Wealth managers seek broader tech themes

Private banks are questioning the sustainability of a narrowly led tech rally, which has driven some investors to seek out smaller firms transformed by AI.

Wealth managers are increasingly emphasising innovation in the technology space, monitoring developments in everything from smart mobility to artificial intelligence and automation.

But returns in the technology space have largely been driven by a narrow group of US large cap companies. Today, Microsoft, Apple, Nvidia, Amazon, and Google’s parent, Alphabet, account for almost a quarter of the value of the S&P 500. Together with Mark Zuckerberg’s Meta and Elon Musk’s Tesla, the so-called ‘Magnificent Seven’ enjoy a combined market cap of more than $13tn, worth more than the entire stockmarkets of the UK, Canada, and Japan put together. Mr Musk has even claimed Tesla could one day be worth up to $30tn, amid advancements in AI and robotics.

Having enjoyed massive market gains, investors are now asking: how sustainable is this narrow leadership, and should they be looking elsewhere?

“The technology sector has been prone to herding and bandwagon effects in the past,” says Victor Balfour, investment strategist at UK wealth firm Rothschild & Co. “The big risk is that stock prices become so detached from fundamentals that a big reversal – a popping of the bubble as it were – becomes inevitable.”

Today’s market leadership is even narrower than in 2000, but according to Mr Balfour, talk of fads and bubbles seems misplaced. “Sentiment may be in the driving seat, but there is some underlying logic to this lopsided leadership,” he says.

Technology companies are “in the van of long-term economic growth”, and their ownership, coupled with increased innovation, “permeates a wide range of activities”. Output is “increasingly digital”, and this trend, Mr Balfour believes, “will continue regardless of whether the promise of productivity-boosting artificial intelligence occurs as quickly or as broadly as many hope”.

Whether this rally continues or not “remains to be seen,” but Mr Balfour draws a useful parallel – more so than the dotcom era – that is the Nifty Fifty era in the 1960s and 1970s, driven by large-cap growth stocks with high valuations. “Although this cohort did eventually disappoint, they owe this to wider macro factors – arrival of the stagflationary 1970s and early 1980s period,” he says. “Many of the stocks went on to perform again. Indeed, many of the businesses continue to produce healthy cashflows today – albeit at less demanding valuations.”

Market historians credit these companies – IBM, Polaroid and Coca-Cola – with propelling the bull market of the early 1970s. Most of them enjoyed high profitability, good growth rates, robust balance sheets and consistent dividend increases, similar to the current Magnificent Seven.

“From our top-down perspective, we continue to favour markets which have a mixture of cyclical and structural strengths,” affirms Mr Balfour. “This needn't always include the US and its technology companies, but, for now, it does.”

Rally drivers

The biggest driver of this tech rally is performance in earnings expectations. Luca Menozzi, director of thematic research at Julius Baer, believes there is going to be a big question mark going into the end of 2024 and beginning of 2025. “I don’t think it's completely sustainable,” he says. “In terms of earnings growth expectation, the gap is going to close.”

Big tech companies will not be able to “continue to grow above 100 per cent”, like Nvidia has been doing. Nvidia, through its specialisms in graphics processing units (GPUs) – where it boasts 90 per cent of the market – and AI solutions, has been driving this market surge. In the past year, Nvidia shares have risen more than 200 per cent, making it the third largest company in the US with $2.97tn market cap.

According to Mr Menozzi, we are seeing “better earnings expectations for the rest of the market”, which could mean the gap between the big techs is likely to close.

“These companies are seen as AI beneficiaries,” he says. “AI and AI demand is cyclical. Semiconductor companies have benefited from these expansions in capex from hyper scalers.” While the big tech companies were in a “cost-saving exercise” in 2023, they are now “increasing their capex spending” and “investing heavily” in the AI opportunity.

The secret of success is the business model.  “Their competitive position is really strong,” and that is “really difficult to disrupt”, believes Mr Menozzi.

Emerging sectors

But there are also smaller firms with similar characteristics, developing AI and emerging technologies for some time, to sustain competitive advantage. Rupen Patel, Rothschild’s co-head of portfolio management, mentions two companies that fit this pattern. The first is John Deere, a precision agriculture company using vast amounts of data and AI to help run technology-led farms and ensure resources such as fertilisers are used efficiently. The second is Booking, an online travel agent analysing consumer behaviours and adapting its offerings accordingly.

“Rather than try and predict a particular sub-sector that will do well, we are thinking more widely about value of quality, proprietary data in all of this,” says Mr Patel. “If we think about training a Large Language Model, for example, it can be a case of ‘rubbish in, rubbish out’, and so the value of a lot of this technology depends a great deal on quality of data,” he explains.

The Covid-19 pandemic, geopolitical tensions and wars in Ukraine, the Middle East and other regions have added pressure to supply chains and governments, says Anjali Bastianpillai, senior client portfolio manager for thematic equities at Pictet Asset Management. “Companies are increasingly interested in ‘reshoring’ or ‘nearshoring’, driving demand for automated or advanced manufacturing capabilities, with significant investments in robots and related solutions including machine vision, cloud infrastructure, and connectivity,” she says.

One interesting area in the industrial part is collaborative robots, "cobots", which are smarter, smaller, cheaper, and easier to integrate, she says. Business process automation with back-office software solutions is also gaining popularity, with Pictet’s diversification boosted by tech transformation.

“We have seen such dispersion of returns and strong diversification opportunities in companies enabled by the AI wave from software, edge AI and autonomous driving,” says Ms Bastianpillai. “AI is a general-purpose technology still at an early stage, especially generative AI,” she adds. But less glamorous, analog semiconductors are also emerging as “unsung heroes” driving our increasingly digitalised economy.

It is vital not to overlook small cap firms, believe some experts, even though they have been sidelined for the last two years.

“There is a preconception that investment in small-cap stocks is risky, volatile, and cyclical,” says Philip Best, chairman of the board at Quaero Capital, a Swiss specialist fund management firm. “It can be, if you pick the wrong type of stocks. But if you pick the right kind of stocks – that are cheaply valued, don't have debt, but have an interesting growth profile – you can knock out the risk.”