Talk Your Book: Growth Stock Concentration

0:00Today's Animal Spirits Talk Your Book is brought to you by Harbor Capital. That's harpercapital.com.

0:33this podcast.

0:37Welcome to Animal Spirits with Michael and Ben. Michael, we've done a handful of live podcasts now. Dare I say this was my favorite one we've done because of the location. I'm kidding. No, this was great. Harbor Capital put on an awesome event in Charleston at a great venue. They did. It was an intimate group of people. You know how comedians talk about how they go to like do a show at Madison Square Garden versus the small comedy show. They'd rather do the small comedy show. We had a little intimate group of people here. It wasn't a huge ballroom. It was, I don't know, 80 some financial advisors and people from Harbor Capital.

1:12It's the first time they've done an event like this for advisors. So we talked to Kathleen McHara, who is the lead portfolio manager for their growth strategy. And it was pretty good timing because we've had the run in NVIDIA and all these other growth stocks. We talked about stock market concentration and NVIDIA and AI and dealing with drawdowns in these kinds of companies. So I thought that the timing of this talk was actually really good as well. Perfect. In the interim, NVIDIA took the crown, number one stock in the world. That's right. We spoke about all the growers, how she became a growth manager.

1:48Most people are value managers. It's rare that you meet somebody who identifies as a growth manager, but we found that person. That's true. So this is, again, this is our live talk from Charleston a couple weeks ago. And enjoy.

2:09Thanks everyone for having us. Kathleen, I want to start off here. You are a large cap growth manager. I've heard a ton of stories from people over the years about their value existence, how they became a value manager. I read Intelligent Investor by Benjamin Graham. I was a Warren Buffett disciple. I read all those books. How does one become a growth stock manager? What is the background there? I would say I start with being an optimist. I love opportunity that companies create and that we as investors are able to envision as we look forward. So it takes curiosity and creativity. And it takes a willingness to go at risk of being wrong.

2:54Because when you're looking at companies creating things and there's no protocol for how to value it, how to see how it will evolve, you're not always going to be right. And so we're very publicly arguing for a point of view where sometimes we're right and it becomes magnificent and sometimes we're magnificently wrong. You've been at Jenison for a while. Just maybe a quick plug for what's kept you there and what you love about the role that you're in. Well, Jenison's a fabulous firm at which to work, we have amazing client base. And the reason I start with that is because as investors, we are charged with and privileged to do what we believe is right for clients.

3:42And so we do not have business risk or pressures that lead us into investments that otherwise we wouldn't take. So number one. Secondly, we've got what I consider to be a very strong and self-reinforcing culture. This idea of taking risk publicly. You can't do that everywhere. And yet it's so important to be a successful investor that you learn from your mistakes and go forward. And that's what we do. The third thing is I will cite one of the founders who I had the privilege of working with for nearly 25 years, Sig Sigalis. And he always said, I'm only as good as the people around me. And so what he did very successfully over decades is he put good people around him.

4:28And so if you've got people who make you better and you make them better, that's a great environment in which to work. I'll say one last thing. I mean, I could pitch Jenison all day long, but I will say one last thing, which is we are the kind of investor that companies like to have as shareholders. We care about the same things they care about. We invest with managements who are developing and leading through various environments. And so we really do get to meet with talented people in all kinds of industries, creating new and exciting things. And that's just a great thing to do all day, every day.

5:09I'm curious what it's like to be investing in the best performing space in the market for the past, I don't know, call it what you want, 10, 12, 15 years. There was an 18-month window there where large cap growth was out of favor. But for a long time, the majority of the time for this cycle, large cap growth has been in favor and outperforming just about everything else. Does that make your job easier or does that make your job harder? Because you have to keep up with a bogey that is doing better than everything else. Well, first I'll say that's a very gentle characterization of 2022.

5:45You know, it never seems easy while you're doing it. And sometimes things seem obvious with hindsight. Things that seem obvious in advance often are not. The concentration in the benchmark is certainly a topic of conversation today. We don't look at benchmark construction as the starting point of portfolio construction. So we're bottom-up stock pickers, and we build portfolios in the way we think we should. So when you've got a benchmark that's gotten as concentrated as the S &P, or even worse, Russell 1000 growth, where after it's rebalancing at the end of this month, 48 % of that benchmark will be in five names.

6:32I mean, that's a really tough bogey if that's what you're trying to manage to. Russell 1000 growth. So what we do is we look for companies we think deserve shelf space. So let's talk about concentration. You were talking about the Russell growth. I'll just broaden out to the S &P 500. NVIDIA, Microsoft, and Apple are now 20 % of the S &P 500. They're 25 % of the NASDAQ. And they're 15 % of the total US market cap of every listed company. And that, that last statistic, that's the highest since the 1960s, just for three companies to have a 15 % weighting. That hasn't happened in a long, long time.

7:11I know you're an optimist. Does this worry you? Or do you think that this is just the natural evolution of the tech giants just crowding everybody out and that's nothing to worry about? Where do you stand on this hot topic? Well, in contemporary investment careers, we've never seen anything like this. So at some point, we do expect it to change. And what will lead to that change? I think, you know, to some extent, law of large numbers. When companies get to the scale that we're talking about, at some point, growth slows. And the market valuation of future growth will, you know, compress a bit.

7:51So that's some of the natural piece of it. The other elements, though, is we've seen such a shrinkage in the number of public companies in this country. Peaked at 8 ,000, now roughly 4 ,000. So companies want to stay private longer if they can. And then there's such an active PE world that that's another place for companies to land. So our shopping basket has certainly shrunk. But when I look at growth investing, what we get to do is we get to find companies creating things that don't exist, that are innovating, and that are creating their own growth. So I think there's still ample opportunity for us to find portfolio names.

8:38The poster child of what you just mentioned, growth and innovation right now, is NVIDIA. We believed that the GPU was creating a new way of compute that would grow in importance. But in 2016, it was all about gaming. So two-thirds of the company was gaming, and it had just come off of a down cycle in gaming. But what we saw that we liked at that time and is a very important piece of why we've stayed is it had become important to data centers. So the massive increase in compute power, the cost advantage of that was allowing cloud and hyperscalers to do things, to process volumes of data in ways that they couldn't at a much more economic cost, which allowed them to do even more.

9:34So we saw data centers actually doubling at that time, even though it was only about 15 % of their business. And then as you move it forward, gaming, of course, has become a much smaller piece of what they do because all things AI, i.e. data centers, hyperscalers, and generative AI have taken over in terms of the utility of this architecture. Sure. So this week on the podcast, Michael mentioned that he went and saw Godzilla minus one at the theater before anyone else. You guys are both early adopters in these kind of things. I haven't seen it. Should I? You absolutely should. It's on Netflix. So I'm curious if you have a contrarian bent at all.

10:16And you mentioned the benchmark, even being underweight, these names as contrarian, let alone just selling them completely. Do you worry at all about missing the turn? Michael always says with Bitcoin that, listen, I want to sell this thing late. I don't want to be early because it could keep rising and growing. Do you view a company like NVIDIA or any of these big, huge companies that have garnered so much concentration, is there any part of you that wants to be contrarian and say, I'm going to be the first one who goes underweight these stocks and tries to outperform that way? But before you answer that, just one piece of data that I think would help that.

10:50So NVIDIA reported earnings 10 days ago, trading days. And in that time, I mean, it wasn't a small company way back then. It's added$607 billion in market cap in the last 10 trading days. And it's now$3 trillion. It's bigger than Apple. For reference, JP Morgan is$560 billion. Now, of course, one has nothing to do with the other, but that's a lot of money. So in terms of being maybe early to sell on the way up, or would you rather sell late? Or maybe that's like a good window into your process. Well, I would not characterize us as contrarian ever. but do we sit in a unique position? Often, when we are buying a stock, we have a point of view that is not common to others, but there are numerous ones where we're getting in, we see something that is not sort of consensus, that's not fully reflected in the price of the stock.

11:45So we're willing to go with our deep knowledge, our deep research, and the conviction around that to take positions that are outsized relative to what our competitors might be doing, and certainly outsized relative to the benchmark when we initiate. But as its success is demonstrated, and as the market rewards that, the stock is running up, it's going up in the benchmarks. You were pretty quick to bat away the label of contrarian. I'm curious, do you think are contrarians money losers? Or when you hear that word, what comes to mind? Why are you so allergic to that word? I don't know. I just am.

12:26Okay, so. No, I mean, I think of it as the need to oppose something, the need to oppose a point of view. And we're not opposing a point of view. We're crafting an understanding of something and hoping to build conviction in that scenario. Well, not even like a contrarian, but how do you view the difference between fundamentals and expectations? Because such a big part of growth stocks is expectations. And how do you try to, you know, it's almost a qualitative thing of how do we quantitatively manage these expectations so it stays within reality? How do you think about that? If like the expectations of investors get way too far ahead, how do you determine what that point is?

13:04Well, it's an art, not a science, right? But I'd say a couple of things on that. One is, you know, if investors' expectations are rising, it is because there's development in the fundamentals of the company. And sometimes those developments are even more positive than what we envisioned. So in the case of NVIDIA, we too were raising our expectations a year ago. Not fast enough. Yeah, we were way above anybody else's. But as they started to deliver, we too took our expectations up. We stayed ahead of expectations. Are we ahead today? I would say not really, because the company is capacity constrained.

13:45So when you look at near term, we're probably sitting more or less where people are, maybe a little above, but not like we were. So now what we think about is the duration of that opportunity. So where's the constraint? They are capacity constrained. Supply chain, you know, they are on allocation. So, you know, they can't, you know, I mean, could they boost expectations again one more round? They could, but not of the magnitude that they have. So we're in a place where they're executing to what I'd consider to be common understanding. And then what we believe we have a differentiated view on is, you know, multiple years into the future, out years, how that will be managed.

14:29You know, it's a semiconductor company at the core, right? And so it's classic in semiconductors for there to be cycles where there is great enthusiasm on the demand increase. When there's demand increase, there tends to be inventory build, and that drives revenues in the near term even more. That leads to valuation expansion in the market. So you're layering these three things on top of one another in the market. And there's always another side to that when you can fill demand. So right now, that is a worry that people are starting to focus on with NVIDIA. If they are successful in managing those allocations, and if demand stays as robust as we think it will, we don't see that inventory problem.

15:18But there will be slowing growth rate. So how will the market take it when growth rates move from triple digit to high double digit to mid double digit? Probably not great. So we'll broach that one when we get there. I promise we won't talk about NVIDIA for the entirety of the session. So the last question for me on this. When you think about or when you hear people say, oh, this is like Cisco. I've seen this movie before. What do you think? What comes to mind for you? Oh, we've been thinking about that 2000 experience for a while. And there are similarities and there are differences. That inventory build is one of them.

15:59The companies into which they're selling are one of them. Are they real? Are they not? Is the capital that's funding them going to disappear or not? But the other thing is - Wait, I'm sorry. Just on that last point - Yes. Are the companies that are funding them. So a large percentage of their revenue is coming from the hyperscalers. When the music ended during the dot-com bust, Cisco's - The companies that were paying them, their clients disappeared. I mean, that is nothing like what's happening - It's totally different from that enterprise cloud hyperscaler layer. There's a lot of capital that's gone into new company creation, and some of those new emerging AI companies are customers of NVIDIA.

16:44So much smaller piece of the revenues going out the door, and I think much more well-managed, but that's what I was referring to. I poo-pooed the 2022 bear market earlier, you said. No, I said you were kind and gentle in your description. of it. Two-thirds of its value. But I mean, a lot of these large-cap growth companies did fall 40%, 50%, 60%, 70%, 80 % in some cases. If you're going to be in the best-performing stocks, especially growth stocks, they are going to get hammered at times. All of these stocks that have gone up in one, you know, Netflix has had three or four different 70 % drawdowns over the years.

17:16How do you handle that part of the process? Well, we certainly try not to be fully invested in the name on the cusp of those drawdowns, right? So there are times where we see fundamentals are coming into question in the short or intermediate term. We'll cut the position size. We'll sell the whole thing and we'll come back to it. So it depends on what we understand around what's taking the prices down. Now, if you think about 22, that was a complete change in our investment environment. Risk tolerance went down. Discount rates went up because of inflation and interest rates. And so there was a repricing across the market.

17:57And growth stocks, in particular very high growth stocks with higher valuations, got hit harder. So when that change was taking place in the market, we sold a number of our names that had benefited from the free money environment, where companies did not have to be disciplined about growth and profitability. when the environment was no longer going to allow that to take place, we exited those names. So it's a function of what's taking them down. There are times we've ridden a stock all the way down where we add to the position, you know, sort of at the bottom, if you will, if we really believe.

18:38But, you know, there are, you know, there are drawdowns and they hurt when they happen. But if we can manage position size successfully around that to some extent, we will do that. Apple has been the largest stock in the S &P 500 for 99.96 % of the time for the last decade. So it's been on top of the mountain looking down at all its competitors. Now, the company, the revenue, the top line has not really grown very much at all for the last several quarters. Obviously, there's troubles in China. They've been behind with the AI strategy. Does it make sense to you that the stock is near an all-time high, given some of the things that I just mentioned, or near an all-time high?

19:20We look at the valuation of those cash flows and think it is appropriately valued. So the fact that it treaded water, it came down, it's done nothing relative to others, I think has rebalanced its valuation versus those that are growing more rapidly. So not so much focused on what its market cap is, but what's the valuation of the cash flows and what is the rate at which we expect them to grow? And then what is the persistence of those cash flows? And with Apple, certainly the services business and the relative impact of that on their profitability is very significant to how we look at duration of cash flows there.

20:00Apple used to trade at a harder multiple. It was four times sales, give or take. It was, I don't know, 13 to 15 times earnings for a long time. And then there was a clear break where the stock got re-rated higher. And it's to your point about the margins on services are much higher than hardware. So it's enjoyed the benefit of that. When you're thinking about valuations and fundamentals and multiples, not every stock trades off of the same valuation levels, right? Some trade on free cash flow, some trade on other things. How do you think about, in general, and you could be specific, valuation multiples when you're looking at some of these different companies, do you adjust for growth?

20:37Like, what's the process look like? We absolutely look at the companies the way we would value an industry, and they are not all the same. So for what I would call a stable quality compounder, we might use similar metrics across industries for companies like that. But if we're looking at companies that are creating something where we expect explosive growth, we are going to take 10-year discounted cash flow models, discount them back, and utilize that as a starting point, fully understanding that every single number in that model 10 years out will be wrong, right? But being able to put best efforts forward on what this could look like and using that relative to other companies with similar kinds of characteristics.

21:25But there are companies we really look at tangible book. So a Goldman Sachs, for example, we're going to look at tangible book rather than some kind of normalized growth rate to revenues. We'll look at PE price to cash flows relative to the company's own history, relative to the market, and relative to others in their industry. You mentioned discounted cash flows. And of course, they're just models, but they are a starting point. One of the biggest inputs to the model is the interest of the discount rate. and the discount rate is a very sensitive input, and the numbers could change dramatically, whether the discount rate is 3 % or even 3.5%.

22:03And now it's a lot higher than that. So you mentioned 2022 being a very, very extraordinarily difficult year as Fed funds went from zero up to 5%. How do you think about how interest rates impact growth companies? There's no doubt that our type of growth companies will be affected more significantly than a GARP or value portfolio if the value names aren't balance sheet constrained, right? But when we have rising rates, we do expect valuation compression in our names to be more significant than that of lower growth and lower valued names. Are you surprised then that valuations have kind of returned with rates still staying high?

22:50Because it seems like investors had that rocky period, and then rates didn't go down like everyone thought they would, but these stocks continue to charge higher. I would say most people are surprised at the strength of the market this year, and I would characterize it as being driven by earnings and around certain companies that have really material opportunities ahead of them rather than a market revaluation per se. And if you look at the S &P at 19 times next year's number, it's a little bit above typical or traditional range valuation, but so are their earnings expectations. So it's not out of line.

23:31One of the interesting things about the interest rate hiking cycle is that it didn't seem to maybe have the impact that a lot of us feared. And one thing that I never could have predicted was the net interest expense of these companies actually going down, because a lot of them were fully funded in terms of their debt loads. They took out a lot of debt, as they should have when rates were super low. And the cash balance now earning more money on their cash than the debt that they're servicing. So actually, the higher interest rates have benefited them. Can Do you talk about how that filtered through to the bottom line?

24:07That's absolutely true. It's not a material part of any of our company's earnings expectations. So if it were, I don't think we'd be calling them the kind of growth companies we think they are. So the tech stocks are sexy and easy to talk about. But what other companies or sectors are exciting you right now outside of the big tech names? Well, there's always innovation in consumer. And what we see there is kind of consumer preference moving from place to place. So, you know, something like Mercado Libre, which is, you know, the largest e-commerce and payments ecosystem in Latin America. and they have 70 plus percent share in Argentina, 50 percent share in Brazil, and they are early in their growth in Mexico, I think is very attractive kind of secular opportunity.

25:06They have invested in technology and infrastructure such that they have a real competitive advantage against anyone else coming into that market, Amazon included. So you're willing to go outside the US borders? Because it's interesting, a lot of people have given up on international stocks in recent years saying, well, why do I need to own any international stocks if S &P 500 companies get 40 % of the revenue from overseas? But you're willing to go outside the borders and own international companies? We do. I'd say, you know, when we started looking at Mercado, you know, we utilized our expertise in what Amazon is and created to understand what Mercado could become in Latin America.

25:49So that's the kind of thing we'll do. We're not going to reach into, you know, kind of exotics, if you will. It's very much the type of name that reflects what we understand going on in the U.S. And the other side to that is something like Novo versus Lilly. One's a U.S.-based company and one is domiciled outside the U.S. They're both global companies. So that's the kind of name that we would look to if we're moving outside of the US. When you listen to earnings calls, whether it's from the credit card companies, the banks, the Walmarts and Targets of the world, they're all saying the same thing, which is that the consumer is doing just fine.

26:29It's consistent. They're reliable. Those are some of the words that they're using. But interestingly, you're seeing a ton of dispersion inside the consumer sector in terms of some of the stocks, whether it's Chipotle and Dick's or Disney or Foot Locker or Lululemon, the consumer is now picking and choosing. We want to spend money here. No, we're not going to spend money there. And that's actually filtered through to the rest of the market. You're seeing the correlation of stocks within the S &P 500 going down in a bull market, which is very, very healthy and exciting, I would think, from the point of a stock picker.