Terry Smith: two reasons why I haven’t bought Nvidia

Global and US fund managers who haven’t owned Nvidia (NASDAQ:NVDA), the hottest stock since the start of last year, have been dealing with a big performance headwind.

The California-based company sells graphics processing units (GPUs), the computer chips that process data in artificial intelligence (AI) software. The rise of AI is fuelling record demand for Nvidia’s processors, which are the most advanced on the market.

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Since the start of last year, Nvidia’s share price has soared by 680%, with its individual stock weighting increasing markedly in US and global indices, and now comprising around 6% of the S&P 500 index.

Overall, the so-called Magnificent Seven, which alongside Nvidia includes Microsoft (NASDAQ:MSFT), Amazon.com Inc (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL)Apple (NASDAQ:AAPL), Meta Platforms  (NASDAQ:META) and Tesla (NASDAQ:TSLA), account for more than 30% of the S&P 500, and over 20% of the MSCI World Index.

Fund managers holding less than the index in the Magnificent Seven – known as running an “underweight” position – will have struggled to outperform since the start of last year. During the period, those share prices soared as the market moved to price in the potential of advancements in AI disrupting various industries. 

In an interview with interactive investor, in one of our On The Money podcast episodes, widely followed stock picker Terry Smith, manager of Fundsmith Equity, explained the impossibly high hurdle facing active fund managers seeking to gain an edge over index funds and exchange-traded funds (ETFs) that simply track the market.

Smith said the fund returned 9.3% in the first six months of 2024, but failed to keep pace with the global stock market, with the MSCI World index up 12.7%. 

He said: “We had decent performance, I think, 9%, but we didn’t perform in line with the index. You had to be in the 92nd percentile to outperform the index. Or, to put that in plain English, you had to be in the top 8% of funds.

“I get that the average active manager is going to underperform the index. They must do because they’ve got costs. So, we’re going to expect less than 50% of active managers to outperform over time. But 8%? It does suggest that there’s something a bit extreme going on when the guy who’s in the ninth percentile – so the top 10% of funds – underperforms the index.”

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Fundsmith Equity has some exposure to the biggest seven US tech stocks – with Microsoft and Meta Platforms in its top 10 holdings. Smith has owned Amazon in the past, but no longer does, and said he will never own Tesla, as it doesn’t fit his investment criteria for high-quality growth companies.

Smith said: “We had the rise of the Magnificent Seven, which was really the story of 2023. Then, just as you were about to breathe a sigh of relief, we have the AI boom, hype – whatever you want to call it – excitement anyway. Which obviously partly affects the Magnificent Seven, but also dragged in a number of other companies and gave it all another leg.

“The statistics on this are pretty stark in terms of what percentage of the index returns came from these companies during this period. A third of the return in the S&P 500 came from one stock – Nvidia. Didn’t own it. Pretty difficult to outperform, isn’t it?

“And there’s a group, they were half the performance of the index. So, this group of half a dozen companies were half the performance of the index. That was pretty much an insuperable obstacle, unless you were going to own those – and we don’t own all of them, rightly or wrongly. We just simply don’t. [So], it’s a bit of a handicap, really.”

Responding to whether he had considered owning shares in Nvidia, Smith said: “Yeah, we’ve had a look at it. We could own it, it certainly fits our parameters around the investable universe. So, why don’t we own it? Well, probably just because we were wrong. Let’s start with the simplest answer. Because we’ve got to accept that that’s just one possibility. We’ve certainly been wrong so far, haven’t we? We were just wrong.”

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However, Smith says there are two main reasons why he hasn’t owned Nvidia as “it is a stock which has got a couple of characteristics that worry us.

“One is, it’s a company which has made – what people are calling in modern parts – a pivot twice in its business model, very successfully. You might say, what’s the problem? Well, because people who have to pivot in their business model sometimes get the pivot wrong.

“So, it moved from gaming chips to basically chips for digital currencies, very successfully. And then it moved from chips for digital currencies to GPUs for large language models and AI - very successfully.

“Jensen Huang – the founder, and the man who runs it – is clearly very clever – and they’ve done that very successfully, and all credit to them for doing that.

“However, bear in mind the following. On those two changes in the direction of what they were doing in the past, the stock went down 80% on both occasions. You’ve got to have a pretty strong stomach for that kind of stuff. And it does worry us that it’s not got the predictability that we seek in companies. One of the most important things we’re looking for is something that’s relatively predictable, and that doesn’t sound like it’s particularly predictable. Presumably at one time they may do that and it may go down 80% and it might not succeed. So that’s one thing.”

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The second reason why Smith doesn’t own the stock is due to concerns over how well it will perform in an economic downturn.

He said: “There’s only one thing more dangerous than being close to the consumer in a downturn and that’s not being close to the consumer.

“Because if you think it’s bad running a consumer products company in a downturn, when you might see a 5% to 10% downturn in demand, you can only begin to imagine what happens to people who are supplying to those consumer companies, particularly if they’re supplying capital equipment, which just goes on hold.

“They don’t have 5% to 10% downturns. They get properly strapped into the roller coaster at that point. That tends to be what happens to them. And there’s no doubt whatsoever that what Nvidia is doing is selling into a massive capital cycle. They’re building things which are going into people to put into data centres, to build models. They’re not selling direct to consumer. They’re two or three stages back from the consumer basically here.

“So, at some point, if the end demand for this falls, or even just doesn’t go up as fast as it has been going up, there’s going to be an interesting outcome.”