease.
This third wave belongs to genetics. Health care companies, bolstered by insights from genetic sequencing done in recent years and the ability to process a wealth of data at faster speeds, have developed methods to more specifically intervene in the disease process.
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One key advancement is the development of technologies that allow intervention in disease pathways at the genetic level, further upstream than many conventional medicines. Through sequencing and data processing, drug developers can apply highly specific interventions like gene therapy, where normal genes can be transplanted in place of missing or defective ones to address the disease.
Investors poured an incredible amount of capital into the biotech and pharmaceutical industries over the past several years, driving innovations that resulted in the creation of intellectual property and know-how that will likely be improved upon for years to come. As such, there is potentially an explosion of new therapeutic opportunities coming over the next decade.
The bottom line
The growth paradigm has been dominated by big tech over the past few years. But the opportunity set is much broader, and given the concentration in the market, especially in the US, it is incumbent on us to look at other areas of opportunity to construct robust, well-rounded portfolios with medium- to long-term horizons.
Some themes are clear, and it is a matter of valuations – others become more transparent over time. But having a broad set of themes, expressed through a range of companies, helps our pursuit of active returns while seeking to mitigate risk in our portfolios.
