Equity Opportunities Beyond AI

This episode discusses the overlooked investment opportunities in various sectors beyond the artificial intelligence (AI) hype.

1. The tech sector's volatility highlights the need for diversification in investment portfolios.
2. Healthcare and industrials are identified as key areas for potential investment growth.
3. Global trends such as aging populations and decarbonization drive opportunities outside the tech sector.
4. The episode underscores the importance of looking beyond headline-grabbing sectors to identify value in underappreciated markets.
5. Long-term demographic and economic trends play crucial roles in shaping investment landscapes.

1: Introduction

Host Oscar Polito sets the stage by questioning the focus solely on AI-driven equities, hinting at broader opportunities in the market. Oscar Polito: "AI is all the rage, but what are investors missing beyond AI?"

2: Market Dynamics

Kerry King discusses the bifurcation in business cycles exacerbated by the pandemic, highlighting the resilience of non-tech sectors. Kerry King: "COVID has created dual business cycles that are now beginning to normalize."

3: Investment Opportunities

The conversation shifts to specific sectors like healthcare and industrials where recovery and growth are anticipated. Kerry King: "There's tremendous value in healthcare due to demographic tailwinds and innovation."

4: Global Perspectives

King expands on opportunities in international markets, particularly in Japan and Europe, stressing the advantages of global diversification. Kerry King: "We're very bullish on Japanese equities right now."

5: Closing Thoughts

The episode concludes with insights on prudent investment strategies and the importance of valuation in a rapidly evolving market. Kerry King: "Being rooted in a disciplined valuation framework is essential."

1. Diversify investments to include non-tech sectors like healthcare and industrials.
2. Monitor demographic trends for long-term investment opportunities.
3. Consider global equities, particularly in markets showing strong government and corporate reform.
4. Pay attention to company valuations to ensure investments reflect long-term value.
5. Stay informed on sector-specific risks, such as patent expirations in pharmaceuticals.

AI has powered stock market returns over the past year, but what are investors missing beyond AI? Carrie King, U.S. and Developed Markets CIO for BlackRock's Fundamental Equities Group, joins host Oscar Pulido to shine a light into forgotten corners of the US equity market to uncover what may be some underappreciated sources of return.
Sources: BlackRock Fundamental Equities analysis with data from FactSet as of April 17, 2024; “The Looming Patent Cliff: Big Pharma Giants Brace for Fall”, Healthcare Technology Report, February 13th 2024; Russell 1000 and Russell 3000 as of April 2024

This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener. In the UK and non-European Economic Area countries this is issued by BlackRock Investment Management (UK) Limited who is authorised and regulated by the Financial Conduct Authority and in the European Economic Area this is issued by BlackRock (Netherlands) BV who is authorised and regulated by the Netherlands Authority. For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures

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Oscar Polito
AI is all the rage, and its unparalleled potential has powered stock market returns over the past year. So what are investors missing beyond AI? And as the economy moves further away from the COVID pandemic, how are changes in the business cycle unearthing opportunities in other sectors of the stock market? So really, what's been underpinning the market that you don't see, see, at the headline level is two very different business cycles going on at the same time. And as this normalizes again, we think this will lead to a broadening out of the market.

Welcome to the bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm Oscar Polito. On this episode of the bid, we'll speak with Kerry King. Us and developed markets CIO for BlackRock's fundamental equities group. We'll shine a light into forgotten corners of the US equity market to uncover what may be some underappreciated sources of return.

Carrie, thank you so much for joining us on the bid. Thank you for having me. Carrie, in your role as chief investment officer within BlackRock's fundamental equities group, you look at the equity markets every day. And so I'd like to start with what have you seen over the past year in equity markets? It seems like technology stocks, and particularly those associated with artificial intelligence, have been leading the way.

Do you see a change on the horizon in that respect? So over the past year, I'd say a handful of mega cap tech companies and Internet stocks have driven about half of the return of the market during that period. Some of those companies doubled and tripled over the past twelve months. But what I want to do is share some context with you. Remember, and I think a lot of market observers don't remember this, that same cohort of companies, the mega tech companies, had a big fundamental setback in 2022, and some of those companies saw their values halved in that year.

Carrie King
And so going forward, we think that fundamentals for these companies will normalize and that this normalization of their growth rate will leave room for other parts of the market to catch up, and therefore we'll see more market breadth. You mentioned 2022, and perhaps a good reminder that these stocks can be volatile. And while perhaps recent memory is that they've only been going up, there are some periods here in the not too recent past where they've also gone down. So volatility is something that is very prevalent with this group of stocks. So this handoff, what it reflects is the Internet or tech specific business cycle that had been out of sync, or has been out of sync with the rest of the market.

So really what's been underpinning the market that you don't see at the headline level is two very different business cycles going on at the same time. And as this normalizes, again, we think this will lead to a broadening out of the market. Talk a little bit more, if you could, about this concept of two different business cycles. I always think of there's just one going on, but what do you mean by that? And how does that impact market returns?

So what's behind this dual business cycle? Is COVID really?

On the one hand, the revenues of technology companies really accelerated during the pandemic as life as we all knew it pivoted online in response to this COVID induced increase in revenues. These mega cap tech companies were benefiting, had an aggressive investment in their infrastructure and in their people to keep up with this accelerated COVID driven demand.

And then what happened is, once the pandemic started to ease and revenue started to moderate, they were met with a bloated cost structure. So in 2022, you had revenue growth starting to moderate, coming down from the COVID piper growth levels, right at the same time the cost structures were bloated. Let's remember the interest rate environment. The Fed funds rate went from zero to four and a quarter. So you had a trifecta of events that led to a very difficult period during 2022.

And as I said earlier, many of those mega cap tech stocks were cut in half in that environment. And so the strong performance that you alluded to over the past year or so really marked a return to normalization coming out of that COVID induced business cycle. So, right when they started to then rein in costs, these mega cap companies, you saw the growth rates start to moderate. That is what helped drive increased profitability over the past year. And then, oh, by the way, let's not forget, AI entered the scene.

Now, let's talk about the rest of the market. Outside of these mega cap tech stocks of across that same timeframe, many sectors were having the exact opposite effect. Their revenues suffered amid COVID related shutdowns. So we saw this in brick and mortar retail, we saw this in travel, and we saw this in parts of healthcare, like elective procedures, for example. You weren't going to the hospital to have something done that wasn't an absolute necessity during COVID So these companies all suffered a COVID induced falloff in demand, the exact opposite of what the Internet companies experienced.

And now what we're seeing is many of these companies are still recovering today from that drop off in demand. So, for example, hip and knee replacements, which were delayed during the pandemic, are back on. Consumers are still playing catch up on missed travel and experiences. So that's where we're seeing spending. So, Nat, as these two different business cycles are starting to normalize, putting COVID in the rearview mirror, this, I think, is what will allow the market to broaden out.

And let me punctuate that with some numbers. Our analysis shows that earnings growth for these mega cap tech companies could decline from near 30% levels this year to the mid teens in 2025. We're not bearish, but we think that's a normalization of earnings growth. At the same time, the earnings growth rate for the remaining 400 plus companies in the s and P 500 should advance from single digit growth to double digits in 2025. What you're seeing is a more head to head race in terms of earnings growth.

And we think that broadening will lead to some stock picking opportunities for fundamental investors. So it's fascinating. COVID was obviously an important inflection point, is what you're saying. And it created these two different business cycles. It impacted the market, benefiting some companies more than others.

Oscar Polito
But now, as we look back on COVID, now a few years behind, the opportunities are broadening out exactly right. And so when you think about the stock market, not the tech companies, everything else, I suppose there's a better term for that. But if I just think about everything that you've described, not in the tech sector, where are those best opportunities right now? So where we're seeing a lot of value for investors is two specific areas, in healthcare and in industrials.

Carrie King
In healthcare, what we're seeing in terms of earnings, earnings growth. The sector had declining earnings in 2023. We see that accelerating to positive in 2024 and even higher growth in 2025. So there's earnings momentum there. But there are a lot of other things we like in addition to healthcare, besides the earnings momentum, one is the demographic tailwind.

Populations are aging in the US and elsewhere, and we all know that as you age, you consume more healthcare. These companies largely have very high quality characteristics. They have strong balance sheets, they have strong cash flow. So we love the quality part of the equation. And the earnings streams tend to be more stable.

If you look at the eleven sectors in the S and P 500, this is a sector with the most resilient earnings in times of economic stress. And the icing on the cake is this sector also has a lot of innovation. Just think about the GLP one drugs that you've heard a lot about GLP one s are the drugs that are addressing the pandemic of diabetes and obesity in the US and elsewhere. So on top of all that, the sector's trading below the S and P 500 average and it's trading below its own long term average. So we see a tremendous amount of value in healthcare.

So another area where we see a lot of interesting tailwinds is industrials. So we see several tailwinds that should underpin increased capex spending in this sector. And some of the trends that are underpinning our favorable view include catch up from years of underspending on infrastructure. One source, the American Society of Civil Engineers, calculates that there's an infrastructure spending gap of about $2.5 trillion. And we've seen bipartisan action from the federal government to help fund upgrades.

De globalization trend is another great tailwind that we're excited about. This is happening as companies are relocating manufacturing operations closer to home. We're seeing this in the semiconductor space as one example, and we think that should continue in the future. Global decarbonization is another tailwind. There are efforts underway to build out new eco friendly energy systems, and again, we're seeing government funding support these efforts.

And finally, there's increased interest in automation. So we think the prospects of a shrinking workforce, given aging demographics, will propel spending for industrial and technological efficiencies as companies continue to seek productivity gains against that demographic headwind. When you talked about industrials, you mentioned infrastructure. That's one of the topics that Larry Fink talks about in his annual letter to investors. I think you mentioned a few of the megaforces as well.

Oscar Polito
Demographics and decarbonization. Now those sectors then therefore sound like there's a lot going for them. But are there any risks that you're monitoring with respect to either those two sectors or perhaps other sectors outside of the tech arena? It's a great question. And so one area that we're closely monitoring is the consumer.

Carrie King
On the one hand, the consumer looks fantastic. The job market's very healthy. Wage growth now exceeds inflation. It's a great position to be in as a consumer, and spending has been very resilient. But we are starting to see signs of stress that raise the red flag, shall I say?

Excess pandemic savings are largely spent away in the US. Credit card debt in the US is at all time highs. And we can see from recent earnings reports from banks, not only this quarter, the past couple of quarters as well, that credit card delinquencies are starting to tick up. And this is particularly apparent, I think, for the low end consumer and then tack on high interest rates, that's definitely having an impact on some purchasing decisions across the economy. So again, this is most acute among the lower income group.

But even high end consumers, we can see, are starting to get more discerning with big ticket purchases. So we're looking for companies that can maintain and grow market share against this backdrop. And we generally prefer providers of experiences over goods because this is where consumers are continuing to prioritize their spending. So, for example, in the fourth quarter, if you look at the earnings results from hotels, restaurants, leisure, these companies enjoyed nearly 90% year over year earnings growth and profit margins that are still just returning to pre COVID levels. In fact, just this morning, a large hotel chain reported earnings and surprised investors to the upside with the strength in its room growth.

So this is continuing. Kerry, so far we've focused our discussion a lot on opportunities within the US. And perhaps you can take us outside the borders of the US and talk a little bit about some of the opportunities that you're seeing internationally. So really three main areas I can talk about. One is our platform in fundamental equities is very excited about Japan.

So we see a strong case for japanese equities right now after decades of economic stagnation and deflation. Why is that? We're finally seeing strong government support, we're seeing corporate reforms, and we're seeing unprecedented steps by the Tokyo Stock Exchange. And these forces are all working in tandem to underpin japanese equities. So we're very bullish there.

Oscar Polito
That's consistent with what Belinda Boa, who is another colleague of yours and who's also been on the podcast, has said about some of the things that are changing in Japan and making that stock market more of an interesting opportunity. So, Kerry, go back to some of the other international opportunities that you mentioned. I think you said there was a couple others. Yeah. So let's shift and look through a sector lens.

Carrie King
So when we're evaluating large integrated oil companies, we definitely see better value in the european large integrated oil companies versus the US peers. So if you look at the european oil companies, they're of similar quality, but they trade at much more attractive and generous free cash flow yields than their us counterparts. And then the other area where we're seeing value outside the US is in pharmaceuticals. So similar to integrated oil, we favor the european large pharmaceutical companies versus the US peers. This is interesting.

The major us drug makers have anywhere from 30% to 70% of their revenues facing patent expiration in the next three to five years. So that's the highest level of exposure that we've seen in 15 years. Obviously this presents some steep revenue risk for some of these companies and it highlights the importance for active stock selection. So consider this. Roughly one third of the US healthcare sector, if you're measuring it using Russell healthcare indices, is made up of large cap pharma companies.

So the indexes are heavily exposed to this patent expiration wall that's coming in the next three to five years. So our teams in our active process have steered clear from patent expiry exposure through stock picking. So instead we focused on areas innovation like, as I mentioned earlier, the GLP one platform companies, and we focused again on the european competitors who have a much more attractive patent expiry profile. And then within that backdrop, the drug distributors are another area of interest and attractiveness. So these companies actually benefit when large cap pharma companies lose patent protection.

So what they do is they'll distribute an increasing volume of generics which have a more attractive margin profile. So index trackers can't see these patent cliffs coming and the large impact that they'll have on the index level. So we've been very attuned to this as active investors and able to manage around these patent waves. Kerry, we've deliberately tried to focus a bit more on the sectors outside of technology and outside of the more artificial intelligence oriented companies that have really been characterizing the market over the last couple of years. But presumably your team also has a view on that particular area of the market.

Oscar Polito
And there must be opportunities. Maybe they look a little bit different than the past year or two. So tell us about what does get you excited in that space. So in terms of technology and what's been leading the market? Absolutely, we have a ton of excitement and interest there as well.

Carrie King
So our platform has been largely overweight semiconductors, and that's been the way we've seen those as the picks and shovels to rolling out this new, exciting generative AI technology. But we've been evolving our thinking as this market's moving so quickly and we've developed a greater appreciation for the data. So it's the data that feeds these generative AI models. And so we expect investors will continue to start to ascribe more value to companies that own data, that sell data and that store data. Examples are market data and intelligence providers and companies, other companies involved in financial information and analytics.

The technology is being deployed so rapidly that we're watching it evolve and we're looking to capitalize on any change. And active investing is a really great tool to capitalize on this change because the technology indexes are very concentrated in few companies, so we can be very nimble and deploy our expert insights across other companies. So artificial intelligence as a theme is one that you think will persist. But perhaps the individual companies that benefit are going to change as time goes on. And that's where your insights can come in and identify those.

Oscar Polito
And Carrie, your insights, you've been an investor for over 30 years, and so with that perspective, what would you say to somebody who is a newer investor in the markets and they're entering the markets at a time when AI and all this innovation is taking place, what are some words of wisdom that you would share? So I think every enduring investment process needs to be grounded in a valuation framework. Just buying the best company on the block isn't always the best investment. So I think being rooted in a discipline valuation framework will help you discern if the price you're paying for a company today reflects the long term value. And you're right.

We live in an environment where news is coming at us fast. We see headlines, we hear about a popular company, and that might be a great investment. But what you're saying is also pay attention to the price, the valuation. Sometimes the hype might be reflected in the price and there might be a better entry point. And that's a little bit of what your 30 years of perspective gives is knowing to look into those details.

Carrie King
Exactly. And I will leave you with a final note on what I've learned over 30 years. And it's sad that it took me so long to realize how important this is. And it's your people. People are your most important and your most precious commodity.

So nourish their souls, nourish their hearts, nourish their brains so that they're at their very best. And that's great for everybody. Carrie, thanks for bringing your 30 year investment perspective and helping us dig a little bit beneath the layers of the stock market to understand more of the nuances. And thank you for joining us on the bid. My pleasure.

Thank you.

Oscar Polito
Thank you for listening to this episode of the bid. If you've enjoyed this episode, check out a stock picker's guide to 2024, where Tony despirito highlights his views on the stock market for the coming year. Subscribe to the bid wherever you get your podcasts. This content is for informational purposes only and is not an offer or a solicitation reliance upon information in this material is at the sole discretion of the listener. In the UK and non european economic area countries.

This is authorised and regulated by the Financial Conduct Authority. In the European Economic Area, this is authorized and regulated by the Netherlands Authority for the financial markets. For full disclosures go to blackrock.com. Corporate compliance bid disclosures.