How to best capitalize on AI capex buildout

Key Concepts

• Earnings Acceleration: The rate at which a company’s earnings are increasing. A key metric used by Stone Castle Investment Management for stock selection.
• Rotation: A shift in investor preference from one asset class or sector to another, currently observed from large-cap (Mag 7) to small and mid-cap stocks.
• Mag 7: Refers to the seven largest technology companies (likely Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) that have driven significant market gains in recent years.
• Russell 2000: A stock market index representing approximately 2,000 small-cap companies in the United States.
• Hyperscalers: Companies that operate large-scale data centers and cloud computing infrastructure (e.g., Amazon, Microsoft, Google).
• Fuel Cells: Electrochemical devices that convert chemical energy into electricity, often considered a cleaner energy source.
• Backlog: The total value of orders a company has received but not yet fulfilled.

Market Overview & Rotation

The TSX is potentially reaching new records, while US markets are mixed. The discussion centers on a significant market rotation occurring, moving away from the previously dominant large-cap technology stocks (the “Mag 7”) towards small and mid-cap companies. This rotation is primarily driven by earnings acceleration and valuation discrepancies.

Bruce Campbell of Stone Castle Investment Management explains that the rapid earnings growth of the Mag 7, previously around 50% for both revenue and earnings, has slowed to approximately 20% while still positive. Conversely, the Russell 2000, representing smaller companies, has transitioned from negative earnings acceleration to positive growth. He anticipates this trend to continue for 18-24 months or longer, as these shifts typically persist for multiple quarters. Investors are drawn to smaller caps due to this earnings acceleration and because their valuations haven’t fully recovered from the 2022 market bottom to the same extent as large caps.

Sector Preferences & Rationale

Stone Castle Investment Management currently favors three sectors: precious metals & materials, industrials, and energy.

• Precious Metals & Materials: Strong cash flow acceleration is being observed in these companies due to rising commodity prices.
• Industrials: The sector experienced a recession in 2022 but is now recovering, leading to stronger earnings and stock performance.
• Energy: Despite a decrease in commodity prices, increased cash flow is being generated due to companies’ focus on capital strategies.

Stock Picks & Analysis

Three specific stock picks were discussed, with detailed rationales:

1. Bloom Energy (San Jose, California): Bloom Energy differentiates itself by producing on-site energy systems using fuel cells, offering a green and efficient electricity generation solution for hyperscalers and other high-demand users. The company has demonstrated significant revenue and earnings growth over the past 6-8 quarters and maintains a substantial backlog, alongside a growing service business. The modular nature of their systems allows for scalability as energy needs increase.

2. Tanaz Energy: Tanaz Energy acquired international assets (in the Netherlands) from a major supermajor at a favorable price. They are actively enhancing production through drilling and recovery work on these properties. A key aspect of their strategy is financing acquisitions primarily through the cash flow generated by the acquired assets, demonstrating financial prudence. They plan to continue pursuing similar acquisition opportunities.

3. TTM Technologies: TTM Technologies manufactures printed circuit boards and radio frequency technology used in high-growth sectors like space, defense, and autonomous vehicles. The company has experienced substantial revenue and earnings growth, with a 605% increase over three years. TTM aims to become a global leader in its field and is actively expanding its geographical reach. Campbell believes there is continued growth potential despite the recent strong performance.

Investment Methodology

Stone Castle Investment Management employs a “bottom-up” process to identify stocks with the fastest earnings acceleration. This means they focus on individual company fundamentals rather than broad macroeconomic trends. They prioritize companies demonstrating consistent and increasing earnings growth as a primary investment criterion.

Notable Quotes

• “...the market is always forward looking and is concerned about that [potential earnings deterioration].” – Bruce Campbell, regarding the software sector.
• “...it's not a surprise to us really that we started to see the the smaller cap market start to broaden out and accelerate…” – Bruce Campbell, on the anticipated continuation of the market rotation.
• “...they financed the acquisition mostly through uh the cash flow from the property.” – Bruce Campbell, describing Tanaz Energy’s acquisition strategy.

Logical Connections

The conversation flows logically from a general market overview (TSX performance, US market mix) to a discussion of the broader market rotation. This rotation then leads to a detailed examination of Stone Castle’s preferred sectors and specific stock picks within those sectors. The stock pick discussions are consistently linked back to the overarching theme of earnings acceleration and valuation.

Conclusion

The interview highlights a shift in market dynamics, with investors increasingly favoring small and mid-cap companies exhibiting strong earnings acceleration. Stone Castle Investment Management is positioned to capitalize on this trend through investments in the precious metals & materials, industrials, and energy sectors, focusing on companies like Bloom Energy, Tanaz Energy, and TTM Technologies. Their bottom-up investment approach, prioritizing earnings growth, underpins their stock selection process. The key takeaway is that the current market environment presents opportunities in areas beyond the previously dominant large-cap technology stocks, particularly for companies demonstrating robust financial performance and growth potential.