'We are cautious on the AI space': Portfolio manager

Key Concepts

• Tech Market Skepticism: A prevailing sentiment of doubt and caution regarding the valuations and future performance of technology companies.
• Government Shutdown Impact: The disruption caused by a government shutdown, leading to a lack of economic data and potential negative effects on GDP and consumer spending.
• AI Investment Growth: The rapid and significant investment in Artificial Intelligence and its implications for various sectors, including chip spending and utilities.
• Valuation Compression: A decrease in the perceived value of assets, particularly tech stocks, due to factors like slowing economic growth and reduced market inflows.
• Brookfield Asset Management (BAM) & Brookfield Corporation (BN) Model: A business strategy focused on acquiring capital, making profitable investments, and leveraging returns for shareholders, which is sensitive to market conditions.
• Brookfield Infrastructure: A company focused on infrastructure assets, benefiting from increased demand for utilities driven by AI.
• Bombardier: A company positioned as a potential defense play, with a strong order backlog and growth in its aftermarket business.
• Canadian Pacific Kansas City (CPKC): A rail carrier whose stock has retreated to peer valuations, with expectations of continued EPS growth despite potential tariff impacts.
• Funds From Operations (FFO): A measure of a real estate investment trust's (REIT) cash flow, often used to assess its operating performance.
• Credit Spreads: The difference in yield between two debt instruments of similar maturity but different credit quality, which can indicate market risk appetite.
• Discount Rate: The rate used to determine the present value of future cash flows, which can increase with perceived risk, impacting valuations.

Tech Market Malaise and Economic Uncertainty

The tech market is currently experiencing an atmosphere of skepticism, with many tech stocks trading significantly off their highs. This sentiment is exemplified by the rapid decline in Coreweave's stock, despite it still being well above its IPO price. This decline is occurring in a period of unusual economic uncertainty, exacerbated by a government shutdown that has removed crucial economic data such as retail sales and GDP.

Impact of Government Shutdown on GDP and Market Valuations

Economists estimate that the government shutdown, by impacting paychecks of government employees and contractors, could shave 1-2% off the annualized GDP number for Q4. This slowdown in economic activity raises concerns about the sustainability of high valuations for tech companies. The market is questioning whether income flows into equities will slow down if consumers have reduced disposable income due to the shutdown. This slowdown in consumer spending can lead to a decrease in inflows into equity markets, which are crucial for sustaining the high valuations of tech companies, often based on future growth prospects.

AI Investment and Valuation Pressures

The valuation of tech companies is heavily influenced by factors such as the growth rate of tech earnings, investment in AI, and chip spending. However, a lack of cash moving into or a retreat of cash from the markets can make it difficult to sustain valuations that are primarily based on long-term hopes and dreams. The speaker expresses caution on the AI space, anticipating potential weakness in Q4.

Retail Earnings as Bellwethers

Key bellwether earnings from major US retailers, including Walmart, Target, Home Depot, Lowe's, and TGX, are expected this week, with an October 31st quarter-end. These earnings will provide insights into the economic slowdown, with at least a month's worth of data reflecting the impact of the government shutdown. The expectation is for weak retail numbers and potential reductions in future guidance. A significant challenge will be distinguishing between the impact of the government shutdown and a broader economic malaise affecting consumers due to factors like tariffs. This uncertainty is detrimental to market stability.

Investment Strategies and Stock Ideas

Given the current market uncertainty, a cautious approach to risk is advised. The discussion then shifts to specific stock ideas, with a focus on companies that can weather economic headwinds or benefit from specific trends.

Caution on Brookfield Asset Management (BAM) and Brookfield Corporation (BN)

Despite their historical good returns, the portfolio manager is currently avoiding Brookfield Asset Management (BAM) and Brookfield Corporation (BN). Their business model relies on attracting capital and generating returns that exceed the cost of that capital, which is leveraged for shareholders. However, when the market or capital markets slow down, capital availability decreases, and the cost of capital increases. This is evidenced by narrowing credit spreads. Peers of BAM and BN in the US have already experienced significant valuation squeezes, and a similar "catch-up" is anticipated for BAM and BN. Concerns about private credit issues, though not yet directly impacting BAM or BN, can lead to an increased discount rate, further pressuring their premium valuations.

Positive Outlook for Brookfield Infrastructure

In contrast, Brookfield Infrastructure is viewed favorably. It offers double-digit Funds From Operations (FFO) growth, with a strong track record of investing and recycling assets by selling them at a premium. The company is also poised to benefit from increased interest in utilities, driven by the significant new utility investments required for AI development. Brookfield Infrastructure is considered a good yielding option.

Bombardier as a Defense Play

Bombardier is identified as a potential defense play, with the possibility of benefiting from increased government spending on weapons. Discussions around Swedish fighter jets and potential industrial benefits for Canada suggest that Bombardier could be a strong bidder for contract work. Beyond defense, Bombardier's fundamental strength lies in its very strong order backlog and growth in its aftermarket business, indicating room for multiple expansion. The company's cash flows have also been improving over the past couple of years.

Canadian Pacific Kansas City (CPKC) and Trade Dynamics

Canadian Pacific Kansas City (CPKC) is another favored stock, despite concerns about tariffs disrupting cross-border trade. The expectation is for low double-digit EPS growth next year, and the stock's multiple has retreated to align with its peers, meaning investors are not paying a significant premium. The outlook is that the real economy will likely hold up, even with some tariff-induced slowdown in activity. While US consumers may face a "tax" on consumption due to tariffs, a collapse in consumption is not anticipated. Furthermore, with interest rates expected to come down, there are potential benefits for sectors like home building, which could lead to increased spending and positively impact CPKC.

Conclusion

The current tech market is characterized by skepticism and uncertainty, largely driven by economic headwinds such as the government shutdown and its impact on consumer spending and GDP. While valuations in the tech sector face pressure, specific companies like Brookfield Infrastructure and Bombardier present attractive investment opportunities due to their underlying business strengths and potential to benefit from emerging trends like AI and defense spending. Canadian Pacific Kansas City is also seen as a resilient play with expected EPS growth, even amidst trade uncertainties. The overall sentiment suggests a cautious approach to the market, with a focus on companies that demonstrate strong fundamentals and can navigate economic volatility.