Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 530

Is the market wrong on AI and China?

In October 2022, a renowned analyst at one of the world’s leading investment banks published a report that downgraded the stock of Meta Platforms (formerly Facebook) and halved his price target to $105 per share. The analyst had been spooked by Meta’s guidance on the scale of its future capital investments – largely for AI. The spending was simply too much, too scary. It was 'thesis changing', the analyst said. After the analyst’s report was published, Meta’s stock crashed 24% the next day.

But fast-forward 10 months, and the market now loves AI investments, and the more the better, seemingly. From the lows reached in late 2022, Meta’s stock has nearly quadrupled.

Put simply, the market was wrong on Meta.

Here is another example. In 2020, Bed Bath & Beyond, a US big box retailer of homewares and furniture – a company that had earnings declines each year since 2013 – experienced something unusual.

Bed Bath & Beyond – Five year stock price

Source: Bloomberg

Over a 10-month period, its stock increased by 14x, adding nearly US$4 billion in value to the company. To put this in perspective, the value of the entire company – including all its indebtedness – amounted to only $3 billion at the beginning of this escapade.

Did this share price surge fairly represent the intrinsic value of the business? Or was the market simply swept up in some Covid-stimulus-related exuberance at the time? It was surely the latter. Two years later, Bed Bath & Beyond filed for bankruptcy.

The dangers and opportunities in a market that misleads

The conventional, academic view is that markets are ‘efficient’ – they price in all available information effectively and are therefore fairly valued. But as you can see in the stock stories above, the truth is that the market is often wrong: that is, stock prices can deviate from true value from time to time, and sometimes significantly. Ben Graham was certainly right to dub the stock market ‘Mr. Market’, a manic-depressive character prone to bouts of pessimism and optimism.

And that means stock prices are not reliably good at telling you whether your investment ideas are right or wrong. Shareholders of Silicon Valley Bank, for example, probably ‘felt right’ for nearly 40 years based on the continual steady rise in the bank’s stock price. But ultimately, their investment would turn out to be worthless.

So what should investors do when investing in a market that can be wildly wrong? The secret to navigating periods of market mispricing is simple, but not easy: remain focused on business fundamentals – revenues, earnings, cash flows – and how these evolve relative to prior expectations.

Investors should view a stock price as simply a window of opportunity to buy or sell. The window might be closed most of the time, but sometimes a window opens to buy a stock when its price becomes cheap – that is, the market is pricing-in the future earnings power of a business too low. Conversely, a window of opportunity may open to sell a stock, even the stock of a world-leading company, if its price becomes too expensive.

The huge rewards to holding onto Amazon when the market was wrong

With this approach, investors would view the large stock price drawdowns that Amazon has suffered throughout its history, for example, as nothing more than an opportunity to buy more shares – and not an indictment on their original investment thesis.

Amazon, one of the world’s best businesses, has arguably remained structurally undervalued by the market for most (if not all) of its corporate lifetime.

Amazon – plenty of large draw-downs

Source: Bloomberg; Montaka

Not only has Amazon’s stock halved on three occasions – the dot com bust, the GFC, and the 2022 price downturn – it has experienced a 30% decline on numerous occasions. History has always shown these drawdowns to be unreasonable.

But if an investor could have held on when the market was wrong, they would have been rewarded with an annual return of 33% for 26 years, or compound growth of 1,800x).

Is Mr. Market wrong today?

So where could the market be wrong today? Two areas are AI and China.

There is clearly a lot of hype about AI. And while the technology itself appears to be genuinely revolutionary, history shows that mercurial Mr. Market is not always as discerning as he should be in periods of great hype.

Take NVIDIA, the designer of the world’s most in-demand accelerator chips for AI today. The stock has rallied more than 3x this year alone. The stock now trades at 41x next year’s (substantially upgraded) earnings. Has the market got this valuation right? Time will tell.

Today, NVIDIA’s AI chips are essentially the only game in town. This is an extraordinarily attractive position for the company to find itself in. But the competition in the chip design space is intensifying. Most of NVIDIA’s largest customers are investing in their own competing chip designs. It would not be a complete shock to look back in a few years and conclude that today’s valuation was unreasonably elevated.

On the other end of the spectrum, Chinese equities have had a miserable time of late. A weakening economy, combined with geopolitical concerns, has led many investors to sell.

NVIDIA vs Alibaba – YTD stock returns

Source: Bloomberg; Montaka

As a result, shares in Alibaba, China’s largest e-commerce platform and cloud computing platform, are flat year-to-date (but down by two-thirds from its 2020 peak). Yet investors might be surprised to learn the following:

  • Alibaba’s revenue is growing at double-digit percentage annual rates,
  • Its employee count is down 7% compared to last year,
  • Group profit margins are expanding,
  • Free cash flow is double where it was a year ago,
  • Cash is being returned to shareholders via large buybacks (the equivalent of 1/6th of today’s enterprise value has been returned in the last two years alone), and
  • The stock now trades at just 6x next year’s earnings.

Has the market got this valuation right? Or is it being overly pessimistic?

Again, time will tell. In this instance, one needn’t dispute the risks of investing in China. Instead, it’s a question of what price for Alibaba is simply too cheap. It would not be shocking to look back in a few years and observe an Alibaba stock price that is materially higher than current levels.

Remain anchored in fundamentals, not stock prices

It’s human nature to view stock prices as a feedback mechanism – an adjudication of investments that were right and wrong. So it’s important to remember the market can mislead and is often wrong.

Instead, view stock prices as nothing more than offers to buy and sell. And divorce prices from your assessment of business fundamentals. Own businesses when your fundamental expectations greatly exceed those embedded in stock prices. And sell those when the reverse is true.

 

 

Andrew Macken is the Chief Investment Officer at Montaka Global Investments, a sponsor of Firstlinks. This article is general information and is based on an understanding of current legislation.

For more articles and papers from Montaka, click here.

 

3 Comments
Frankie
October 14, 2023

I really struggle with the AI stuff (China I've written off on ageing demographics and trade barriers). I can see how Nvidia does well from it based on it chips, but it seems every company small and large is using AI so what's the barrier to entry and how does it give a competitive edge that makes money?

Economist
October 12, 2023

Um, one opinion that got a forecast wrong doesn't equate the market getting it wrong.

The market is the sum total of all opinions - those that turn out right and those that turn out wrong - and pricing at any point in time reflects those opinions. That's how the market gets it right all the time - there is never an opinion not reflected in the pricing. Presumably you are currently buying China and AI - fair enough, and your purchases are reflected in the current price. If the prices go up more than an index of the whole market into the future and you do well, bully for you. But that doesn't mean the market got anything wrong.

Philip Rix
October 19, 2023

All "market opinions" are formed on the data points that those investors chose to rely upon which are in turn acted upon subject to the human emotional biases that will have hard wired into us (confirmation bias, fear, greed etc). So to my thinking, it is therefore very plausible that the majority of opinions on a stock could actually be wrong and this in turn leads to the market pricing of a stock also being wrong. I therefore do not believe " ... the market gets it right all of the time".

 

Leave a Comment:

RELATED ARTICLES

5 exciting areas of investment opportunity

Five steps to become a better investor

Why are some companies vulnerable in 2022?

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

Latest Updates

Investment strategies

Investors are threading the eye of the needle

As investors cram into ever narrower areas of the market with increasingly high valuations, Martin Conlon from Schroders says that sensible investing has rarely been such an uncrowded trade.

Economy

New research shows diverging economic impacts of climate change

There is universal consensus that the Earth is experiencing climate change. Yet there is far more debate about how this will impact different economies across the globe. New research sheds more light on the winners and losers.

SMSF strategies

How super members can avoid missing out on tax deductions

Claiming a tax deduction for personal super contributions can end in disappointment if it isn't done correctly. Julie Steed looks at common pitfalls and what is required for a successful claim.

Investment strategies

AI is not an over-hyped fad – but a killer app might be years away

The AI investment trend looks set to continue for years but there is only room for a handful of long-term winners. Dr Kevin Hebner also warns regulators against strangling innovation in the sector before society reaps the benefits.

Retirement

Why certainty is so important in retirement

Retirement is a time of great excitement but it is also one of uncertainty. This is hardly surprising given the daunting move from receiving a steady outcome to relying on savings and investments.

Investment strategies

Have value investors been hindered by this quirk of accounting?

Investments in intangible assets are as crucial to many companies as investments in capital equipment. The different accounting treatment of these investments, however, weighs on reported earnings and could render ratios like P/E less useful for investors.

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.