AI boom isn’t a bubble, and why we don’t own defence stocks

Mike Fox, fund manager of Royal London Sustainable World C Acc Trust, explains why he’s comfortable with the amount of capex the world’s biggest businesses are spending on artificial intelligence (AI) advancements, and dismisses concerns that AI-related stocks are overheated and in bubble territory.

Fox, who has been managing sustainable funds for more than two decades, notes a frustration that demand for sustainable funds comes in waves, saying that “as the fund gets more expensive, it tends to get more interest and as it gets cheaper, it gets less interest”.

Fox also explains why the funds he manages don’t include defence stocks, why clean energy stocks are a key hunting ground, and why the US will remain the main country focus for the fund.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Mike Fox, who manages various sustainable funds for Royal London Asset Management. Mike, thanks for coming in today.

Mike Fox, fund manager of Royal London Sustainable Leaders: You’re very welcome.

Kyle Caldwell: So, Mike, the first couple of questions are related to the Royal London Sustainable World Trust. I can see in your top 10 holdings plenty of stocks seen as artificial intelligence (AI) leaders. AI is, of course, prompting lots of excitement about its potential growth, but there are also worries about capex. What’s your stance?

Mike Fox: This is a great question. The fact that we own these in our top 10 suggests that we are more comfortable with the amount of capex that’s being spent at the moment. It is unprecedented. It is huge. However, if AI and its potential is true, then what we will see is huge demand for compute, as effectively labour gets replaced by computation. And if that happens, we think the scope for growth in compute power, and therefore the need for capex, is entirely justified.

Kyle Caldwell: Of those top 10 holdings, you own Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), Microsoft Corp (NASDAQ:MSFT), NVIDIA Corp (NASDAQ:NVDA), and Alphabet Inc Class A (NASDAQ:GOOGL). Naturally, there are some comparisons between the dot-com boom and the AI boom of today. However, is a key difference between the two, the fact that those companies you own, they’re very profitable, whereas in the dot-com boom and bust, a lot of the companies weren’t making any money at all?

Mike Fox: Yeah, I think there’s a massive difference. I started my career in the late 1990s, so I did actually see the end of the dot-com boom and bust, and it’s night and day from today. There were completely profitless businesses in the late 90s, and the valuations were ludicrous.

Today, you look at the rating that something like Nvidia trades are on - it’s on a similar multiple to BAE Systems (LSE:BA.) in the UK. There’s no obvious high level of kind of valuation that there was before. They’ll be very dependent on how AI progresses and whether the volume of use of AI is what people perceive. But it’s not a valuation bubble, which I think was very much the case in the late 90s.

Kyle Caldwell: In terms of the country weightings, you have around 60% in the US. What’s been your approach given that there’s been a pivot to other markets over the past year?

Mike Fox: We are remarkably underweight the US, even with 60% exposure. I think it’s one challenge for a global investor at the moment. You look at index composition and you’re really very much weighted to the US and very much underweight other areas. As the US has become a little bit less exceptional, all the markets have benefited.

So you’re right, Europe, the UK and Asia have been better markets both last year and have started more strongly here. So, I think we do want to evolve into that. I do think it’s quite critical to say, though, that the US is exceptional, and that there aren’t really comparators with the same governance standards, the same disclosure standards in other markets.

So, while I do think we will evolve into owning less US and more other markets, it’s pretty likely that the US is going to be the main focus for the fund for probably the rest of my career.

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Kyle Caldwell: The fund has modest allocations to emerging markets and Europe. Could you talk us through some of the exposure you have to those areas?

Mike Fox: Companies like MercadoLibre Inc (NASDAQ:MELI), which is Latin America’s largest e-commerce business, also has a payments business within it as well, and it’s a great example of getting exposure to that market. We also own HDFC Bank Ltd ADR (NYSE:HDB), an Indian bank, and we’re looking at other ideas in Brazil and areas like that.

So, you can most definitely find them. But I do think it’s still a little bit by exception. I think that when, particularly for us,  we’re looking through a sustainable lens and looking at environmental, social and corporate governance standards, they do tend to be weaker in a lot of these geographies.

We can find ideas, we do make progress, we also invest in companies listed in the UK and US with big emerging market businesses within them, so that helps as well. And then you put it all back together and we do think in totality we have reasonable exposure to emerging markets.

Kyle Caldwell: You’ve been managing money for over 20 years, so you’ve seen a lot of change over that time when it comes to sustainable investing. How do you think the landscape for sustainable investing will change over the next five to 10 years?

Mike Fox: It definitely goes through cycles. That’s my experience of it. For a lot of the 2010s it wasn’t really an area that people invested in, but then in about 2017-18, it really got a kind of tailwind behind it. Then, I think partly because of the change of the president in the US, the outbreak of wars and other factors, that it’s been de-emphasised to some degree.

Against that though, when we meet corporates they’re very much still aligned. They think sustainability aligns with more value-add products, with less cost because resource efficiency means cost efficiency, and often more motivated employees many of whom do have values and they want to see those in the companies they work for.

So, even though from the top down there’s a little bit less of a tailwind than there used to be, bottom-up companies are still as committed to it, and I think as long as that remains it should still be a durable place to grow capital and invest.

Kyle Caldwell: As you mentioned, around five to six years ago, there was a big pick-up in demand for sustainable funds. Then, a couple of years later, we saw that demand cool. Demand cooled at the same time as performance cooled. So, are the two things heavily linked? Do we need to see a pick-up in performance for sustainable funds for investors to return?

Mike Fox: Probably. I mean, it’s one of my frustrations that as the fund gets more expensive, it tends to get more interest and as it gets cheaper, it gets less interest. One of the real challenges for any investor is to just think counter-cyclically. It’s like what’s gone down has potential, more potential, to go up. It’s often that the mentality is the other way around.

I do think performance drives everything and, ultimately, when people see the performance that they think they can buy into, then they will show more interest in sustainable investing. But even since 2022, I think it’s important to say that we’ve still managed to grow capital quite nicely, even in an environment that hasn’t been particularly favourable.

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Kyle Caldwell: Over time we’ve seen some shifts in sustainable investing. One shift over the past couple of years is the debate over defence stocks and whether they should be included in a sustainable fund. What’s your stance?

Mike Fox: So, I have two points on this. One is that if you take the company I work for, Royal London, we offer our investors funds that do and don’t invest in armaments. The most important thing is that it is a choice that an investor makes. Within the sustainable funds, we don’t own armaments really because we struggle to find an armaments company where we can guarantee that the weaponry is only used for defence and is traceable.

We fully understand the need to defend democracy, society, and all these other things. But the reality is when we look at armaments companies, once a fighter jet’s been sold to a government, that government uses it however they want. That can become very, very controversial into what’s attack, what’s defence, and these kind of debates.

So, we’re just very clear with our investors that if [they] invest in this fund, that we’re not going to be owning armaments manufacturers. But we totally respect the view that people may say, I’m fine with that for justifiable reasons, in which case we offer other funds that invest there.

Kyle Caldwell: I also wanted to ask about clean energy stocks, which you have described as the most obvious sustainable investments. How do you gain exposure to that area?

Mike Fox: Yeah, so the reason why we say it’s the most sustainable thing is like literally everything is energy transformed - you can’t do anything without energy.

So, the fact that you can find renewable sources or sustainable sources of energy is a good thing, how you can invest in it. I think it has been super interesting that since Donald Trump was made US president on a very anti-environmental agenda, renewable stocks have performed really well.

Because there is this huge demand for power in the US, particularly around data centres, and things like solar are very practical, very quick ways of dealing with that. Solar stocks, I think, are having something of a renaissance, [but] you’ve got to pick carefully which ones your own.

But things like wind as well, look at SSE (LSE:SSE) in the UK. Some companies do have fossil fuel exposure as well. SSE has gas generation, which we need to make sure is run environmentally well. But it is possible to buy them as distinct renewable businesses as well as these composite companies as well.

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Kyle Caldwell: And our final question, which we always ask fund managers, is whether you have skin in the game. Before you answer, Mike, as you run numerous funds, I wanted to ask, are there certain funds that you personally invest in, or do you invest across them all?

Mike Fox: So, I have investments in Royal London Sustainable Leaders C Acc, Royal London Sustainable World, and our Royal London Global Sustainable Equity M Acc fund.

For me personally, I quite like having an equity exposure and I’m quite comfortable with the volatility, and I’ve still got long enough to invest to manage that. We also run fixed-income funds as well, which are for people who maybe want a bit less volatility or have got less time to save.

What I’ve learnt over the 25 years I’ve been managing money is the genuine power of innovation and the genuine power of economic and societal progress. Equities give you really undiluted exposure to that and that’s how I choose to invest.

Kyle Caldwell: Mike, thank you for your time today.

Mike Fox: Thank you.

Kyle Caldwell: So, that’s it for our latest Insider Interview. For more in the series, do hit the subscribe button, and hopefully I’ll see you again next time.