What are some of the key themes you’ve heard from second quarter earnings and/or potential red flags that investors should be considering?
It’s been a robust earnings season, but one consistent theme is that there is still a lot of uncertainty, despite management teams feeling better than a quarter ago. One CEO put it well on his earnings call, stating that companies are becoming “more comfortable being uncomfortable.” To us, this environment feels more fragile; management teams don’t seem to have a lot of confidence that the strong results will continue. If we do see a slowing in demand or a further increase in prices, we think companies may be quicker to cut headcount or to pull back on capital investments. We’re also seeing pockets of slowing demand outside of AI, and consumers are becoming increasingly price-conscious.
Recent economic data has sparked fears of stagflation (rising prices with slowing economic growth). What do you look for in a company that can weather this type of challenging macro environment?
We seek companies that are durable and can withstand stagflation or any other challenging environment. We’ve been consistent and disciplined in the characteristics of the businesses we look for. When we think about durability, we first think about the stability of a company’s demand profile. Take internet service, for example. If the economy starts to slow or inflation rises, consumers are likely to continue using their internet service. The same goes for insurance. Although there may be fewer policies to write, consumers and businesses will still require insurance. So, there is stability in the demand for these services. We also focus on strong value propositions. Discount retailers, for example, whose core value proposition is to save people money, are positioned well for this type of environment. Lastly, a focus on strong balance sheets leads us to companies that have less debt. Net cash positions are very common across our portfolio. These businesses can play offense when their competitors might be focused on making their next interest payment or refinancing their debt. Our businesses can continue to invest opportunistically or buy back shares.
While you are focused on bottom-up stock selection, the factors that have been driving markets this year are hard to ignore. Do you think equity returns have become detached from fundamentals?
The short answer is yes. Several data sets indicate that the market is in pure risk-on mode. One example is to examine the performance of stocks with the highest short interest. These are businesses that tend to have high debt, aren’t earning money, and investors question the durability of their business models. Not the types of stocks we invest in. The top 10% most shorted stocks, which have historically performed poorly, have been performing very well recently. This has occurred a few times in the past, most notably before the tech bubble and during the COVID re-opening with the meme stock craze—both periods that didn’t end well.
We also look at factor analysis. High momentum has been the leading factor over the last year and a half. This has little to do with the underlying fundamentals of these businesses, unlike the Low Volatility factor, for example, which reflects more consistent businesses.
Specific to mid caps, if you look at what’s been working this year in the Russell Midcap Index, the characteristics of the top 20 performing stocks in the index also reflect the speculative market. Half of these top performers are actually losing money, yet investors continue to bid them higher, hoping they will turn a profit in the future.
So, despite the risk-on market, we will continue to focus on managing risk by investing in high-quality, durable businesses.
How has your view on AI evolved? With companies continuing to spend on AI infrastructure, have you found opportunities in the mid cap space that meet the quality and durability criteria we look for?
There’s certainly a lot of money going into the infrastructure buildout. There are also questions about the return companies are seeing on pilots of AI applications. Lots of moving parts, so we’re staying very close to the developments here. But an important distinction is that we are seeking truly exceptional investments; we’re not just looking to gain exposure. We believe there are some very compelling opportunities that will benefit from the buildout. Amphenol, a company we’ve owned for 16 years in the mid cap portfolio, is a good example. We first invested because it has an exceptional moat, management team, culture, and balance sheet. And over time, we got to know it well. It has proven itself to be a durable business; it is not a new company. Amphenol makes interconnect products that perform critical functions. Their components are in mobile phones, automobiles, and industrial, aerospace, and defense applications. They are really spread throughout the economy. But they are also very useful in AI data centers, as they connect servers, Graphics Processing Units (GPUs), and help distribute power, facilitate cooling, and more. We believe the data center buildout is still in the early innings, and Amphenol is well-positioned to benefit, given its wide moat and differentiated products. It is an AI beneficiary, but it has all the marks of a durable business, and it trades at a reasonable valuation.