By Darius McDermott, managing director of FundCalibre
Investing in the US market is becoming more complicated. For much of the past decade, as long as investors had sufficient exposure to a handful of large technology companies, they did the hard work on growth. AI has thrown the pieces in the air, and it is not yet entirely clear how they will land.
Economist Brian Arthur describes the ‘fog of technology’: “No one knows how well the technology is going to work, or who else is going to be in the game or who their competitors are going to be. They don’t know how their technology is going to work. They don’t know whether the public or other businesses will be interested. They don’t quite know what the regulatory atmosphere will be.”
This is the world created by AI. While the fog is starting to clear a little, the winners and losers on AI, and how the technology will evolve, is not certain.
While hyperscalers such as Amazon, Microsoft, Alphabet and Meta are key players in the AI race, it is increasingly clear the gains may not accrue to them, at least in the short term. They have compromised their huge cashflows to spend vast sums on the AI build-out with uncertain results. It is not yet clear that they will all reap the rewards from their investments.
The Artemis US team says its exposure to the hyperscalers is evolving. Head of the team, Cormac Weldon, says: “We added to Amazon but trimmed our positions in Meta and Apple due to concerns about their relative weakness in the AI buildout.” The CNBC Magnificent 7 index has notably lagged the wider S&P 500 year to date, returning 6% versus 12% for the wider index.
Managers are focusing more of their attention on companies that supply the hardware, software and services underpinning this buildout. The Artemis US Extended Alpha fund holds Advanced Micro Devices’ semiconductors, Texas Instruments, Applied Materials, and SanDisk.
Kirsty Gibson, manager on the Baillie Gifford American fund, says: “The market has focused on what is most visible: a series of rolling bottlenecks in the AI supply chain, from central processing units (CPUs) to memory and other components required to scale AI models. Memory has been at the centre this quarter. Dynamic random-access memory (DRAM) prices doubled in the first quarter alone. Pricing has been increasing monthly, and buyers are taking whatever supply they can get.”
However, here too, investors need to proceed with caution. Gibson points out that while bottlenecks can create spectacular profits, they can also migrate or fade as capacity expands. “For now, the market is treating these choke points as moats and paying accordingly.”
They do not want to chase every new constraint in the supply chain and are confining their exposure to areas where they see genuine structural demand. Gibson says: “Broadcom is an example of where we do have conviction. It has become a critical provider of custom AI silicon.”
The other area where the market is still working out the impact of AI is in the software sector. A lot of companies have been sold down, but the recent earnings season suggested some software groups can weather the storm.
Gibson makes the contrast between Snowflake and Salesforce: “Snowflake’s shares halved in the SaaS sell-off before more than doubling again as results showed growth reaccelerating. Salesforce, which is not held in our portfolio, tells a different story. Its shares have almost halved and have yet to recover.”
Her view is that one stock remains a growth story; while the other increasingly looks like a value story, perhaps even a value trap.
The Artemis US Extended Alpha team has also been exploring this theme. Manager Adrian Brass says: “The carnage in parts of the software sector in the first quarter was indiscriminate. That created opportunities in stocks with a reasonable chance of surviving amid the new reality being created by AI – or even benefiting from it. ServiceNow and Twilio both fall into this camp.”
There remains a question over whether market leadership broadens away from the technology sector. The worry is that economic growth is concentrated in AI spending, while the rest of the economy is weighed down by higher inflation and interest rates. The consumer does not yet appear to be rolling over, though there are pockets of weakness. Walmart’s recent results gave some cause for caution, with the retailer forecasting a more difficult third quarter.
It is not generally where most fund managers are oriented. Artemis has been building selectively in healthcare, while the Baillie Gifford fund has made new investments in IDEXX and Mastercard. IDEXX focuses on pet healthcare diagnostics, with testing devices, software applications and data analytics.
Smaller companies may also be another area of interest. They have started to recover since the start of the year. The MSCI USA Small Cap index is up 19.5% for the year-to-date, significantly ahead of the 13% return from the MCSI USA index.
Earnings from this part of the market have been strong and this has helped share prices improve. This has boosted performance for funds such as T. Rowe Price US Smaller Companies Equity.
A final question may be whether the quality segment of the market can recover. This has been a real weak spot, with quality-focused funds languishing near the bottom of the performance tables. A weaker economic climate and higher interest rates may favour economically-insensitive, low-debt companies. This would favour funds such as GQG Partners US Equity or Comgest Growth America.
Christophe Nagy, manager of the Comgest Growth America fund, says the first half of the year was a reminder of how narrow and fast-moving market leadership can be. He is making sure the portfolio has a range of structural growth drivers beyond AI: “These span digital payments, better medical care, the outsourcing of business services, and rising public infrastructure investment.”
The North American market is in flux. It is clear that the strength of former winners may not endure, but the next generation of success stories is not established. It is an open playing field from here.
