SustainAbility: How high can equities go?

To infinity and beyond!

After a short breather, equity markets have started to rise again. Supported by a strong economy, a good first quarter earnings season, and a continued belief that the interest rate cycle has peaked, the inherent value of equities is increasing, and share prices are following.

In my view, one of the lowest probability bets investors can make is that equity markets will fall. Looking back over history, for those investors willing to show patience, one of the truisms of investing is equity markets go up. Investors who bought the day before the great depression of 1929, the World Wars, the bursting of the technology bubble in 1999, and the financial crisis were handsomely rewarded in time even despite these catastrophic events.

There is no natural ceiling to how high equity prices can go. This is because they reflect factors such as innovation, rising wealth and societal improvement. As these things increase, so will equities in the long run. This isn’t to say they cannot become overbought in the near term, or that events will occur to see temporary declines. Buy the dip is however the lesson of more than 100 years of equity investing, and we doubt this will change in the future.

Artificial intelligence reality check

Artificial intelligence (AI) saved the markets in late 2022. In that year, a rapid rise in interest rates undermined nearly all asset prices and particularly those of growth-oriented companies. At the time it seemed certain we were entering a new dawn for value investing as areas such as oil & gas led the way. In the fourth quarter of 2022, AI entered our lives in the form of ChatGPT which allowed language-based queries and answers, as opposed to the more data-led AI which preceded it. This rapidly expanded the number of use cases for AI, and markets began to discount this in better prospects for many companies.

There has been a suspicion AI has been overhyped. Technology has a habit of doing that, with many things seen to be transformative fizzling out. In the mix of this however, there have been transformative innovations such as the personal computer, internet, and smart phones. These have fundamentally changed society and created huge investment opportunities.

Our view is AI will take its place alongside the defining investment trends of our lifetimes. In the last few months, evidence has built that the reality check we all need on AI is similar to the one we needed about the internet in 1999. Despite a temptation to dismiss it as a hype, AI will profoundly change society and create (and already has created) significant investment opportunities. We are very early on in its evolution and, more precisely, mainstreaming it into society. Make no mistake though, your future AI assistant is already in your pocket in the form of a smart phone.

There are multiple ways to invest in this area, from large software companies such as Microsoft, to semiconductor companies such as Nvidia. Perhaps the most underappreciated opportunities however are in the physical world. AI is a physical world phenomenon. It requires huge amounts of electricity, land, buildings, cables and ventilation amongst other things. Suddenly industries such as utilities, property and construction are becoming AI plays.

AI will likely transform every business. Drug discovery will be made easier, transportation networks will operate more efficiently, investment managers will make better informed decisions, healthcare providers will diagnose disease more effectively. The list goes on.

The main point here is there is a logic to AI having saved the market. It has the potential to lift economies and markets to a new level. Of course, like the internet, this will not be linear and will present its challenges along the way, but it is at least as important, and likely much more so, than the future path of interest rates and inflation which dominate so much of investment discussions currently.

Think differently

The skill to being a successful investor is to have views which consensus opinion will agree with….in the future. Investment opportunities by definition come from believing something which the general consensus does not. As the saying goes, it isn’t what you think that matters, just what you think relative to everyone else.

We experienced this in Q4 2022 and Q1 2023 when we materially added to our position in the banking sector. The decision to do this was process-led, with both the sustainability and financial performance of this sector improving. Our timing could have been better, with SVB and CSFB banks running into problems shortly after, but the direction would appear to have been correct.

At the time, we underestimated the amount of muscle memory investors have with banks. Some of this goes back the financial crisis of 2008, and some due to their weak investment performance in the subsequent decade. Famous investors were writing articles for national newspapers on why they weren’t buying banks. Which is the sector globally which is now delivering investment performance today? Banks.

Banks benefit from higher interest rates, which we now see, and a strong economy. They are inexpensive and provide high levels of dividend income. They are also critical to funding the transition to a more sustainable future. Some of this is becoming more accepted, but we still have a way to go to describe this as the consensus view.

The ability to think differently often defines successful and unsuccessful investors. Investing in the present, using consensus views, is a path to mediocrity at best. Thinking 12-18 months into the future, and actively looking for ideas which are different from the consensus are two good ways of becoming better at this.

What are the non-consensual views today which may or may not become accepted in the next 12-18 months? I can think of a few examples: China is in a healthier economic state than believed; equities are in the early stages of a new bull market; investors need to hedge the risk of a stronger, not weaker economy; inflation will not return to 2% in the coming years; Trump will be the next president of the United States. If all these things came true, we suspect investors would need to be running very different portfolios than they are today. Even just as a thought experiment, it helps shake views out of the present time and focus on what isn’t, rather than what is, the accepted view in markets.

As we have written previously, we are optimistic about what the coming years will bring. Sustainable investing is in rude health and continues to access the most important areas of investment markets. To infinity and beyond!

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. 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, and is not investment advice.