The prior-year period, along with persistent volatility into 2022, reinforces our premise on relative return opportunities (aka alpha) in public markets. Outperformance opportunities are becoming increasingly less uniform, rarely available in even quarterly increments or succinct calendar years. There’s a silver lining to this though, one that also speaks to a core tenet: we see encouraging evidence of favorable conditions for value creation over longer-term periods. It requires a lens that an emotionally-driven equity market is incapable of identifying as necessary. It also entails rampant mispricings in the short term.

We can see how disproportionate the opportunity set for alpha is via our growth portfolio’s 2020 vs 2021 performance. SWS Growth Equity delivered 4-5x its typical base case excess return in 2020, fueled by a massive demand acceleration towards all-things-digital in the global pivot around the pandemic. The following period has given back some of this, yet we see zero change to the fundamental mechanics behind the ultimate exercise of the public marketplace: pricing future cash flows of its issuers. The weighing machine can and does get thrown out-of-whack, especially by outsized capital flow impacts by its participants.

China and Retail Investor Impacts on US Market Flows

On this latter front, we’ve been served our fair share of flow-related disruptions: cracks that turned into fissures in China (tech company crackdowns, Evergrande debt crisis, wealth scrutiny, etc.) have made the US-domiciled tech complex far more favorable on a relative basis. Here our trillion-dollar mega-caps welcome Chinese capital defections with open arms of ample daily liquidity. Some US issuers also offer Chinese consumer demand exposure, e.g. Apple with 19% of its revenues being derived from greater China.

Retail market participation also reached elevated levels last year, a trend we noted this time last year in the throws of Reddit/meme-stock hype. JPMorgan called out specific evidence of the magnitude of this trend, noting prolonged flow impacts from its retail customers across the entirety of 2021, extending beyond just the early Q1 spike. By triangulating insights from its customer income levels and trading activity, the bank saw its 18-25 year-old customer cohort spiking to 4x their trading volume during CY2021.

Slicing the data by income bracket, its $0-$20k income customers spiked to 6x their normal investment flow volume (indexed off Feb 2020 levels). Return chasing is becoming an increasingly frictionless pursuit, enabled by commission-free equity trading from the same smartphone app that can deploy crypto gains alongside direct-deposited government stimulus checks. Last year also provided a target-rich environment for the return chasers in US equities, allowing for speculation across SPAC issuances, meme stocks, EV IPOs, and innovation-focused ETFs promising 40%+ compound annual growth rates.

Widest Valuation Dispersion in 25-Years

The aggregate outcome of these flow-related effects helped fuel broad valuation dispersions across the public equity landscape. In fact, the spread between the 20th and 80th valuation percentiles of the S&P reached their widest mark on record for the prior 25-year period, quite a feat considering this timeframe also encompasses the days of dot-com froth. Typically, this 20/80th spread sits at 11.3-handles of price/earnings (“P/E”) multiple; in context to a median P/E of 16.0x, this roughly equates to the 20th percentile trading 22x earnings, and the 80th trading 10x. We ended 2021 with this spread sitting 21.3 points wide, almost 2x its average spread, straddling an overall median market P/E of 20.3x. In other words, 2022 started with the greatest disparity between the “haves” and “have nots” in the past quarter-century when it comes to public market issuer valuations.

This naturally poses the question of whether this is the formation of a new norm, or whether these conditions are ripe for a correction. We believe odds are stronger for the latter, with fundamental evidence of top-heaviness exhibited by certain mega-cap issuers. This is an increasingly critical exercise due to their disproportionate impact on the entire large-cap landscape. The top-10 issuers of the S&P 500–populated by names like Tesla, Microsoft, Apple, Amazon, etc.–averaged 33.2x forward P/E at year-end 2021. The remaining 496 constituents, on the other hand, average 19.7x in aggregate. Performance, particularly delivered via valuation multiple expansion, has been extremely concentrated among the market’s largest issuers: the top-10 issuers now account for 29% and 48% of S&P 500 and Russell 1000 Growth Index weightings, respectively.

This has led to disproportionately inferior returns across the lower-ends of the market-cap spectrum relative to larger caps. Headwinds were most pronounced among the broader small-caps and growth-oriented mid-caps: the Russell 2000 and the Russell Mid Cap Growth indices netted 14.8% and 12.7% returns, respectively, for CY2021.

Silver Linings: Following Beneficiaries of Capex Trends

Meanwhile, many pillars to our fundamental theses have largely strengthened over the recent prior quarters. Take the proxy of capital expenditures (“capex”) spending: with persistent global supply chain bottlenecks, semiconductors find themselves in many crosshairs as the ultimate culprit. The entire semiconductor industry measures ~$550 billion in gross revenue, while spending over $80 billion on equipment capex to manufacture chips. Last week Taiwan Semiconductor Company, the largest manufacturer of chips by volume, boosted its planned equipment capex by 40% for CY2022 to $42 billion due to increased demand by its customer base (made up of players like Apple, NVIDIA, Qualcomm, etc.). We expect the main equipment suppliers to be beneficiaries of these tailwinds, both in the shorter term as capital flows to resolve bottlenecks. Longer-term, we also see equipment players being key arms dealers for the semiconductor industry, as it marches towards a $1 trillion/year revenue opportunity by the end of the decade. This frames our bullish stance on ASML Holding and Applied Materials, two semi equipment positions held in our growth portfolio.

These near-term investments definitely will assist in alleviating the current bottleneck in the automotive industry, where new vehicles sit idle awaiting delivery of backlogged chips. Longer-term, we see trends of semiconductor content per vehicle as having multi-year, sizeable tailwinds (ones specifically responsible for driving semiconductor revenues by a couple $100 billion to that $1 trillion opportunity). Of the ~90 million light vehicles produced globally/year (pre-pandemic), semi content per vehicle averaged $460, roughly 1-2% of the average selling price of a vehicle. Workloads that will undoubtedly drive this figure higher occur far before the public arrival of full level 5 autonomy. Having automotive-grade compute systems handling blindspot detection, automatic braking, lane-keeping assistance, data recording, and driver drowsiness monitoring are just a few applications either currently shipping or arriving in the near future. Future regulatory safety initiatives will also mandate many of these pre-full autonomy features, both in the US and abroad.

Obvious beneficiaries here are automotive OEMs with clean-sheet-of-paper thinking and dry powder funding, factors massively favoring Tesla and Rivian. However, tying in our earlier analysis of large-cap top-heaviness, this trade seems largely overcrowded with Tesla garnering a $1 trillion equity valuation (representing 105x forward-earnings and 13x forward-sales) while Rivian came out of the IPO gates at a pre-revenue valuation of $100 billion. We see greater upside opportunities along the periphery via the indirect beneficiaries that are the arms dealers to these trends. For Growth Equity, Marvell Technology, Ambarella, and Visteon position for the direct beneficiaries. Within Dividend Equity, Broadcom exists as an important player in wireless vehicle connectivity.

A New Constituency of Capex Spenders

That’s just one thread of following capex breadcrumbs in the automotive realm. Historically, outsized capex spending companies (e.g. in the double-digits $ billions) were wireless service and cable providers (e.g. Verizon, AT&T, Comcast), Intel with its PC and server monopoly, multinational oil/gas producers, and the two “Generals”: Motors and Electric. Today, a new constituency is steering meaningful capex dollars towards outsized return opportunities. These include the cloud titans of Amazon, Microsoft, and Alphabet, who deploy between $22-57 billion/year each to build the infrastructure that’s enabling compute capacity to be delivered as a global utility.

We also are in the infancy of an entirely new compute paradigm, one that’s unfolded in fits and starts while garnering its fair share of ridicule along the way. Although much of this was and still is merited, the rhetoric surrounding the metaverse and its AR/VR hardware is very reminiscent of those who balked at the notion of a $500+ iPhone circa 2007. Evidence of the meaningful bets being made can be seen in Meta Platform’s current 2022 capex plans. The company is planning to spend $29-34 billion this year, a ~58% increase over what it spent in 2021. This figure is a far cry from the sub-$1 billion capex outlays by the company during its IPO, putting the company among the top tiers of capex spenders seeking returns well in excess of the cost of that capital.

2022 CES Observations

Our trip to CES this year provided a glimpse on the future of AR/VR and wearable technology. Despite vendor presence being pared down significantly due to COVID, the debut of a medical device manufacturer, Abbott Laboratories, to the event reminded us of how the physical evolution of CES can reinforce directionality to the broader evolution of technology. Roughly a decade ago, the north hall of the Las Vegas convention center was the dedicated automotive showcase of the event. It featured countless after-market car audio companies, like Pioneer and Alpine, alongside massage chair manufacturers and other quirky in-home gadgets. Today the north hall hosts many companies innovating in electric-vehicle air transportation (e.g. eVTOL), autonomous vehicles, and the many software systems that will enable their operation. It would not be a surprise to see a similar physical evolution of wearable computing at CES, possibly at a time when the event is entirely hosted virtually in the metaverse.

Conclusion: Value Creation Occurs Among Large-Caps

All of these big-ticket capex deployments target big-ticket addressable opportunities, some of which are entirely greenfield while others have less nimble incumbents in their crosshairs. That said, the size of a capex outlay has no bearing on its odds of success. By definition though, the returns from this spend will accrue to the benefit–or will deteriorate to the detriment–of large-cap issuers. With evidence of stretched valuations among the largest issuers, we see meaningful value creation potential among issuers outside of this cohort that trade at discounts to our longer-term outlooks. In our continual effort to sift through the noise, which can be elevated at the start of new years, we see favorable conditions for relative value creation. We also see an attractive backdrop for absolute returns by the market, just more so among the constituents trading sub-$ trillion market caps.