Q2 2023 - Market Review
ECONOMIC COMMENTARY
The global equity markets decisively broke out of their narrow trading range in early June and ended the second quarter of 2023 with strong gains. Specifically, the MSCI All Countries World Index (US$)[1], S&P 500 Index, and the S&P TSX Composite advanced 6.18%, 8.74% and 1.10%, respectively, during the quarter. The markets’ jolt coincided with the signing into law of the Fiscal Responsibility Act of 2023 by President Biden, which ended a debt-ceiling crisis that had started in January, and which averted triggering dramatic federal spending cuts. Other factors contributing to the generally positive improvement in sentiment[2] were better than expected: first-quarter corporate earnings relative to the same quarter a year ago; limited immediate fallout from the US regional banking system stress; improved 2023 and 2024 global growth outlook[3]; and better-than-expected new building permits issuance and new housing starts despite decade-high mortgage rates.
With the gains achieved during the second quarter, global equity markets have now rallied over 20% since the October 2022 lows, thereby proving once again that equity markets may rally aggressively when the outlook is the most dire. Once again, the market’s state of mind appears to have shifted away from an impetus to guard against the downside to a fear of missing the upside. This has happened even though it is still unclear to what extent the cumulative effect of monetary policy tightening has caused the economy to slow down and inflation to moderate and whether there will be more unintended consequences or spillover effects like those that were experienced in March.
Interestingly, the US equity markets, which were led by a small group of large capitalization issuers in the information technology and communication services sectors, easily outperformed most of the other national and regional indices. This phenomenon has been testing for active equity managers who have generally been lagging equity market indices up simply for being underweight in one or more of the recent significant positive contributors to the equity markets’ performance on valuation concerns. As a matter of fact, at the end of the second quarter, the degree of optimism bestowed to large capitalization information technology issuers relative to the rest of the market was comparable, if not even more extreme than it was in the summer of 2021 or in September 2018, just before the group experienced significant underperformance.
Fixed-income markets posted modest negative returns during the second quarter. Once it became clear that the US regional banking system crisis would be contained and that its detrimental effects on long-term growth would be more limited than initially feared, interest rates slowly drifted upwards, largely reversing the severe declines witnessed in the aftermath of the Silicon Valley Bank debacle in early March. Incidentally, the slow rise in yields was not interrupted by the first Federal Open Market Committee (“FOMC”) pause since the beginning of this hiking cycle in early 2022. As a result, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index returned -1.35% and -0.68% respectively. Corporate bonds generally outperformed government bonds as defaults remained limited despite higher rates. Also, the resolution of the debt-ceiling crisis put additional pressure on US Treasuries due to the immense amount of issuance that would be needed to fund ballooning deficits that will ensue. The high-yield sector was one of the few bright spots in the fixed-income market during the quarter. To this point, the ICE Bank of America Global High Yield Index returned 1.26%, besting investment grade and government bond benchmarks.
Commodities declined modestly during the second quarter. Specifically, the S&P GSCI Commodities posted a return of -2.73% as the re-opening of China did not have the impact that some had anticipated on the demand for energy, metals, and agricultural products, as all three sectors declined during the quarter. In the energy sector, the decline in the price of natural gas was more palatable than the decline in the price of crude oil. With respect to natural gas, thanks to a significant increase in liquefied natural gas (“LNG”) imports and relatively benign weather, Western Europe averted a winter energy shortfall, which put significant downward pressure on the price of natural gas. With regards to oil though, the decline in price occurred even after Saudi Arabia implemented a production cut in early April and announced incremental cuts starting at the beginning of July. This is perplexing as it is a signal that does not match the idea of a strong and resilient economy.
NVIDIA AND THE OTHERS
In our opinion, the spectacular year to date contribution to stock market returns of US large capitalization information technology and communication services companies should not necessarily be heralded as a sign of improving macro conditions. On the contrary, it may just mean that investors are only comfortable holding companies that can thrive and even surprise positively in a slumping economy, either through their exposure to growing cloud revenue stream or euphoria around the development of artificial intelligence (“AI”) applications.
One company that garnered its share of attention during the second quarter was Nvidia. The Santa Clara, CA based Graphics Processing Units (“GPUs”), Application Programming Interface (“API”), and System on Chips (“SoC”) designer shattered sales and earnings expectations for the first quarter ended on April 30th[4] and lifted its guidance for 2nd quarter revenues from a little over 7 billion to 11 billion on the back of strong demand for its family of AI chips. Nvidia’s stock price jumped 24% on the announcement and kept rising afterwards, establishing itself as a member of the select club of companies worth over 1 trillion US$ by June 30th. On that date, Nvidia was trading at over 50 times 2024 projected earnings, over 35 times projected revenues, and over 40 times book value. Moreover, in a world where multiples of 20-25 times earnings before interest, taxes, depreciation, and amortization (“EBITDA”) can be deemed excessive, what should we make of Nvidia’s 160 plus EBITDA valuation?
As it turns out, NYU Stern School of Business professor Aswath Damodaran, who specializes in corporate valuations and equity risk premium estimations, had similar interrogations about Nvidia’s otherworldly valuation metrics. As he has more credibility than yours truly, we thought we would summarize the ideas he gracefully exposed in a lengthy blog post on the matter[5].
Professor Damodaran estimates that the current intrinsic value of Nvidia is $237.55 per share in his base scenario. This compares with the company’s share price of $423.02 on June 30th. In other words, Nvidia could be 78% overvalued according to his model. The main assumptions used by the professor include the following:
Annual sales of AI chips going from 15 billion per annum to 325 billion per annum in 2033: an increase of more than twenty times current levels.
Nvidia’s market share of AI chips sales going from 75% to 60% in 2033.
Annual sales of chips to the automotive industry going from 20 billion per annum to 200 billion per annum in 2033: a tenfold increase from current levels.
Nvidia’s market share of automotive industry chips sales going from 3% to 15% in 2033.
Nvidia’s research & development operating margin going from 35% to 40% in 2033.
Nvidia’s cost of capital decreasing from 12.21% to 8.85% to account for lower business cyclicality and non-existent failure risk.
1.3 trillion terminal value in 2033 based on growth projection beyond that.
Nvidia’s sales to capital ratio increasing to the industry average of 1,15:1 to account for higher research and development efficiency.
The reader can decide whether these assumptions are realistic or not but given that Professor Damodaran studied sales, profit margins and research and development patterns of the overall semiconductor industry from the dawn of the personal computer (“PC”) age in the 80s until the first quarter of 2023, it would seem to us that the assumptions are credible. Yet, what we find striking is that the stock appears dramatically overvalued despite explosive sales growth projections in two key markets as well as Nvidia’s relatively optimistic market share retention, research and development efficiency, and cost of capital metrics. Damodaran’s sanguine views are rooted in Nvidia’s founder’s skill at identifying emerging end markets before competitors and in moving quickly to capture the lion’s share of the market. Damodaran cites the company’s successive forays into high-end computer gaming, cryptocurrency mining and, more recently AI, as perfect examples. Still, the stock appears dramatically overvalued.
Damodaran then proceeds to simulate Nvidia’s intrinsic value distribution as a function of different market growth, market share, profit margin, and cost of capital scenarios. He concludes that, while there is a chance that Nvidia’s intrinsic value is materially higher than the current share, it is a low probability scenario.
There are always some financial assets whose valuations are temporarily disconnected from their intrinsic value. Nvidia appears to be an outlier even among those. Some of our recommended active equity managers own Nvidia. But those who do, owned it before the company delivered its first-quarter results. They profited from the price surge. Given their discipline, they’re more likely to start reducing their exposure than adding at the current levels. Those who did not own Nvidia before did not acquire it after the company delivered its first-quarter results. We believe this is the right approach. Missing opportunities is normal in the professional investment management business. It happens more often than most are willing to admit. It should not foment frustration.
[1] Unless specified otherwise, index performance references total returns denominated in local currency terms.
[2] Citi Economic Surprise Index
[3] Source: International Monetary Fund
[4] Nvidia has a January 31st fiscal year-end.
[5] https://aswathdamodaran.blogspot.com/ AI's Winners, Losers and Wannabes: An NVIDIA Valuation, with the AI Boost!, June 23, 2023.