AI stock hype could create hidden risks in your portfolio. Here’s how a ‘quality’ strategy can help.

Matthew Benkendorf co-manages the Vontobel U.S. Equity Fund
VTUIX,
+0.07%,
which is rated four stars (the second-highest rating) within Morningstar’s “large growth” fund category. During an interview, he underlined the need for investors to have exposure to “high-quality businesses whose value is determined through consistent earnings compounding rather than external support drivers,” such as all the buzz over AI.

While AI promises to transform many aspects of business and life by improving efficiency and capability, you also need to consider how hype affects financial markets and investors’ habits. Remember how previous investing fads evolved, including the dot-com tech bubble that burst more than 20 years ago, and the decline in cryptocurrency values and associated demise of several industry players. You may also recall how it seemed at one point that every technology company was calling itself a “cloud company.” Now they will all be AI companies.

Here’s how investors’ enthusiasm can lead to a high concentration of risk. Following the 174% increase for its share price this year, with last week’s 25% surge driven by the company’s prediction of a 50% sequential increase in quarterly sales, Nvidia’s market capitalization is close to $1 trillion. The stock trades for 22.4 times its consensus revenue estimate for the next 12 months among analysts polled by FactSet. And its forward price-to-earnings ratio is 49.8.

In comparison, the S&P 500
SPX,
-0.20%
trades at a forward price-to-sales ratio of 2.3 and a forward P/E of 18.3.

Nvidia’s stock has gotten too expensive even for Cathie Wood, whose ARK Innovation ETF
ARKK,
+1.07%
sold its position in the stock last year. In a Twitter posting, on Monday, Wood said Nvidia was ” “priced ahead of the curve.”

To underline the concentration risk, take a look at the top five companies held in the $396 billion SPDR S&P 500 ETF Trust
SPY,
-0.19%,
which tracks the benchmark index:

A 24% allocation to five companies is a high level of concentration in a group of stocks that tends to move together. This isn’t to say that investors shouldn’t take advantage of low-cost index funds and ride along with the tech giants that have helped to propel the S&P 500 over the past decade. But adding exposure to high-quality, consistent performers away from the same handful of tech giants can lower risk and make for a smoother ride over the years.

Reflecting on decades of experience, Benkendorf said “the journey is as important as the returns.” Looking ahead, with “labor’s ongoing consistency of strength,” he sees no quick end to high inflation, which foretells a time of “more divergence” of corporate financial performance.

“The lower-volatility journey only comes with quality,” he said. This notion of a smoother ride might be very important to you as an investor. How difficult is it for you to ride out a tremendous decline in the broad stock market? Can you wait for it to recover? If you sell into a declining market you will lose money and after moving to the sidelines, investors tend to return to the market after a recovery has started. Attempts at market timing are likely to lower your long-term performance.

Diversification to high-quality companies can increase your comfort level enough to keep you from making harmful moves during inevitable periods of weak performance for stocks as a whole. “And if you get the businesses right, they will continue to grow even during a period of economic contraction,” Benkendorf said.

“You will see a big shakeout of corporate profits going down,” he said, underscoring his view that it is time for investors to focus on companies “starting to hit their stride.” He named three “core consumer staples people should own” with a five-year horizon: Coca-Cola Co.
KO,
-0.67%,
PepsiCo Inc.
PEP,
+0.07%
and Mondelez International Inc.
MDLZ,
+0.03%.

When asked if these companies might suffer as people react to stark price increases, Benkendorf said “some consumers will make a trade-down,” but he believes this is less likely in the beverage category. “It may not make sense to pay a premium but consumers still do it. For certain products that have branded themselves successfully, there is a consumer satisfaction gain.”

Benkendorf said that when selecting stocks for the Vontobel U.S. Equity Fund, he and colleagues begin with a “negative screening process to eliminate all but clean businesses with proven track records” for high profitability and returns on invested capital. That brings the list down to “a couple of hundred” U.S. stocks. The fund currently holds 38 of them.

There is also plenty of subjective analysis. For example, within healthcare, he prefers to steer clear of pharmaceutical companies, which always faces the problem of critical medications coming off patent. This means pharma (and biotech companies) “have consistent pipeline issues,” he said. “You need an incredible discovery — a blockbuster. It is possible, but harder.”

Healthcare companies held by the fund that Benkendorf named include Abbott Laboratories,
ABT,
-0.42%,
Boston Scientific Corp.
BSX,
-0.80%
and Beckton, Dickenson and Co.
BDX,
+0.88%.

Top holdings of the Vontobel U.S. Equity Fund

The Vontobel U.S. Equity Fund’s five-year performance has been neck-and-neck with that of the S&P 500, but we’re one year out of the environment during which super-low interest rates and an excess of available cash worldwide drove up asset prices. It is possible that a higher-quality approach will outperform the index during a long period of tighter economic policy. There are no guarantees, of course, but the quality approach can lower risk through diversification.

The fund was established in 2017, but Vontobel has been running the same strategy for private clients since 1990. For 15 years, the strategy’s average annual return, after expenses, was 10.8%, compared with 9.8% for the S&P 500, through April 30. Going back 30 years, the strategy’s average return net of expenses has been 10.4%, compared with 9.9% for the index, according to Vontobel.

Here are the fund’s top 10 holdings as of March 31:

Click on the tickers for more about each company, fund or index.

Click here for Tomi Kilgore’s detailed guide to the wealth of information for free on the MarketWatch quote page.

Microsoft is the largest holding of the Vontobel U.S. Equity Fund, although the fund’s concentration in this stock is less than the S&P 500’s concentration. When asked about this holding, Benkendorf said: “We believe it has one of the best and [most] resilient growth profiles of the big cap tech names, and it is firing on all cylinders right now. “

“While the markets are buzzing right now about everything AI, our view is that Microsoft is still probably the highest quality play in the space and it is significantly cheaper than other AI ‘winners’ like Nvidia,” he added. 

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