Innovation to Drive Growth Outperformance

In this podcast, Alger's Director of Market Strategy Brad Neuman provides his market outlook with IBKR's Senior Economist Jose Torres. Brad identifies investment opportunities while explaining the drivers that are likely to produce growth outperformance. 

Summary – IBKR Podcasts Ep. 159

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jose Torres 

Hello everyone, I'm Jose Torres, your Senior Economist here at Interactive Brokers. Welcome to our podcast. Investors are all too familiar with the current challenges that equity markets face. Recent data points to an increased risk of a possible downturn and hopes of the Fed promptly pivoting to a dovish stance have faded. Meanwhile, equity valuations are a little rich. The US continues to scrutinize China's trade practices and China's relationship with Taiwan is strained. Elsewhere in the world, the Russia / Ukraine conflict and the Israel / Hamas war threatened supply chains and the flow of energy commodities. But hope for equity and investing exists, and today I'm thrilled to talk with Brad Neuman, Director of Market Strategy for Alger Investments. The firm is highly regarded as a pioneer of growth investing and over its 60-year history, has weathered a variety of challenging market conditions.  

Brad has an impressive background, including previously managing investments at Omega Advisors and Glenview Capital. Brad has unique insights into the power of innovation and, more specifically, how technology can help companies disrupt existing business practices and produce earnings growth that drives equity gains. In addition to developing market strategy at Alger and providing the firm's clients with timely guidance. Brad appears frequently on CNBC and has been quoted in Barrons, the Wall Street Journal, Bloomberg, Washington Post, Institutional investor, Pensions & Investments and MarketWatch. Welcome, Brad, I am really looking forward to chatting with you today. How are things in New York? 

Brad Neuman 

Oh well, thanks for having me. I'm thrilled to be here right now. We're recording on a beautiful sunny day, all is well. 

Jose Torres 

Terrific. Let's get straight into it. What do you think of the macro backdrop, especially as the Fed has shifted from foe to friend by appearing to embrace a dovish stance? 

Brad Neuman 

Well, I think there are certainly some challenges in the monetary landscape. There's been sticky core services inflation, so that services ex housing and food and energy, that's actually been trending up, which is not the way we want to see it. That's causing the Fed to push out their easing from historically high interest rates. I think that's kind of the near term. We're also seeing businesses having intentions of increasing prices accelerating recently with the National Federation of Independent Bureau Small Business Survey showing businesses or maybe increasing prices on a more frequent basis. I think that's the short term and I think investors shouldn't get too caught up in the short term. I think the big picture is that the Fed funds rate of 5.5% is too high, and it's going to come down. I think there are a couple of ways to look at that.  

First, the Fed itself says at the long-term rate, it should be about 2.6%. That's a long way down from the 5.5% that it is currently. Another way of looking at this is that the current real Fed funds rate is in the high two. It's about 2.7%. I'm just taking 5.5% less than the current as we're recording this core personal consumption expenditure deflator, which is about 2.8%. So that 2.7% or so of the real fed funds rate is very high. Relative to history, the last time it was that high was 2007 and it was relatively brief. The median since 1990 is close to zero, about 0.2%, so we're 250 basis points, maybe higher than we should be. Of course, if inflation comes down, then the rate should come down even more. I think that's a good indication of why the Fed is looking to cut rates. I think for investors they should keep their eye kind of on the long-term fall, which is that interest rates will fall. 

Jose Torres 

Terrific. One thing that I've been watching is that inflation is quite a tailwind for risk assets. Earnings per share, all else equal, if inflation is running at 3.5%. You have revenues and expenses growing at that rate, then that's a pretty good tailwind for equity performance going forward, particularly against the backdrop of a Fed that's going to be cutting, like you said, Brad. Now, what opportunities are you seeing in small to mid-cap areas? Are you favoring growth or value tilts in this environment? 

Brad Neuman 

Well, so we were just talking about interest rates and the potential impact it has on equity prices. Interest rates should have, in general, some impact on all types of stocks, because interest rates affect the cost of capital and the discount rate with which you discount back future cash flows. It seems that interest rates mostly impact small growth stocks and maybe the reason for that is because small growth stocks are kind of long-duration assets. Just like interest rates impact, say a 30-year bond, more than a one-year bond. They may impact macro stocks more than, say, large value stocks where the cash flows are more current. What we've observed for the past couple of years is that there has been a higher than -80% correlation between small cap growth stocks, the Russell 2000 growth and two-year interest rates. If you look at the declining interest rate environment from 2018 to 2021, you saw small growth outperform then in the rising interest rate environment from 2021-2023, you saw small growth, underperform and more recently it seems like small growth is getting its sea legs back. As rates have stabilized, they stopped going up significantly. I would say that as interest rates come down in the short, end that that may benefit these long-duration small cap growth stocks. Like the Russell 2000 growth, and I think there are three other reasons if you want to go into it of at least a couple other reasons why we like small cap growth stocks and that's valuation and fundamentals. 

Jose Torres 

Yeah, absolutely. We've been looking at valuations for small caps, which look historically attractive relative to large caps. The last couple of years have seen a big driver of outperformance coming from the large caps. Now, as a growth investor, what are some of the Evergreen reasons for investing in growth? Separately, are there any timely developments that make this a particularly appealing time for growth investing? 

Brad Neuman 

Historically, growth and value traded off between different time periods and academics for a lot, while though, value stocks were the long-term outperformers. Over the past 20 years, growth has really taken the baton from value and has been trouncing it recently. In fact, the Russell 3000 growth has. Fully doubled the performance of the Russell 3000 value over the 20-year period ending in 2023, outperforming it by 430 basis points annually. We think there are a couple of big structural reasons why growth has outperformed value over the past couple of decades and why it will continue to outperform value over the next couple of decades. One issue is related to style classification, and the second issue is related to accelerating innovation. If you want me to go into detail, I am happy to do that. 

Jose Torres 

Yeah, we're happy to hear from you, Brad. 

Brad Neuman 

On the topic of accelerating innovation, when you buy value stock, you're typically buying a stock that's cheap, and you're hoping that it's only temporarily cheap, and it's going to increase in valuation. However, if innovation is accelerating and change is accelerating, some of those value stocks may simply be value traps. They may be victims of change. So here I'm thinking about things like newspapers, coal stocks, or companies and industries that look cheap, but they were cheap for a reason. The world changed so dramatically. Such as, within media or energy, these companies' earnings degraded, and they were like melting ice. What we're seeing, I think in the past couple of decades is that innovation is accelerating. We're all familiar with Moore's Law. I think that the number of transistors on a chip is doubling every couple of years and that's one of the driving forces that's making these new technologies diffuse through society and much faster. For example, it took many decades for the washing machine and cable TV in the 20th century to reach 50% penetration of American households, whereas the Internet did it in fourteen years, social media did it in nine years, and tablets in seven years. That's driving increased disruption. It took a quarter of a century for the Microsoft operating system and office suite to reach a billion users, it took Google search only 12 years, Facebook and YouTube did it under a decade. TikTok did it in five, and we think that GPT may do it in just a few years. I think already up to about 180 million users. Going forward, I think this innovation is going to accelerate. Artificial intelligence is actually going much faster than Moore's law. We think it's doubling possibly every four months instead of every couple of years. For context, a 6-inch plant growing at the rate of Moore's law would be 16 feet tall in a decade, but growing at the speed of AI would reach the moon in a decade. So, there are very significant differences in rates of growth. 

Jose Torres 

You make a good point, Brad. Earlier, you were talking about how growth has outperformed value and when you ask regular investors what their major holdings are, it's been a significant shift over the last 20 years. Back then, folks had a lot of energy, financials, and industrials. Today, to your point, it's all about tech stocks. 

Brad Neuman 

Yeah, and that has I think a lot of significant impacts on the overall index. Maybe some investors aren't super familiar with it. For example, I think that there is a lot of asset allocation between stocks and bonds and other assets based on traditional valuation metrics of the S&P 500, for example. Maybe people look at price to earnings multiples and that influences their asset allocation. Well, as you mentioned, when there are more growth stocks and the composition of the index changes. That has, I think maybe, trillions of dollars of implications for asset allocation because valuations have now changed. These large tech stocks I think should trade at higher price earnings multiples than the leaders of the S&P 500 decades ago. There are several reasons for that. They have higher returns on capital and more importantly, they have higher free cash flow conversion. Meaning, for every dollar of earnings they generate more in free cash. I think there are a lot of implications from the fact that these indices are loaded with more growth and tech stocks as you mentioned. 

Jose Torres 

What's the shift in dividends? Back in those times, two or three decades ago, a big chunk of investment returns was driven by dividends and now we're not seeing that, it's more about share repurchasing. To your point, a lot of innovation and new products and services. 

Brad Neuman 

We have seen Alphabet institute a dividend and Meta, of course, buying back stock and returning cash to shareholders. It is on the companies, and I do think that some of these large tech companies because they have such a high return on capital. The beauty of that is that you can grow and give back to shareholders. Whereas the companies of decades ago, with their very low returns on capital, had to make a choice. Either we're going to grow, in which case because of the low returns on capital, we have to invest a lot in our business or we can give it back to shareholders and it's possible that some of these large tech companies may be able to give investors their cake and let them eat it as well. 

Jose Torres 

We saw it before during that time before we moved into AI, a lot of firms, had too high of a dividend payout ratio. They lost market share because of that, especially the big department stores. When you think about the big telecommunication providers, T-Mobile came in, took a ton of market share, Amazon came in, gained a lot of market share as well. Now let's talk a little bit about AI. Everyone knows what the large-cap companies are doing. We followed a lot on the news. Big headlines talk to me a little bit about small and mid-cap growth companies benefiting from artificial intelligence. 

Brad Neuman 

First, let me just set the stage. We just completed about half of the S&P 500 earnings for the first quarter. One big take away is how much these companies are investing in AI. Now the large cloud companies, they're now increasing their CapEx investment in cloud or by these big data centers to support AI growth 35% year-on-year. They're spending over $200 billion and growing very rapidly to provide these AI services. Now those are the big companies. Clearly, some of that spend goes to other big companies. The Nvidia's of the world, the big semiconductor companies of the world. However, we're seeing benefits of that spending in smaller mid-cap companies. For example, Vertiv is a company that provides some of the cooling systems and other maintenance and technology to data centers because the new chips go into these data centers generate a lot of heat, and as the chips become more powerful and as the data centers grow there's more of a focus on how to maintain and cool these data centers.  

Now, Vertiv just reported seeing a huge surge in their business with a big surge in orders and sales. They mentioned specifically that they're seeing artificial intelligence as a big driver for their business, again because the chips are changing data center growth. So that's a way that is filtering down into smaller companies. Additionally, we think there's going to be a strain on power. Data centers use about 3% of US power now and because of artificial intelligence and the growth of these data centers and as I mentioned that chips that go into the data centers that use more energy, we think that 3% is going to go to about 10% by the end of the decade. That's going to benefit the companies that build and maintain power grids. There are some smaller companies that do that company, like Quanta would be a good example. Then finally again within the data center, there are interconnections that are very important between the servers and to reduce energy or make the energy as efficient as possible. These interconnections are quite important for high bandwidth and speed, reliability and scalability. So, a company like Amphenol, which is in the mid-cap space would benefit there. So, they're companies that both do the enablement infrastructure of AI and companies that adopt AI to make their own businesses better. That's where it's trickling down to the mid and small-cap realm rather than platform companies that are providing cloud-based services, but they are integral to helping these large companies provide the services. 

Jose Torres 

Shifting to the election, any opportunities or risks with the election coming up and the possible shift in administration, which sectors do you think will benefit from each outcome? 

Brad Neuman 

Well, I think the stock market is likely to be increasingly volatile as we head into the election. The market historically often sees weakness since the election and then rallies upon the certainty of the election. I wouldn't be surprised if volatility picked up here. It's probably more than likely that we're going to have a split government. In other words, if the Senate and the House and the executive branch aren't all lined up then that means that not that much consequential can get passed. I think that would be the best case for markets, and it's probably the most likely case, although we'll have to watch it carefully. I think our major message in the election is that investing in policies doesn't work. If you look at the 2016 election, if you had invested in domestically oriented companies based on the “America first” policies that were enacted back then, like corporate tax cuts. Those domestically oriented companies underperformed in the first year and performed in line over 2 years, so it wasn't a great investing approach. Similarly, investing in renewable energy companies, which was one of the cornerstones of the Biden administration after the 2020 election, that didn't really work over the two years after that election. Those stocks significantly underperformed. We could rattle off a few industries that would do well if in a Trump win or if Biden prevails. For example, a Trump win would probably favor traditional energy and hurt renewable energy. Trump win would also probably help big banks, via lower capital requirements, but I think it's probably not a great idea to try to invest along those policy lines. 

Jose Torres 

You make a really good point, Brad. Sometimes Washington spends money, and the benefit isn't really that obvious. Are there any investment themes that you would like to discuss overall? 

Brad Neuman 

We already talked a lot about AI and the AI adjacency, so I won't go through any of that, but just some other areas that we like. We really like aerospace parts. These are companies that mostly make replacement parts that go into commercial airlines. There are three reasons why we like that space. First, there's strong secular growth in that industry. You've got an aging fleet of aircraft and you've got increasing traffic, particularly as emerging markets like China begin to travel more. Secondly, a recovery still after COVID and long-haul travel. Like transatlantic, transpacific type flights. Third, there's high entry barriers for this segment. These are companies like HEICO and TransDigm, and they provide FAA approved parts at a lower cost than the OEM's do. Most of the parts that they provide, they're the sole provider. They've got some pricing power there. They are in limited competition because they are FAA approved. So, we think it's a great business that has some secular and cyclical growth. Maybe one other area to highlight is private market asset manager. These are companies that allow individuals to invest in private equity or private credit. They're public stocks, they trade on the Stock Exchange, but they allow their customers to invest in private markets. These are companies like Hamilton Lane and Stepstone. We think it's a strongly growing market because the allocation for the US mass affluent investors in private equity is only about 3% as compared to 28% for US institutions. That's one of the reasons why Bain projects that individuals investing in alternatives, that AUM may go from $4 trillion in 2022 to $13 trillion in a decade, which would be 12% growth. These companies are providing a lot of innovations, like increased liquidity and lower minimums to allow individual investors into that asset class. I think that's an interesting area as well. 

Jose Torres 

There you have it, ladies and gentlemen. That's Brad Neuman, Director of Market Strategy for Alger Investments. Brad, it was a pleasure having you here. We're so grateful, and thanks a lot for your time. 

Brad Neuman 

Thanks so much for having me. 

Jose Torres 

Ladies and gentlemen, thanks a lot for tuning in to this episode of Interactive Brokers. IBKR podcasts. Feel free to download our podcast on your favorite podcast channel, and I'll see you next time. Thank you.