The Viewpoint: All I want for Christmas

It’s that time of year again...Christmas is coming. The decorations are up, gifts are being discussed, and excitement is in the air. I’ll join in, though I admit, my enthusiasm for the season is a bit muted. As someone once said, “I’m happy to participate, but I’d rather do it from another room”.

For many, the focus is on the perfect present: often the shiniest, swankiest gadget, the Nintendo Switch 2, the latest noise cancelling headphones, whatever it might be. As portfolio managers, we have seen the market's collective wish list focused on one area for the last 18 months: the hyper growth narrative. It's all about the generative AI super cycle and the magnificent few companies that drive it.

This concentration has been so extreme, and the narrative so compelling, that it has left huge parts of the equity universe completely ignored. I'm talking about companies defined by old-fashioned quality, consistency, and profit.

The question we are dealing with this December is simple. Do we chase the flashy, high risk, high-return gift that everyone is clamouring for, or do we quietly invest in the durable, proven, and consistently useful stock? The pair of comfortable slippers if you will.

I must acknowledge that the AI revolution is real. It has rightly captured the imagination, and the capital, of the world. These businesses promise huge growth, almighty addressable markets, and the potential to fundamentally shift how we live and work. It is exciting, fast moving, but with its poster child, Nvidia, generating share price gains of almost 80% per annum over the last five years, it hasn’t gone unnoticed.

These businesses promise huge growth, almighty addressable markets, and the potential to fundamentally shift how we live and work.

Valuations for leading AI and high-growth names often hinge on highly optimistic earnings. In many cases, these prices require near-flawless execution to be justified. Are we in bubble territory? Perhaps not across the board, but certainly in some individual stocks.

Left on the shelf

Investors’ obsession with AI has sucked the oxygen out of other parts of the market. When every incremental dollar flows into the same group of ten or so mega-cap names, it doesn’t just inflate their prices. It starves every other corner of the market of attention. The investment world, much like a child with a new toy at Christmas, has simply forgotten that their other toys exist.

And that, for fundamentally minded equity managers, is precisely where an opportunity presents itself. With most investors focusing on all things shiny and AI-related, it might be worth considering more traditional fare So what makes a ‘comfortable slipper’ stock?

First, I like to focus on a high return on invested capital (ROIC). In my view, this is the ultimate proof of a company’s competitive advantage. A true quality business consistently turns one dollar of capital into more than one dollar of profit, year after year. That ability signals the presence of a durable economic moat.

Second, I value consistent and growing free cash flow (FCF). FCF is the oxygen of any business. Companies that generate significant FCF have the flexibility to reinvest, reduce debt, repurchase shares, or increase dividends, whatever makes sense given their stage in the corporate life cycle. These businesses can be financially durable and less dependent on external capital markets, which can be a major advantage.

Companies that generate significant FCF have the flexibility to reinvest, reduce debt, repurchase shares, or increase dividends

Third, I prefer companies with a rock-solid balance sheet. These businesses can thrive when the economy is strong but also have the financial firepower to do more than just survive when conditions weaken. In fact, they often invest counter-cyclically, either in themselves or through acquisitions, at precisely the moments when opportunities are most attractive.

Finally, we often talk about the ‘moat’ - which is basically an enduring competitive advantage. I look for companies providing products and services that people or companies just need and keep buying, regardless of the economic backdrop.

In short, the companies I like could be described as a bit boring, reliable, profitable, and consistent. They are the anti-hype trade. They won’t give you the thrill of a 50% jump in a week, but they deliver the relentless compounding power of earnings, year after year.

Unwrapping the gift of quality

Here is the central paradox of the modern equity market. Some of the most fundamentally sound, profitable, and dependable businesses are currently trading on the lowest relative valuations versus their flashier peers and the broader index, that we have seen for years.

We are witnessing a profound dislocation. Investors are willing to pay astronomical prices for mere potential revenue growth, while simultaneously placing a remarkably low multiple on businesses that are already producing substantial, proven, and reliable profits.

Historically, periods where the valuation gap between the most consistent earners and the most speculative growers has widened to this extent have been followed by sustained periods of outperformance for the quality factor. You are buying resilience at an almost recessionary price. You are buying compounding assets that, unlike the latest tech wonder stock, do not rely on a constant stream of exponential acceleration just to justify their current valuation. You are buying a reliable defensive asset.

You are buying resilience at an almost recessionary price.

However, if the opportunity is so clear cut, why haven't the fundamentals won the day yet? This brings us to the most difficult part of all of this…timing the trade. The manager who is six months early on this opportunity is, to the short sighted, indistinguishable from the manager who was simply wrong. It takes conviction. I believe that the shift from the AI hype cycle back to old fashioned fundamentals won't be one single event. It will likely be triggered by one or more events.

First, the high-multiple stocks must deliver not just great earnings, but absolutely perfect earnings. Any stumble in AI monetisation, any deceleration in their already astronomical growth rates, could instantly trigger a violent re-evaluation of their future cash flow potential. That is a huge risk.

As AI productivity gains finally trickle down to the 'real economy' (e.g. industrials, manufacturing, services), I think we are likely to see an acceleration of quality company earnings that the market simply cannot ignore forever. Suddenly, a traditional business using AI to achieve a 15% efficiency boost becomes an exciting, yet cheap, growth story.

Higher-for-longer interest rates and sticky inflation create a challenging environment for companies reliant on external funding or massive capital expenditures that won't pay off for years. This macro environment inherently favours businesses that are self-funding and cash rich, our quality stocks. As financial pressure mounts, resilience becomes the most prized asset.

Weathering the storm

This December, while the headlines are saturated with discussions of the latest AI breakthroughs and the latest bubble fears, the prudent portfolio manager must exercise a disciplined approach. It’s akin to a thoughtful gift-giver who resists the temptation to buy every trending, expensive present, choosing instead of focus on the gifts that truly last.

The Nintendo Switch 2 is a fantastic bit of kit, and MarioKart may provide entertainment for a few years. But when building a durable portfolio, it’s the comfortable slippers, the reliable, essential stocks, that keep you warm, keep you grounded and keep you steady through the inevitable market storms.

The time to find the best gift is not when everyone else is queuing up to buy the same item. It's when they are neglecting the core essentials. High quality stocks, consistent profitability, and resilient business models are currently out of fashion, meaning that for those with conviction, and a long-term investment horizon, now is the perfect time to quietly fill the stocking with genuine, compounding value. As with all things Christmas, don’t overindulge, keep your portfolio balanced but maybe consider a new pair of slippers.

Happy Christmas.

For professional investors only.  This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties, Actual outcomes may be materially different from those expressed or implied.