How much more Nvidia and Apple do you need?

Chris Wallis, Vaughan Nelson CEO and CIO thinks that AI is both ‘over-hyped and underappreciated’ and better investment opportunities could lie outside megacap tech, particularly in global small-mid caps. In this in-depth podcast Chris talks to Louise Watson, Head of Country for Natixis Investment Managers Australia about:

• Why he first started investing and why he loves it
• Where he is seeing the best investment opportunities
• His thoughts on the global economy and future prospects
• Why global small-mid caps are misunderstood and why it is an attractive asset class
• What sets Vaughan Nelson apart, including the Vaughan Nelson culture

This podcast was recorded on 19 September 2024.

Lightly edited transcript

Louise Watson: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers Australia, where we bring you insights from our global collective of experts to help you make better investment decisions. I'm Louise Watson, head of country for Natixis Investment Managers in Australia and New Zealand, and today I'm joined by Chris Wallis, who is the CIO, as well as the CEO and Senior Portfolio Manager at Vaughan Nelson Investment Management.

Chris is a regular to our shores, so he understands the Australian market and he's also one of the most astute and entertaining commentators on the global economy and equity markets that I have ever come across. I'm very much looking forward to our conversation today and I'm sure our listeners will also enjoy it. Chris, I've got my book club coming up this week. You're a self-confessed knowledge junkie. What book are you reading and what are you doing outside of work?

Chris Wallis: Yeah, I am a self-confessed knowledge junkie, and I've got the worst habit in the world. I probably buy four books for every one I get through. I just finished a timely book, which is Chip Wars, and for anybody interested in the geopolitics behind the semiconductor industry for the last 50 years, I highly recommend it. I'm starting a new book called Shape and it's how geometry can be used to understand not just social constructs, but politics, markets, physics, just our universe in general, so I'm excited about that.

Louise: Yeah, that's great. I think geopolitics and semiconductors are certainly two hot topics and combining them into one book is going to be fascinating. Chris, you've been investing for many years now, including more than 20 years at Vaughan Nelson. Why did you first become interested in investing?

Chris: For me, I always enjoyed business, I was intrigued with it. Even through high school and college, I worked in multiple different businesses and managed warehouse and did a range of different activities. So I knew I wanted some element of kind of entrepreneurship and that morphed into, "Okay, well what does it mean to own a business?" And my plan all along was to get an accounting degree, go to law school and buy and sell companies, whatever that meant. Ultimately, I pivoted to grad school and took the two years in business school to really study investing. What did that mean to buy and sell companies? How do you even do that?

For me, what I really liked, I think it's part of being a knowledge junkie and understanding how things work is really incorporating not just the business fundamentals, but what the future's going to hold, what the macroeconomic setup is. And I like the ability to allocate capital, and I just think it's critical. It's important for underlying investors to be able to make money in any environment so that they can defease those liabilities. And it's one of those career choices that, it really is an act of service. Yes, professional investors are paid well, I'm not here to say that's not the case, but if you take your craft to heart and you're a steward. We manage money for teachers, we manage money for firemen, look, they're not going to have a retirement if we don't do our job.

Louise: And that curiosity and sense of entrepreneurial spirit that you've built at Vaughan Nelson is one of the things that we've come to love and know about the firm. And for some of our listeners that might not be so familiar with Vaughan Nelson, can you tell us a little bit about the firm and what sets you apart from other active managers?

Chris: I think there's two things that really distinguish us from other active managers. One is we really do focus on the ability to defease liability. So you're not going to hear us talk about relative return objectives or relative valuations or relative fundamentals. Because if you're in a secular bear market, losing less is fine, but it's not going to get anybody to the finish line and the outcomes they desire. 

So for us, although we started quarter-century ago with a 12% discount rate, we still use that discount rate and we use it all around the world and it works well because that's our opportunity cost as we allocate capital.

And then I think the other thing that's a distinguishing factor is look, if we're looking for these mid-teens returns and we want very little downsides of good valuation support, how do you do that in a range of changing environments? So we've always had a heavy focus on macro, not to pick stocks. We don't use the macro to pick stocks, but what we do is we probably cover a little over two dozen countries. It gives us about a 9-12 month lead on economic decelerations. It gives us about a six-month lead on recessions and similar leads on recoveries, and we get the same lead on inflation. So when you have these shifting economic conditions, they're not a surprise to us. So we know when to dial up the risk, we know when to dial it down and we can tilt towards factors that are beneficial.

And this really proved valuable not just during the financial crisis, because inevitably if you track those factors, you track liquidity and credit. So we were anticipating a fairly significant credit event. But even in '22, look, we knew inflation wasn't going to be transitory, we knew it was going to be a global issue, and central banks were going to have to react. And we knew what the implications of that were going to be for either long duration assets, whether that's high PE growth stocks or long-dated fixed income securities. So again, we could protect and preserve that capital and then redeploy it when we got to the bottom once we knew inflation was no longer an issue. So again, just that absolute valuation, absolute return objective, combined with a pretty robust understanding of what's going on in the macro environment, I think has been our distinguishing characteristics.

Louise: And that's a big part of your process, and I'm a big believer in company culture as a differentiator and part of a company's competitive advantage. As the CEO, as well as the CIO, what do you focus on for your team culture and what do you think is part of Vaughan Nelson's special sauce?

Chris: Yeah, look, I think culture is everything, especially in investing. And you said it right, it's a team. If you met any one person on our team, you're going to see some fairly consistent attributes. Number one as a firm, the star of our firm is our philosophy and process. And everybody is committed to improving that process across time and space and everybody's committed to seeing each other be successful. So that just creates a lot of collaboration. It creates a lot of information flow, it creates a lot of sharing of both good ideas and concerns.

The other thing is look, while we may be collaborative, we're all crazy competitive. We know we're going to win, but we're going to win as a team. We know we can't rely on any single individual to be successful. And so we get up every day, we know what we need to focus on. We come to the markets with a game plan, we don't react to news in the market, we understand what's coming our direction and we know there's nobody that's going to outwork us or out-think us.

Louise: Let's dig into the economy now. And while the US economy is slowing, it appears to be still reasonably robust and you said recently that at this stage you think a US recession is unlikely. The European economy appears to be still struggling, Asia looks mixed, which areas of the global economy do you feel most positive about for the future?

Chris: We're going to get into a more nuanced environment where it's going to be where is the strength relative to the expectation. So it's not just that, hey, economic data may be weak, but you actually may generate your highest returns there. And that's going to be true not just in regions, but really when you get down to specific sub industries as well. But the general setup is pretty interesting right now, the inflationary issues are in the rearview mirror. There's no question that over the longer term we have increased inflationary pressures, but that doesn't have to mean high inflation, it just means it's higher than it otherwise would've been.

Globally, we've been in about a seven-quarter industrial recession, and that's coming to an end, but we're going to have a very muted recovery and a lot of that is driven by the weakness in China. And that weakness in China is not just the balance sheet recession from their excess reliance on property markets and infrastructure. It's also a lack of demand.

So I look at the globe and when we look at it contextually, we can see fits and starts, but what we're really focused on is at the company level who has been making the pivots already, who has been investing in those balance sheets so despite a sluggish environment around them, they're going to see underlying growth.

And we can see that. We can see opportunities across the whole globe, across whole industries and across whole sectors, but it's not going to be any specific region.

Louise: The US markets have been strong in recent times, though still a relatively narrow rally. Many investors have been positioning for rebound in European markets, but that rebound still hasn't arrived. Do you think there will be a European market rally or should investors look elsewhere?

Chris: 

And the reason I say that is it has a lot to do with the policy choices in and around the energy transition. And an underlying economy is nothing but two factors. It is your cost and availability of energy combined with capital, and they've made no significant attempt to increase the capital, and they have actually reduced and increased the cost of their energy.

So they're going to be sluggish, and we're seeing that and that's going to remain the case. So if you take what I'd call the mid-cap space for the German industrial base, and Germany is over 50% manufacturing export oriented, they've been relying on the strength in the growth in China, now China's becoming a competitor. It's not that these businesses may be permanently impaired, it's they got to pivot, they have to find new export markets or they have to move their manufacturing locations.

So I don't know that we're going to have a region or a sector that you're really going to want to hone in or is going to do well, but again, at the company level, it's going to be the haves and the have nots. And this element of rebalancing is going to be with us for a while. So we feel pretty good, it's going to be a pretty target-rich environment.

Louise: And understanding some of these company dynamics and finding these opportunities is what our investors are really interested in. And one of the areas Vaughan Nelson focuses on is global small and mid-cap companies, global SMIDs. That's an asset class that some investors are probably less familiar with. Can you tell us why investors should consider adding global SMIDs to their portfolio?

Chris: This is a common question we get and everybody's like, "Why do I even need to make the allocation?

And why would that be the case?

If you look at the size of the universe, the global SMID universe is easily seven to eight times larger than the global large cap. There's just more companies to pick from.

Now let's get rid of the myths. The myths are that this is a risky place, it's a risky environment, and I'm going to talk in US dollar terms here, but the upper end of the global SMID universe is $60 billion. These are not small companies by any stretch. The lower end that we're willing to invest in is really around one and a half billion US, which again, these are not companies that are trying to prove themselves in the marketplace.

So when you roll it all together, you have a lot less analyst coverage, you have a lot more companies to pick from, you get much better diversification, you get higher EPS growth, you get higher total returns in the aggregate and you do it in a more target rich environment so you have just less inherent concentration, quite frankly, less overlap with the rest of your portfolio. How much more Nvidia and Apple do you need exposure to? I mean come on.

Louise: I love this myth busting on the asset class and changing the perception of the universe and you mentioned some of those big names there and speaking of the trend of AI, AI excitement has driven many US listed mega tech stocks to very high valuations. Are you seeing AI also benefit mid and small cap companies around the world?

Chris: Yeah, for sure. And that's kind of the other myth that you had to own large cap tech to get that exposure, it's just not the case. We have plenty of companies that either make subcomponents, optical components for that infrastructure or make memories or do the testing for all of those chips and those stocks have performed in line with Nvidia for the last year or so. There's no question when you step back and look at AI, I think there's two things that investors need to remember, it's overhyped and it's underappreciated. And what I mean by that is it is a gold rush. There's no question there's going to be money to be made here. Do you want to own Nvidia that everybody knows about and its customers are trying to diversify away from? Why not go down cap and own all the infrastructure?

And when I say infrastructure, I'm not just talking about memory chips, I'm not talking about semi-cap equipment and testing equipment. How about all the HVAC units that have to go into all these data centers that have massive backlogs built up? How about the electrical infrastructure that has to go into these?

So like I said, look, it's a gold rush. You have a choice. You can buy a property claim and a shovel and you can go out and dig a hole and hope you found gold, or you can own the general store at the bottom of the hill and sell shovels and mining equipment to every hopeful individual who wants to go up and find gold. We were always in the picks and shovel business, and so we can get the same exposure without getting that concentration risk.

Louise: And the AI surge we were talking about earlier (sounded strange) has caused US markets to become increasingly concentrated in technology. And we're also seeing the Australian market become increasingly concentrated. The big four banks and large mining companies now make up close to 50% of the ASX 300. Do you think this is a trend that investors should be concerned with or do you see it as an opportunity?

Chris: Any risk is an opportunity, so look, concentration is a risk for everyone. You really need to be factor aware, I can't stress that enough. I guarantee you nobody thought the risk-free mortgages they owned were going to be correlated with Google stock, but guess what? They're both long-duration assets when inflation peeks its head up. So just be aware of your factor bets and just understand market structure has changed. When you see prices move, somebody's going to wrap a story around it and they're going to put it on all your favorite news networks. It may be true, and it may not, so be careful.

Louise: Well, thank you, Chris. It has been so great to have you on the podcast and get your insights into global equity markets. If you enjoyed the episode, please click follow on your favorite podcast platform to be notified of future episodes and tune in again to hear more from our global collective of experts.