Which themes should be favored in equity markets?

We sat down with Thematics Asset Management' CIO, Karen Kharmandarian, to get his thoughts about the best themes to consider for 2024.

US equity markets have become rather concentrated and correlated, thanks to the AI hype and bubbly tech stocks. Where can value still be found?

The market breadth in the US has been narrowing down. The Magnificent 7 have led major indices, such as the S&P 500¹. These seven stocks have really driven performance at the index level. The other 493 stocks of the S&P 500 have managed to just be in positive territory, but they are just not performing to the same extent.

So, yes, there is a big tech bias in the market. And I suspect this is related to the fact that these large cap Tech companies have some attractive features in the context of macro uncertainty and geopolitical tensions. They have strong balance sheets, strong growth, and attractive margins. They are perceived as a safer option for investors waiting for better visibility going forward.

Valuations at the index level are maybe a bit extended, but if you adjust for the Mag 7, there are many stocks in different sectors with good fundamentals which are trading at attractive valuations. The story for 2024 and beyond is to be more selective. Yet we can find in different themes and strategies that there are attractive companies growing nicely, executing well, and having plenty of growth opportunities in expanding addressable markets which are also trading at attractive valuations.

How are you thinking about ongoing geopolitical conflicts and the outcomes of major election in the US, Europe and elsewhere in 2024?

Obviously political tensions and conflicts, the uncertainty around the outcomes of various elections across regions and countries, in particular in the US, are a factor of uncertainty for investors. And this means that one needs to apply maybe an extra premium to market valuations, or at least factor that into valuations, going forward.

That said, these uncertainties and risks can be also sources of opportunities.  Thinking of the deglobalisation trend, geopolitical conflicts and potential tensions that exist between different countries means that Western countries are more and more willing to re-shore, onshore or friendshore some of their manufacturing capacity, and have a better grasp on their sovereignty when it comes to technological innovation, the pharmaceutical industry or to renewable and energy industries. With some of these capacities being brought closer to home there are tailwinds for the companies that are exposed favourably to these trends.

We try to identify those companies that are positively exposed to this re-shoring, onshoring, and friendshoring trend and capitalise on the growth momentum.

Which themes have performed best since the beginning of 2024 – and why have some themes been more successful than others?

Since the start of the year, all the things that have a bias and a tilt towards technological innovation have benefited the most. That's where the excitement around Artificial Intelligence, and specifically Generative AI, has attracted most interest, capturing the imagination of investors, consumers, and companies alike.

We see huge flows of investment going into the development of the technological infrastructure that runs the large language models and AI algorithms. This is benefiting those who are exposed to the infrastructure build-out: silicon manufacturing, semiconductor companies, all the wafer equipment makers and providers of the machines in the wafer fabric equipment. All these companies are benefiting quite significantly from that trend.

The theme of ‘AI and robotics’ is the one that has benefited the most because it’s most exposed to the theme itself. But this is also the case for the theme of ‘safety’, especially in the context of patent uncertainty and geopolitical tensions, where cybersecurity and other security considerations are becoming top of mind for governments, companies, and consumers. We see the build-out of infrastructure in the US with initiatives such as the Inflation Reduction Act, but there are also big infrastructure spending plans in Europe too, in terms of water infrastructure, which is obviously benefiting themes that invest in water.

So, I believe the most impactful primary force or megatrend that we leverage on when we build our strategies is technological innovation. That's the one which has the most direct near-term impact in terms of the profitability and growth of companies. But there are also demographic trends, climate and environmental issues – which are directing a lot of money towards new investments in the field – and a trend towards deglobalization, all of which are benefiting some of these strategies quite significantly.

For clients, all these trends have the potential to deliver attractive returns over the cycle. Robotics would also be a tactical, near-term investment, but it’s really of benefit to have exposure to a combination of all of them over the longer-term cycle so you can capitalise on the different megatrends to which they are exposed.

What differentiates Thematics AM from the thousands of other thematic equity funds that investors can be exposed to today?

What makes Thematics Asset Management special when it comes to the way we manage thematic equity strategies is, first of all, the way we design our investable universes. We create depth and breadth across our investable universe, affording different growth engines, drivers and sources of performance from which we can build a concentrated yet diversified portfolio of high conviction stocks.

Second, we always focus on the providers of products and services related to the theme considered. We don't invest in the adopters because we believe they have a very diluted and loosely related link to the theme itself. It's only a tiny portion of their operations and it’s not really driving their operating performance, or the stock price performance of the company. We want to be as pure as possible, and therefore we focus on these providers of products and services related to the strategy considered.

Third, we have in our portfolios a bias towards small- and mid-cap companies. We have built expertise in different strategic themes with many years of experience in managing such strategies, and where we can really bring value to clients and to their performance is in identifying those small and mid-cap companies that can be the compounders over the next few years and the future gems that will be the larger weights in the future indexes, whether it is the S&P 500, the NASDAQ or the MSCI world. So, our small and mid-cap tilt is where we can really bring this expertise in finding these attractive gems for clients.

Why is ‘safety’ such a compelling theme in particular?  

Safety is a compelling theme because first of all it's the primary need on the Maslow pyramid of basic human needs.. But Safety is also driven by a lot of regulation, so it's not something that is discretionary in nature.  More and stricter regulations mean that we need to invest in safety features, irrespective of the specific engagement. It can be from governments, companies, IT enterprises, passwords – more and more safety features are embedded into products and services that we can buy every day. This is also very compelling because you rarely have the ability to opt out of these elements. When you buy a car for instance, the safety features are included. Indeed, most of the time, you buy safety as an embedded component of a product or a service.

Therefore, you can have an attractive growth as a provider of these products and services because they are embedded into other products and services themselves. This theme exists within different sectors across the global economy, through the digital world and the cybersecurity world. We have increasing complexity to protect networks and devices and the digital world is increasing in size and becoming increasingly complex to protect, so we need new technologies – we need to keep up with the increasing threats. This is also the case for payment processing, which we need to protect throughout the chain – from buying an item to how it is processed and debited on your account.

It's also in the real world, whether it's in transportation, food safety, water safety, diagnostics.  It can be in the work environment, and many other areas of the economy. It results in a diversity of companies in terms of behaviour, investment styles, some of which are defensive, some are cyclical. You can build your portfolio depending on where you stand in the economic cycle and the different phases of the market.

And in terms of performance, our safety theme has been a very strong performer relative to peers, whether they are actively managed or some of the more niche strategies targeting cybersecurity specifically, for instance. When cybersecurity does well, safety can do also very well because they are exposed to cybersecurity. But where you can have some sources of underperformance in the cybersecurity space because valuations are extended, there are other opportunities that our fund can play in other parts of the investable universe. This is more difficult to do when you are only targeting cybersecurity and where you can suffer quite significant underperformance. Managing a safety fund which is diversified across the value chain can be really critical when you think longer term.

Interview conducted on 4 June 2024