Best AI stocks amid market exuberance, and portfolio defenders

James Cook, portfolio manager on the JPMorgan Global Growth & Income Ord (LSE:JGGI) investment trust, talks to ii’s Dave Baxter about recent performance, AI red flags, software stocks, and more.

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Dave Baxter, senior fund content specialist at interactive investor: Hello and a very warm welcome back to our Insider Interviews series. I’m Dave Baxter here at ii, and today I’m joined by James Cook, portfolio manager on the JPMorgan Global Growth and Income Investment Trust. James, thanks for joining today.

James Cook, portfolio manager on JPMorgan Global Growth and Income: Thank you very much for having us. 

Dave Baxter: So, your latest financial results give quite a mixed picture. It mentions a 15% total return over the last one-year period, which is very good, but it also mentions that it lags behind a 28% return from the markets. What’s going on there?

James Cook: Yeah, good question. So, several things within that. First, it has been a difficult performance period, and it has been for most fundamental investors. 

Within that number, you have about a 3% decline, which comes from the discount widening. And then the net asset value is still around 8% to 9% behind the market. And behind that is really two things.

First is that the market has focused on short-term earnings. So, earnings today at the expense of long-term fundamentals. And that is always going to be painful for long-term fundamental investors.

The second part is high-quality companies have underperformed the lower-quality parts of the market. And, again, when you go through an extreme demand-led market, which is what we’re seeing with regards to AI right now, the operational leverage of those lower-quality companies is so significant that they can outperform on a short-term basis.

Again, we can discuss why we think that’s short term rather than long term. Again, I can give the example of SanDisk Corp Ordinary Shares (NASDAQ:SNDK) having a 10% EBIT margin having jumped up towards 60%. That’s a very strong earnings uplift.

Now, to some extent, the good news is that our process has been here before. There’s been a significant drawdown in our underlying process and our portfolios. We’ve been here 10 times before, though, over the past 30 years of a drawdown around this magnitude or more.

Interestingly note, the good news is that every single one of those periods, every single one of the 10 times in history, we’ve seen a rebound in the process to the same magnitude as the drawdown, if not better. So, that’s what we’re hoping for in the future again, the market returns to long-term fundamentals. We think now is a really attractive entry point. 

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Dave Baxter: The trust’s report mentions this idea of underestimating the scale and market impact of the AI boom, but it also warns of market exuberance. When it comes to the AI trade turning potentially, what red flags might you look out for? 

James Cook: Yeah, there’s a lot in there. To start with, we were always quite optimistic on AI, but what we had arguably underestimated was the operational leverage of the lowest-quality bottlenecks within the AI supply chain. And that leverage and margins that we talk about has been so extreme. And we’re beginning to see risk signs of that reversing. So, there is a real risk that if you chase earnings today, there is real downside risk to those numbers and those share prices. 

So, in terms of the red flags, ultimately, long term what’ll drive the margins of those companies will be the barriers to entry. Supply normalisation always takes place. It’ll be: how’s that industry structure? What does that industry look like? Is the product differentiated enough? 

And again, it comes back to why we have that preference of the NVIDIA Corp (NASDAQ:NVDA)s, ASML Holding NV (EURONEXT:ASML)s and Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM)s. Those are monopoly businesses within the categories they do because their products are unique versus many of those bottlenecks where they are commoditized products. They’re earning great results right now, but there is a real risk in the short term, near-term future that those fall away. 

Dave Baxter: I found it striking that the trust describes that period, that return, as being disappointing and challenging, given 15% is normally very strong. How do you avoid getting caught up with FOMO [fear of missing out] and trying to keep pace with a potentially exuberant market? 

James Cook: Yeah, I think particularly in these markets, you need to be momentum aware. One of the biggest flaws of fundamental investing is you find a stock that’s attractively valued on a long-term basis, but you miss the opportunity cost of holding something else. 

But I want to be clear, that doesn’t mean that you suddenly go and chase these overvalued low-quality businesses that are doing incredibly well right now, but you don’t like them on a long-term basis. We’re not trying to do that. 

But what we are trying to do is being more momentum-disciplined within our existing stocks that we do like. So, the names that we think are delivering right now, we talked about Microsoft Corp (NASDAQ:MSFT), because those short-term earnings are coming through and the long-term opportunity looks really attractive. 

So, we build a larger position in those names. And for the names we fundamentally like on a long-term basis, but it’s not operationally delivering right now, we’re much more disciplined about limiting the active size of that position, or even potentially exiting and finding something else somewhere else. 

The fact that we look at 2,500 companies gives us that flexibility that if a stock in the portfolio isn’t working, and we can’t see when that unlock of the valuation will take place, we can find other stocks out there to replace it with. 

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Dave Baxter: Is it fair to say you’ve been paying a bit more attention to the market’s winners? Because I think the reports before the last one spoke about the idea of momentum and maybe not missing out so much by not having enough in some of those leaders. 

James Cook: It’s a great question. It’s really difficult to see exactly how long the AI trade will last. You know, whether that’s two, three, five years, I’m not sure anyone out there knows the answer to that question. So, you need to be cognizant of that. And for us, we don’t want to miss out on that long-term opportunity. 

We see huge opportunities within AI, but we also know there’s the risk of a reset that could happen. So, we don’t want to make that an active position within the portfolio. Instead, we want to make sure we get the stocks right within those cohorts. So, within those AI enablers, the Microsofts, the Amazon.com Inc (NASDAQ:AMZN)s, within the AI semiconductors, it’s the long duration, higher-quality businesses that we think can grow through that cycle. 

Dave Baxter: If we talk about investment styles, momentum has really shot the lights out in the last year, but the trust does try and be flexible. What kind of mix are you striking at the minute? 

James Cook: In terms of the portfolio, we’ve always tried to be balanced between growth, value, low growth, defensives, and cyclicals.

At points we’ve lent into certain directions, but it’s never been an overly meaningful part of the active risk we take, and 70% of the active risk we take within the portfolio is stock selection. That’s our bread and butter, that’s what we’re really good at.

We take a little bit more risk from industry selection as well. We think at the edges we’re pretty good at that. So, in aggregate, that gets you to about 80% of the active risk that we take. 

The momentum factor itself, as we’ve discussed, is less about chasing those extreme parts of momentum where we don’t fundamentally like the stocks on a long-term basis, but instead just being disciplined within the existing holdings. 

Dave Baxter: If our fears come true and markets do turn, what kind of defensive exposure does the fund have? 

James Cook: We’ve got your typical bond proxies, so NextEra Energy Inc (NYSE:NEE) in the US, where we still see plenty of growth in the renewable energy theme. We think the valuations are now super-attractive. That’s right towards the top of our valuation screen, so we like that one. 

Then outside those sort of typical bond proxies, we’ve also got really good-quality companies. So, the exchanges, for example, so Chicago Mercantile Exchange (CME Group Inc Class A (NASDAQ:CME)), trading on around 4.5% free cash flow yield, Hong Kong Exchanges trading on around 5.5% free cash flow yield. 

And when the market tends to go risk-off, you tend to find volatility picks up as well. That volatility, all else being equal, tends to come with higher transaction volumes. So, these companies are actually beneficiaries of risk-off. 

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Dave Baxter: What are the more contrarian stock picks in the fund right now? 

James Cook: I want to be clear, I don’t think we’re a particularly contrarian fund at all. That tends to be much more the deep value investors. 

But within the quality arena, I’d say there’s two areas of controversy right now. First is quality. Quality is the most attractive it’s looked in the past five years. There’s big question marks around the AI losers, [are] these higher-quality asset-like businesses going to be AI losers in the future? So, we do an awful lot of work around trying to ensure that the stocks we like on a fundamental basis are AI risk-proof. 

The second area is, I’m coming back to the hyperscalers again, and they may not sound like typical controversial names, but actually the valuations you’re getting at right now look really attractive. 

Dave Baxter: So, has that led you, I guess on the first point, into the software space? 

James Cook: That’s a great question. Within software, we still think there’s plenty of risks out there for many of those names. The recent news with Salesforce Inc (NYSE:CRM) and Claude, I think the market got quite excited that large language models (LLMs) weren’t going to necessarily disintermediate software, but instead partner with them. That’s not actually that clear yet. So, the revaluation in those names I’d be quite cognizant of whether that really is upside opportunity from here. 

Instead, we’re looking at that much broader suite of AI losers, the asset-like business models out there. Instead, we find Mastercard Inc Class A (NYSE:MA) really attractive. We think you’re always going to need those payment rails and Aon  Class A (NYSE:AON), which is the largest US broker insurance company. 

Dave Baxter: And, finally, our usual question, do you have skin in the game? 

James Cook: Yeah, absolutely. So, the way it works at JPMorgan is we get a long-term incentive, a plan which is dependent on the performance that you’ve delivered. Within that plan, 50% of it will be mandatory. My CIO will put that into JGGI, that 50%. And the other 50% is my allocation. That can go anywhere across the JPMorgan range of products. 

Since being named on JGGI, every single year, I put that 50% also into JGGI. So, I’m 100% incentivised to make sure the portfolio and the stocks work. 

Dave Baxter: James, thanks for joining today.

James Cook: Thank you very much.

Dave Baxter: And thank you for watching as always. I hope you found it useful and enjoyable. As always, do let us know what you think in the comments and if you’re enjoying the series, hit the like button and please hit the subscribe button. Thanks and take care.