Portfolio manager explains drivers, areas of risk for growth leading sector
Like it or not, tech tends to set the tone for equities. Volatility in tech means volatility on US and global markets. Outperformance in tech has resulted in strong performance by US equity markets. Underperformance in tech has been matched by similar fraught reactions. Tech, too, has almost become a shorthand for the mega-cap technology names that have become so influential. Later today Nvidia — perhaps the poster child of mega-cap tech stocks — reports its earnings. Wall street analysts are buying out sports bars for watch parties. Ahead of that call, Nicholas Mersch broke down the drivers he now sees in the tech space.
Mersch is a portfolio manager with Purpose Investments specializing in technology. He explained how tech investors have digested recent volatility in the space. He outlined how cloud computing and AI have driven growth so far, and what they will need to provide in future to drive further growth. He outlined why the more maligned software segment may be set for a recovery and highlighted areas of potential risk for investors going forward. His view, fundamentally, is that while there are uncertainties on the horizon, there is an underlying scale to mega-cap US tech stocks that should continue to drive their performance.
“Over the tech mega-cap earnings we saw that cloud growth is really strong, the capex super cycle is still underway, AI revenue is still pending and software might be trying to stage a comeback after being really beaten down on a year to date basis,” Mersch says. “There’s been a lot of volatility on the market lately and over these times it’s really important to check your notes and go back to first principle thinking. That doesn’t mean you should ignore volatility, rather I think you should use volatility to verify your long-term thesis.”
Hyperscalers in forcus
Cloud growth is one key area Mersch sees continuing to drive returns. The so-called ‘hyperscalers’ like Google’s GCP, Amazon’s AWS, and Microsoft’s Azure, have all shown remarkable revenue growth. Where initial growth in these services was driven by organizations undergoing a digital transformation, the recent acceleration of AI workloads has appeared as a new growth area. Microsoft Azure, for example, saw a 30 per cent growth rate last quarter, and around eight per cent of that growth could be directly attributed to AI.
While cloud divisions are “rock solid” in terms of revenue, Mersch notes that they’re also ploughing billions into their capex to improve AI rollouts. Demand for semiconductors, and specifically Nvidia GPUs, is far outstripping supply. CEOs of these mega-caps are speaking more about the risk of underinvestment than the risk of overspending on AI. As these hyperscalers grow to the point where another acquisition will result in anti-trust action, their billions of dollars in free cash flow can go one of three places according to Mersch: share buybacks, dividends, or Nvidia GPUs.
“That does bring us to the next point of contention, which is that we need to see some ‘R’ from the ROI,” Mersch says. “We’re heavy on the ‘I’ with all the capex, but we’re not to heavy on the revenue return aspect.”
Can AI actually generate revenue?
Mersch says that the next fiscal year will be key to determining the amount of revenue tech companies are actually going to generate from their AI investments. He cites a recent Morgan Stanley chart that predicted outcomes for Microsoft’s AI-specific revenue. The base case was $40 billion, the bear case was $10 billion, and the bull case was $90 billion. With such a wide range, it’s difficult to know how the revenue side will play out.
Mersch notes that past tech innovations have been able to justify investor patience, but he says that patience may be required again. In looking for signs of AI revenue, Mersch notes that some companies are changing reporting around their specific business areas. He expects the cloud providers will continue to strip out their AI revenue because investors want to see that data.
Software and Hardware (Nvidia)
While cloud providers and mega caps have flourished, many software companies have struggled under the expectation that AI may actually kill off their businesses. In response, Mersch notes, these companies have gone back to basics, strengthened their balance sheets, and positioned themselves as a key distribution layer in the future of AI. Given the multiple compression we’ve seen in some of these names, Mersch thinks there could be some room for recovery.
Nvidia has been the standout technology story of recent years, and Mersch believes that today’s earnings as well as future earnings will continue to validate the company. On today’s call he will be watching for revenue guidance and margins. Revenue guidance will inform on the cadence of new chips and margins will show us how much pricing power Nvidia still has. Nvidia is set to launch a new series of chips called Blackwell, however there are rumours of a delay. Mersch only sees a potential delay as a small hurdle, however. While he has some concern about the diversification of Nvidia’s revenue base, he sees any short-term bad news like a rollout delay as a buying opportunity.
Where risks arise
As mega-cap tech has accelerated its growth, much has been made about growing concentration risk and whether these companies can beat their tougher comps. Mersch, however, argues that mega-cap tech tends to have better profitability than the broader market. He thinks that company fundamentals justify the current levels of concentration. He also believes that the scale and computing power required by AI advantages the largest players in this space.
The other key area of risk that Mersch highlights is the end of this capex cycle. If revenue doesn’t begin to materialize from AI and mega-caps pull back on their capex, we could see Nvidia harmed significantly. He says that this capex cycle may be around the “6th or 7th inning” but that there is a bit more room to run.
