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Nvidia, surging tech stocks and the ‘hidden risk’ of elevated valuations
Surging US technology stock values may have put wind in the sails of portfolios around the globe, but those same valuations can pose a ‘hidden risk’ to quality investors looking for a safe haven in their global equities sleeve, Atrium Investment Management says.
The performance of top-end tech stocks, led by the ubiquitous MAMAA cohort (the latest incarnation of the FAANG group, now consisting of Meta, Apple, Microsoft, Amazon and Alphabet), has been hard to fault over the last decade. Despite hitting a wall in 2022 – and shedding Netflix – the group accounts for more than 20 per cent of the S&P 500’s value, or about USD$30 trillion.
It’s these lofty valuations, however, that give Atrium Investments’ senior portfolio manager Brendan Paul cause for concern. The hype around the latest big US tech stock, chipmaker Nvidia, is a big reason why.
“When you look at the stocks that are driving returns and ask, ‘Where are those returns coming from?’ a lot of it is around this AI narrative,” Paul said during a recent televised interview. “This generative AI is being priced in, and Nvidia is a great example.”
Nvidia is the fourth largest stock on the S&P 500 by index weight, behind Apple, Microsoft and Amazon. The integrated circuits it produces are used in devices around the world and are pegged as a leading supplier for the next generation of large-language, generative AI tools such as ChatGPT.
While other big tech stocks are having their valuations inflated by the promise of AI, none has as much positive momentum as Nvidia – which is a red flag for the Atrium team.
“We looked at Nvidia and we said, ‘so, currently [it’s] trading at something like 24x the next 12 months’ revenue,” Paul revealed. “Not earnings, but revenue.”
The question, he said, is what level of growth would be needed to make the investment profitable at such an elevated multiple.
“If you go out 10 years and say ‘That stock is going to grow its revenue at 30 per cent per annum because AI is real and it’s going to generate sales’, that will still only get you a return of about 20 per cent over that timeframe,” he said.
“That sounds fantastic, but what you need to consider is that there’s only been a couple of stocks in history that have ever actually achieved that sort of growth for that length of time, and that’s Microsoft and Salesforce.”
Companies that can sustain such growth rates are incredibly rare, he noted. Nvidia might have incredible return potential, but a lot of that is likely already included in the price. For Nvidia to bank a return for investors, it would have to go a long way to maximising its potential.
“You want to be very careful of what’s being priced in,” Paul said. “It’s a very, very aggressive optimism in some of these stocks.”
Atrium’s wariness doesn’t preclude the firm from owning the stock, Paul clarified. But it does mean being realistic about the company’s inherent value.
“We think that underneath some of that optimism is possibly a little bit of a gap to reality,” he said. “We’ve seen that before, in the late ’90s, with a number of these stocks proving not to be the next Microsoft and therefore, over a long term, generating a negative return from these elevated valuations.”
*This article was first published in The Inside Adviser.
