Madison Large Cap portfolio manager, Joe Maginot, shares how he and the rest of the U.S. Equity team views current market conditions, the impact of AI on their decision making, and where they are seeing opportunity and challenges across the stock market.
Despite interest rates at their highest levels in 20 years, the equity market has been pricing a projected double-digit earnings growth for 2024. Why do investors remain optimistic about stocks?
Last year (2022) was characterized by inflation continually surprising to the upside. Some of the factors that led to that jump in inflation, such as supply chain pressures, wage inflation, rising commodity prices, particularly oil, have largely normalized this year. That's been one piece of optimism for investors. Another would be the economic resilience in the face of higher rates and the regional banking crisis earlier this year. Then there’s the infrastructure bill and Inflation Reduction Act that have spurred the economy and given corporations the confidence to invest. And, of course, the consumer has remained strong. So by in large, some of the economic data that was expected to roll over this year really hasn’t. That’s given investors some confidence. Then you layer on top of that the enthusiasm for artificial intelligence (AI) and how it has been incorporated into businesses and consumer lives, and in this backdrop, there is a lot for investors to be optimistic about. We’ll see if the double-digit earnings growth for 2024 comes to pass.
Speaking of AI and some of the recent events from this year, have you had any changes in your conviction as it relates to financials, following the issues with regional banks, or technology, with new developments in AI?
I'll start with regional banks. We're very risk conscious investors to begin with. So, we didn't have a lot of exposure to regional banks by the very nature of their business models. It's a spread business. There are a lot of things that are outside of management's control within those businesses. The liquidity issues from earlier this year illustrate some of the risks that come from a concentrated deposit base. Not just business versus retail, but also geographically and the percentage of a bank’s deposits above or below the FDIC limits. So, on the margin, the regional banking issues lowered our confidence, given the amplification of some of the risks that have always existed. The financials that we have in our portfolio, we believe, are much more resilient. A couple of companies generate earnings from net interest margin, but also have a large percentage of earnings that come from fee-related revenue.
As it relates to AI, the key question for us is: is this a platform shift, where technologies of the past become obsolete, or will the technology be integrated through existing platforms? We went through and analyzed each of our portfolio companies along these factors. And for the most part, we concluded that a lot of our companies were already incorporating AI within their current offering, even if it isn't consumer or customer facing. Think of payment companies and how they incorporate AI into authorization decisions to better identify fraud and so on. We also asked, what type of risks and opportunities could this present for our companies?’ For the most part, we didn’t believe the threat of AI would obsolesce the current business models, and, in fact, thought it would largely be additive to the business.
Markets are always changing. How do you ensure consistency of your investment approach as the markets change?
We want consistency across the types of companies we invest in and the valuations that we pay. We only invest in high quality companies. The way we think about quality is that it’s not just the business quality by itself, but it includes the balance sheet, the management team, and how the company is governed. To ensure consistency, we have what we call our confidence rankings, where across each of the quality factors, we rate our companies on a one through five basis, with one being the lowest confidence and five being the highest. We only invest in companies that are rated three and above. What this enables us to do is compare and contrast the stocks we own not only relative to one another, but also relative to the stocks that we don’t own. It enables us to maintain a consistency of owning what we deem to be high quality businesses, regardless of the underlying market conditions, however they may change.
The second component is valuation, and we are constantly making adjustments to our valuations of companies. You can’t just look at stated profits and assume they will endure into the future. Companies participate in the economy, and sometimes these markets can run a little bit hotter than other times and a company can be over-earning. Or, when markets are weak, a company can be under-earning relative to long-term trends. So, we make those types of adjustments to make sure that we arrive at what we believe to be true economic earnings of the business. And, because we want to earn above-average returns with below average risk over the long-term, we don’t move our discount rates based on short-term metrics like current treasury yields.
What is your outlook for markets, and where are you finding opportunities?
Overall, we think there are pockets of opportunity. But we try to temper investors’ expectations. In the last 12 to 14 years, it has been a very robust market environment. We saw declining interest rates, declining tax rates, expanding valuation multiples, and these characteristics are unlikely to repeat and have a similar type of impact over the next five to ten years. So, we always try to set appropriate expectations for returns. But that said, we think there are a lot of opportunities out there right now. The U.S. equity markets, especially in the large cap space, are very narrow, where the markets are being driven by a smaller subset of companies. And as a result, certain parts of the market have been left behind. Some of the areas we are finding value today include health care, financials, and technology, particularly in analog chips. Within healthcare, life science tools are certainly out of favor today. This is an area where, as I discussed earlier, we are constantly adjusting our valuations of these companies to reflect what believe to be the true economic earnings of the business. In the years shortly after the COVID shutdowns, demand for these products was very robust. As demand normalized over the last year and a half, the market overreacted, in our opinion. Markets tend to overshoot in one direction and overshoot in the other direction. And that’s led to opportunities within these sectors.