Stocks fell yesterday led by the high-flying tech stocks in advance of tonight’s earnings report from Nvidia#.
We have talked ad nauseam about the impact of the Magnificent 6 or 7 (depending on whether Tesla is still in the elite list) on the overall market. Last year, these stocks accounted for more than half the improvement in the S&P 500 and dominated the NASDAQ Composite performance. It wasn’t just a case of speculative frenzy. Assuming Nvidia reports tonight according to consensus, these stocks had a composite 15% revenue increase last year versus a 3% increase in U.S. GDP and a similar increase in corporate revenues. The leaders saw profit margins rise by a composite 582 basis points or almost 6 percentage points in absolute terms. As a result, their profits rose by 58%. The rest of the S&P 500 had lower margins and lower profits. Indeed, despite their strong composite market performance, some of the leaders ended the year with lower P/E ratios based on forward 12-month earnings forecasts than at the beginning of 2023.
The momentum carried forward into 2024. At its peak just a week or so ago, Nvidia’s stock was up another 40%. Some analysts raised price targets to as high as $1200 per share, nearly double where the stock closed last night. We all get that Nvidia is a wonderful company, that it is capacity constrained and likely to remain so for some time, and that when demand exceeds supply, prices and margins can rise quickly. But any rational person also knows such a state of affairs won’t last forever. Nvidia has built a wide moat around its business. It is building software and design tools to augment the superiority of its chip designs, building further barriers. But there is no question that the opportunities that AI presents will attract competition. Most of the wannabees will fail, even most of the ones heavily backed today by venture capital and private equity. But they won’t all fail.
The question investors must ask is when will the clouds start to appear? When will supply begin to catch up with demand? Who will become the real competitive threat, the next Nvidia? And, yes, there will be a next Nvidia. It may not make GPUs faster, cheaper or better than Nvidia, just as Nvidia never made microprocessors better than Intel. Rather, some company will come up with a new revolutionary design that supersedes the GPU.
But that won’t happen tomorrow. Nor will it happen in 2024 or 2025. With that said, stocks are a financial asset whose values are based on future long-term growth rates plus a terminal value. Just a minor tweak in the expected growth rate can cause a significant change, up or down, in a stock’s price. For proof I offer the overnight performance in Palo Alto Networks#, Wall Street’s favorite cyber security stock. It reported better than expected fourth quarter earnings but reduced forward estimates for growth in both earnings and revenues. Overnight its shares are down by more than 20%. It will still grow much faster than the average company in the future. But perhaps not as fast as optimists had hoped prior to the earnings announcement.
Is Nvidia in for the same comeuppance tonight? Its stock price fell by more than 4% yesterday and is down again today in pre-market trading. That only erases a week or so of gains. We’ll see the real story tonight. By the real story, I mean last quarter’s results and management commentary on the 2024 outlook.
There is no question that investors often get carried away. Even for the best, it’s always a story of two steps forward, one step back. But great disruptive companies generally have a long runway that can last for decades. Just look at Amazon#, Alphabet#, or Microsoft#. Apple introduced the iPod in 2001 and the iPhone in 2007. The iPod has long since disappeared and iPhone device sales have stopped growing, at least for now. But Apple’s stock still flirts with all-time highs. Amazon started as an online seller of books. Look where it is now. There are now millions of companies selling goods online. Yet Amazon continues to grow and gain share of wallet. And don’t forget its AWS cloud business.
The obvious conclusion is that it is likely that Nvidia has a long runway. But that doesn’t mean the road is smooth. It will have to battle competition at some point in time. Its chip suppliers may hit snags. No doubt it will have to pivot more than once in the coming years to maximize potential. And along the way, there will be analysts with overly optimistic expectations that exploit bouts of euphoria. But right now, Nvidia is the best at what it does, and if there is competition, it isn’t significant enough yet to derail opportunities. With that said, today’s profit margins may not be sustainable and expectations still have to match up with reality.
I have no idea what lies immediately ahead for Nvidia’s stock. Options trading premiums suggest a move up or down, of at least 10% over the next 36 hours. Just one note of caution from management can drive prices lower. On the other hand, a boost in guidance can send shares soaring.
But I really don’t care about tomorrow. If Nvidia succeeds as a company or as an investment, it isn’t all about tomorrow. It’s about the next several years. If you want to own Nvidia and it becomes an even bigger giant than it is today, you have to find a good entry point. Note that in 2022 its share price fell by close to 70% from peak to valley as investors fretted about slowdowns in demand for video games and crypto mining, two key markets at the time. AI wasn’t much of a topic of conversation. I doubt shares are set to decline 70% again but we all know that corrections of 20%+ are common, even for the best of companies at times. It’s not my intent in these letters to recommend stocks or to pick a logical buy point. All I can do is set the table. If you believe Nvidia is a great company you want to own, pick an entry point, whether it is $700, $600 or $400 per share. If it gets there, buy some. If it doesn’t, buy something else. Don’t buy all at once, especially with a stock as volatile as Nvidia. Nibble. If you believe in the company and it declines after you buy a little, nibble some more. But only do so if your thesis is intact. Chasing a loser whose fundamentals are deteriorating is always a bad tactic.
Investing isn’t easy. But smart investing can be very rewarding. Think smart and try to shut down the irrelevant noise. Avoid euphoria but identify the best and define reasonable entry points. Happy hunting.
Today Kelsey Grammer is 69.
James M. Meyer, CFA 610-260-2220