By Alex Phillips, chief investment officer at Longview Partners
Over the past couple of years, a consistent – but counterintuitive – pattern has emerged in equity markets. While many high-quality businesses have continued to compound earnings, generate strong free cashflows and deliver in line with expectations, consistency has not always translated into higher valuations. Instead, capital has flowed into businesses more closely aligned with prevailing narratives.
This is not a complaint about short-termism, nor a lament for a more patient era that may never have existed. It is a question about what happens when a narrative becomes dominant enough that it stops being a view and starts functioning as a substitute for analysis.
Reality bites
Markets have always run on stories. The Nifty Fifty of the early 1970s emerged on the conviction that a group of blue-chip American companies were so structurally advantaged that valuation discipline no longer applied. The story stretched beyond what the evidence could support, and the correction was severe.[1]
The dot-com bubble of the early 2000s is another familiar example, but a related episode from that time may be more instructive. In the late 1990s, vast amounts of capital flowed into fibre-optic infrastructure on the assumption that internet bandwidth demand would continue to grow exponentially. The companies that ultimately failed were valued as if a specific future was guaranteed, when in reality it was one possible outcome.[2]
What distinguishes today’s environment is not simply a powerful narrative. Artificial intelligence represents a meaningful technological shift. What is more unusual is the degree of precision to which markets have determined its consequences. Entire sectors have been repriced on the assumption disruption is not only plausible, but imminent, inevitable and broadly uniform.
In many cases, there remains limited evidence of that disruption in underlying business performance. Yet valuations have adjusted as if the impact were already visible. The distinction between what can be observed and what is being assumed has become less clear.
A single explanatory framework is being applied, with extraordinary bluntness, to a diverse set of businesses. American Express sold off in February on concerns that AI could reduce white-collar employment and weaken consumer spending. But if that were the case, it should apply consistently across consumer-facing sectors. Meanwhile, insurance brokers serving multinational clients with complex, bespoke requirements were marked down alongside consumer comparison platforms, despite operating in fundamentally different markets.
In each case, the narrative has done the work analysis would normally perform. Instead of assessing how a particular business generates returns, its competitive position and what it would take for that to be challenged, the market has asked a simpler question: does this company sit within the theme? Once that classification is made, the conclusion follows.
This is not to say the risks associated with AI are overstated. In some cases, they may prove justified. The more relevant point is that the range of potential outcomes remains wide, and varies across industries, business models and time horizons.
Even where disruption is likely, the path from innovation to adoption is rarely linear. Large organisations tend to change gradually, especially when core systems are involved.
There is also a question of where value ultimately accrues. Technological change can strengthen incumbents as well as challengers. Businesses with proprietary data, entrenched customer relationships and meaningful switching costs may be well placed to incorporate new capabilities into their offering. In such cases, the impact is less about displacement and more about adaptation.
Analysis over assumption
There are structural reasons why narratives become influential. They allow capital to be allocated quickly, on the basis of a shared framework that reduces the need for fundamental analysis. In markets shaped by passive flows, momentum strategies and thematic investing, that process can become self-reinforcing.
The risk is not simply that individual stocks become mispriced. It is that the price discovery mechanism itself becomes less effective. When capital is allocated on the basis of thematic alignment rather than differentiated analysis, the link between price and fundamentals weakens.
The current narrative may prove broadly correct. Some businesses under pressure may face structural challenges that justify the market’s view. But markets that treat possible outcomes as certain, and apply a single framework to complex realities, are no longer analysing the future. They are simplifying it. And simplified views of complex systems rarely endure.
[1] Reuters, ‘A warning from history about large-cap stock booms,’ June 2024
[2] The American Prospect, ‘The Great Telecom Implosion’, September 2002
