Why this investor doesn't own NVIDIA (and what she owns instead)

Artificial intelligence captured much of the focus for investors in the back end of 2023 and into the first quarter of 2024. The “mega-cap” technology firms, which comprise around 30% of the S&P 500 index, accounted for a large proportion of the market gains between late October and the end of March. Collectively, they contributed 37% of the index’s gains in the first quarter of 2024.

They also contributed around 10% of the total 26% return delivered by the MSCI Global Growth ex-Australia index between the end of 2022 and March 2024, says Franklin Global Growth portfolio manager Francyne Mu.

But there are other ways to invest in the theme, as we find out in the following interview. Mu provides her view on the AI theme and explains why Alphabet (NASDAQ: GOOGL), Meta (NASDAQ: META) and NVIDIA (NASDAQ: NVDA) aren’t in her portfolio. Mu also discusses how her team finds opportunities and a few other technology names she believes have similar growth drivers but fewer risks.

Where are we now in the AI theme?

Mu believes that across the full Generative AI technology stack, we’re in the early stages of the infrastructure phase.

Mu discusses a “crowding” within this stage, which was kicked off when OpenAI launched ChatGPT in November 2022 (which Microsoft later joined in partnership).

“We’ve seen the high demand for GPU chips, where NVIDIA has been such a strong player, as reflected in the share price and the momentum of their revenues,” Mu says.

The next layer was the creation of the large language models, where Mu says several “hyperscalers” are trying to develop tools to challenge ChatGPT. She alludes here to Meta Llama and Google Bard as two that have launched in competition with ChatGPT.

“The third phase, which we're a long way from, and with questions surrounding how quickly we get to that stage, is how enterprises can build applications on top of all of this, to provide the far-reaching benefits in in this virtual reality/artificial intelligence world,” says Mu.

“At the moment, we think monetisation is still in the early innings in terms of the adoption and beneficiaries down the line.”

She notes that only NVIDIA (NASDAQ: NVDA), through its graphics processing units (GPUs) and Microsoft (NYSE: MSFT) via Copilot and the Office365 suite are reaping the benefits so far.

Mu also explains that AI and machine learning themselves aren’t new, but the language learning models (LLMs) and their applications are.

How do you identify Quality names among your focus area of Growth companies?

Mu and her team focus on free cash flow generation, the supply chains, and the business models of companies.

“We like those companies that are cash flow rich, and on the quality side, corporate governance and capital allocation are also extremely important,” Mu says.

“The company has to be able to reinvest those strong free cash flows into things that materialise in higher growth of the company or stronger returns.”

She also emphasises corporate governance, in the way management is structured and aligned with shareholders.

What is your rationale for not owning the Magnificent 7, given they have performed so strongly?

While their high valuations are part of the reason, the main one for Mu and her team is their strong focus on corporate governance.

“So, for reasons such as dual share class holdings, as minority shareholders in Meta (NASDAQ: META) and Google (NASDAQ: GOOGL), we don't feel our concerns are well represented, we don't have the same voting rights. Those two mega-cap names don’t necessarily pass our hurdles,” Mu says.

While acknowledging there are strong growth drivers for the mega-cap technology companies, Mu also notes the strong competition between them.

“You've got Amazon Prime competing with AppleTV, you've got Google with YouTube, and Meta with Instagram, they're all competing for the time spent on digital media.”

She also sees similar competition between the LLMs, OpenAI’s ChatGPT and Google Bard (which rebranded as Gemini in recent months).

Other companies engaged in this “arms race” include Amazon (NASDAQ: AMZN), which is now also pushing into an advertising-driven business model – an area that has so far been dominated by Meta and Google.

“They're all competing more and more against each other. So, they've got strong free cash flows and they've got all this capital allocation all being pushed into the same areas,” Mu says.

Why Nvidia didn’t make the cut

Nvidia was a company the team carefully considered buying but Mu says the stock’s cyclical performance was a turn-off.

“We have seen peaks and troughs. They did well when they came out in gaming. Then as that demand receded a little, they hit the crypto wave, and now obviously with data centres.

“For our highly concentrated strategy of only 33 to 35 names, we prefer to play in some of the names that are less cyclical,” Mu says.

Why valuations are too rich

On the valuation front, she notes the strong fundamentals supporting the mega-caps but says these must be weighed against inflated valuations for some of them.

“Five years ago, the forward multiple of these mega-cap names was essentially at parity with the rest of the market. Now when you look at the mega caps versus the rest of the market, they're essentially at a 50% premium. How sustainable is that?”

“As investors, we feel there has to be a broadening out [of competition] and as a result, some of these valuation multiples could come down for these mega-cap names.”

“We prefer to invest in other parts of the market that have exposure to the same secular growth drivers but are less stretched on a valuation basis.”

How are you investing in the space?

Synopsys (NASDAQ: SNPS)

Market cap: US$80.46 billion

“We are not in Nvidia, but we are in names like Synopsis, which provides electronic design automation tools for chip companies, enabling them to design more complex chips,” Mu says.

“They're more tied to R&D spend rather than manufacturing spend. We think it provides us with exposure to the same secular growth driver, but without that cyclicality that you might see in other parts of the semiconductor industry.”

MongoDB (NASDAQ: MDB)

Market cap: US$26.68 billion

Coming back to her earlier point about the foundation models of AI and the later applications, Mu says better management of datasets is needed to reach this latter stage.

“We think a name like MongoDB will benefit because they provide software for these hyper-scalers and for enterprises to draw upon their operational databases and to gather data more efficiently,” she says.

“The efficiency in terms of what Mongo can provide to enterprises and hyper-scalers in accessing that information is something we think will play well going forward.”

Ansys (NASDAQ: ANSS)

Market cap: US$28.43 billion

Simulation software company Ansys is another company the Franklin Global Growth Fund is backing. It creates simulation software that supports the chip design functionality of companies such as Synopsis.

As Mu explains, it runs simulations, testing and evaluating models to help chipmakers determine whether their designs are accurate and effective.

“If you can simulate something effectively in your models, enterprises can save money and time in bringing new products to market,” Mu says.

The expansion into new vertical markets is another drawcard, with the aerospace and defence sectors some of the next big applications – in addition to the automotive sector where it already operates. 

Access to global growth

Francyne's fund, which has also just listed on the ASX (ASX: FRGG),  seeks to identify companies with long-term competitive advantages in their respective sectors. To learn more about where they are finding the highest growth opportunities, visit their website or fund profile below. 

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