Midcaps, AI, and Apple's New Headset

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So when you start to look at mid-cap stocks and ones that are profitable and ones that are able to withstand some of the pressures of a higher interest rate environment, from a valuation perspective, they're trading at, you know, close to a 26 to 28% discount.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Kristin Bitterly. She's the head of North America Investments at Citi Global Wealth, and she's cautious about the stock market in general, but she likes mid-caps and some other things. We'll hear about it. We'll also say a few words about how much artificial intelligence is worth to the stock market and the earnings potential of Apple's fancy new headset. Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jack.

Did you see the big Apple show that started off this past week? The Vision Pro headset. It's already been a big day, but we do have one more thing.

I did. Yeah. I skipped to the good part. I didn't watch the whole thing.

You didn't watch all 2 and a half, 7 hours of— yeah. Okay. What did you think? Do you want the new headset?

I think they're beautiful. I don't think I want it. I think it's a little scary, I guess, a little bit. Like, am I going to spend more time of my life wearing those instead of being other places?

Yeah. I mean, I kind of mentioned something like that in the column. Like, I already wake up, I've got my phone next to me, I've got my earbuds next to me, I've got my watch next to me. I'm already spending the first, you know, 30 seconds of my day strapping into my technology. Now, if there's a headset sitting next to me, that's basically full RoboCop. I might never come back. I mean, but what about the part where the dinosaurs jumped into the living room? You don't want dinosaurs jumping into your living room.

I like want that once. I don't know if I want that again and again.

Yeah. I feel like I haven't picked the most compelling use case right off the top. But I think that that's part of the deal with these, right? I mean, that's what I keep hearing is that people say, why would I need these? Well, we don't know yet because we don't have the apps. Cause that's the whole thing that has happened with the iPhone is when it came out, it did a bunch of stuff that we were already doing with other devices. I mean, it was pretty sleek, but it wasn't until years later when that App Store opened up and everybody started making new programs for it that we really figured out, oh, this does a lot more than the stuff I was doing before. And with this headset, we might not know for, I don't know, 5 years why we need them or want them. I did think, by the way, that the headset looked impressive. It looks a lot better than anything else on the market. I described some of the other big-name ones looking like a toddler's toilet seat mounted to the forehead, and this, this is more of an elegant solution than that. But I don't think it'll sell particularly well in the first year. Wall Street certainly is not expecting that. The consensus seems to be that, okay, they come out with this one for $3,500. It's going to sell a little bit in year one, but then the price is going to come down quickly and you're going to have broader adoption after 2 or 3 years. If you're wondering what kind of an earner this could be for Apple, there are a couple of firms that have already taken a crack at guessing that. And these are just guesses, of course, but Goldman Sachs says that it could see this device adding to earnings by a low single-digit percentage starting in 2025. And B of A Securities said something more precise but similar. They said that by 2026, they think that it could contribute $0.36 per share in earnings, not $0.35, Meta, $0.36 per share in earnings. And that's about 5% of that year's consensus, but they do say it could be a much bigger earner with, as they put it, meaningful adoption. One other thing that they point out is that if this thing is similar to other Apple devices, they think that the revenue from software could exceed that from hardware by a ratio of 2 to 1. And also the profit margins, of course, on software are much, much higher than they are for hardware. So anyone looking at this saying, how's Apple going to make a lot of profit out of this thing? The answer is it's going to have another place to sell you endless amounts of apps and services and software. On the subject of the stock price, two things to keep in mind are it's pretty darn high, and also it really hinges on the performance of iPhone and the services and the software ecosystem. And right now there are— there's a huge universe of older iPhones that need upgrading, so I have no idea what the next iPhone is going to look like when it launches, presumably in the fall, but I know there's a lot of people out there waiting to upgrade, and that's going to be the main driver of profits going forward. Apple's earnings growth has slowed over the year. This fiscal year, which runs through September, it's expected to produce a 2% decline actually in earnings per share, and then the following year, a 10% increase. If it wanted to shift growth meaningfully higher. It just needs a new product category. And for a company of Apple's size, that product category has to be big. That's why people were talking about cars, or they're really just looking around for anything that could have a sufficient market value attached to it where Apple could move the needle. Headsets, you know, there's a lot of free real estate right now on people's faces. If you can find something that everyone wants to put on their face, you could have a pretty big market. Hey, Matta, while we are putting entirely hypothetical earnings figures on things that are impossible to forecast to begin with, maybe we should say a couple of words about artificial intelligence. Do you wanna mention the challenge that we issued to each other just before we started recording?

Can you find a company for which AI hasn't come up?

Right, because stocks are running higher on AI and just AI mentioned. This, by the way, this reminds me of, Before the dot-com stock bubble, so back in the, I'm going to say mid-1990s, I don't know exactly the year, I was a stockbroker back then and everybody would just sit there and look for, look at scrolling news headlines about the internet because nobody really had figured out what the internet would be or become or what it meant. Everybody just knew that if there was a stock out there and they had an announcement about anything dot-com, then the price would start to run higher. And to me, You know, everybody talks about Pets.com or these different bubbly stocks as being emblematic of that era. But for me, it was this company, Mako. Have you heard of Mako? That it's an auto body company. They pound dents out of cars. And there was a headline that popped up one day and it said, Mako to launch Mako.com. And I don't know if it was peak idiocy, but it was close to it because I just saw everyone in the room, this big bullpen, everyone saw that at the same time. Everyone hunched over their computers ready to buy some shares. And I don't think anyone thought that an auto body company launching a website would really change the economics, but it wasn't about that. It was about whether other people were dumb enough to think that. And so there was a moment where everyone was trying to figure out, are these other idiots going to buy this stock? And should I buy it before them? And it didn't quite Pop. I guess ultimately people decided that that would not join the idiot parade for that day, but that was the way it was at that time. Anything dot com. So companies would put dot com on their name to be associated with the internet. And I feel like today you're hearing similar things about AI. Everyone wants to mention it. So our AI challenge, can you off the top of your head think of a company that has not been associated with AI? I picked Lam. Weston. And if you're not familiar, they're pretty much in the potato business. They, they take potatoes and they turn them into French fries. They're a big French fry seller. And I thought, French fries, are they in the AI game? I thought not yet, but then I saw, I'm way late because here's a 2020 report from Lamb Weston that it talks about data from their farm and from other farms. And it says, in the near future, we expect to use artificial intelligence and machine learning to generate applicable insights even more rapidly. And then Meta, you had a guess and yours was Campbell's Soup. Hang on, hang on. Let me check it out. Uh-uh. Campbell's Soup embracing AI to innovate. This is from Food Business News. Doing this by tracking and curating billions of data points to find inspiration and leverage agile design methodology to accelerate the development of new products that resonate with consumers. I'm just looking further down. It says one of the products that come out of this effort is a soup called Chunky Ghost Pepper Chicken Noodle Soup. And there's a quote. It says the Insights Engine provided insights on how consumers want to be brought into spicy. So, There you have it. I mean, I don't want to be brought into spicy. Not, not yet. I mentioned all this because the stock market has run up nicely this year. And of course the, the gains have been dominated by the big tech companies, the ones that are right next to AI and talking about it all the time, the Nvidias, the Microsofts. And so that has people wondering, is this a bubble? Is this like the dot-com bubble where Yes, the internet was real and big and promising, but the stocks got ahead of themselves briefly and then had to pull back. And Goldman Sachs has a note on that, and they point out that if you look at a stock like NVIDIA, somewhere around 50 times earnings, huge runway of growth ahead from other companies needing to upgrade their data systems with AI-friendly chips like the ones that NVIDIA sells. But they said that that's kind of like the valuation that we saw on Microsoft and Intel. During the dot-com bubble, 40 times earnings for Intel, 60 times earnings for Microsoft. But it's not equal to the most extreme example that they named, which was Cisco at 125 times earnings. So I don't know, should that make us feel better? Meh. But they also point out that if you add up what AI might contribute to S&P 500 earnings in the years to come, I don't know how you would begin to do that, but they have estimates on how much companies can earn from selling things into AI demand and also how much companies can save on rolling out AI applications across their business. They think that in their base case, that it, that AI adoption makes the stock market 9% more valuable than it is today. And in the event that AI takes off bigger than they expect, it's a 14% boost. And if it's a smaller than expected effect, it's a 5% boost. I think the big takeaway is that Goldman, for one, does not think that we're in an AI bubble. Just that some stocks look a little bit pricey right now. That is one of the topics I spoke about with Kristin Bitterly this past week. She's the head of North America Investments at Citi Global Wealth. Meadow, how about we play that conversation?

Let's do it.

I saw some notes of yours about the stock market, the economy, and it sounded a little cautious.

It is.

I'm not going to say bearish. There are no bears left. There's no such thing as a bear anymore. But cautious.

We're not bearish. We're of the view that it's almost like a rolling recession type environment and that we're starting to see obviously some declines that have already happened and have happened in 2022. You're starting to see earnings be impacted in select sectors. And ultimately, like our base case is we would see some sort of recession and earnings contraction this year. But for clarity purposes, we're still invested. So we're overweight fixed income relative to equities. And we don't think that this is going to last significantly longer, but we're cautious, I would say.

The US stock market has run up nicely to start the year or halfway through the year, and it's led by a handful of big tech stocks. What do you make of that? Do you trust this rally? Should we trust this rally? Should we be doing something different to get more defensive?

So this is probably the number one question that we're getting from investors, and obviously it's dominating headlines as well. I think the exact stats right now is you have 7 companies within the US equity market that are responsible for over 100% of the gains, you have about 3 of those companies that are responsible for about 65%. And the interesting thing is it's not just a uniquely US story. When you look at the global equity market rally, you have about 10 companies that are responsible for 89% of those gains.

The phrase I keep hearing is bad breadth.

Bad breadth to the market.

With a D in there, which is a heinous phrase, but that's breadth with a D somewhere in the middle there. But anyhow, go ahead.

There's not a lot of breadth to this market. So, you know what's interesting about that though, is I think it's rational. Even look at Q4 of 2022, we had 7 of the 11 sectors in profits recessions. And so the idea that money would come into the market in the companies with really strong free cash flow generation, they have the ability to fund future growth, they have the ability to withstand a rising interest rate environment. And a lot of those companies revised guidance upwards in Q1 earnings. And So I don't quite buy the concept that this is a pure flight to quality, but it is following cash flow and it's following earnings growth.

So the right kinds of companies are running higher, but what about the overall? For somebody who's an index investor, an S&P 500 index, what should they make of where they stand now? Has it just been too easy? Should they expect lower returns going forward? Should they expect a big sell-off? What do they do here?

I don't think you expect a big sell-off from here. So even though we're cautious, I don't think it's a question of expecting some type of capitulation event because you have to look at how the broader market is actually positioned. And so yes, we've seen a lot of flows come into these largest companies, but at the same time, what are we seeing? We're seeing a lot of cash on the sidelines. So if you look at the flows that have come into money market funds, they've eclipsed about $5.4 trillion. When you look at the money that's come into T-bills, now that the debt ceiling is resolved. When you look at those flows, that's taken about $1 trillion out of bank deposits and into T-bills. So there's a lot of cash on the sidelines. And so while you could see some volatility, especially with the T-bill issuance that we're going to see over the summer months, which is another form of credit tightening, it's not something that we anticipate that we're going to see a really, really extreme drawdown.

Meta, how about we take a quick break and we'll come back to the conversation with Kristen. We'll hear some about midcaps.

Sounds good.

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Welcome back, and let's pick up on our conversation with Kristen Bitterly at Citi Global Wealth. Let's say I'm a 60/40 investor and the 60%, let's say I've gotten that S&P 500 fund. And because I'm an American investor, I may be atrociously underweight overseas stocks. But, you know, so what should I be doing differently? Should I prefer some of those overseas stock markets? Should I prefer bonds to stocks? Any shifts I should be making right now?

I think there's a couple of important shifts. So the first thing in looking at your fixed income portfolio, there is a desire to really kind of sustain income as rates peak. And so what do we see? Like I just mentioned, there's a lot of concentration in short duration, very, very short-dated T-bills. And so the question there is, why are you holding those T-bills? Is it part of a cash allocation? Is it operating cash versus investments cash? Is it part of your fixed income allocation, or is it a placeholder for risk assets because you feel that you can time the market? So in looking at that T-bill kind of short cash exposure that you have, what we want to make sure is that you're really diversified in your fixed income exposure if indeed you're holding those T-bills for income. And we are of the belief that we are seeing peak rates. And so with that, you want to extend duration a little bit just— and it doesn't have to be super long-dated. It can be extending duration out 2 to 5 years to benefit from some of those elevated rates. And really not have that reinvestment risk 3 months, 6 months down the line.

So the weird condition now is that you can get more for your money if you stay short. You'll get more in those 6-month Treasuries than you will on those 10-year Treasuries. But what you're saying, if I understand, is that these high rates overall aren't going to stay here much longer. You better lock in that, that 10-year-ish Treasury position while you can. Because, uh, that might be as good as it gets for a while.

That is right. And so if you are of the belief that the Fed is going to either skip, pause, continue on this trajectory until something breaks, and then they'll be in a position where they start cutting rates because they're worried about the employment backdrop, they're worried about the contraction that we're seeing in the economy, then what would happen inevitably, rates are gonna be lower. And so you want to have some balance across that fixed income portfolio. We don't see a lot of benefit in really stretching on the credit side. So this isn't about going down inequality. It's just managing out over time and taking advantage of these yields that could be the highest yields that we're gonna see for quite some time going forward.

What other trends, um, or, or, or factors should investors, uh, be watching right now? Are you seeing things out there where you think that investors are making mistakes, um, that you'd like them to change? Or, or, or are there pockets of the market that, that you view as attractive and you don't think they're paying enough attention to?

Yeah, I think there's a couple of things. So going back to the equity portion of the portfolio within US markets, we, we tend to be very US-centric, very home-biased. And so when we look at the opportunities outside of the US, we actually believe that there's value in adding international equity exposure for a couple of reasons. One, when we think of this US dollar dominance, that's really been the story for almost the past decade and it reached the second highest level in history in 2022. This creates opportunities just to diversify abroad from a currency standpoint, which can bring appreciation to your portfolio. The other thing is when we look at this balance of US equities really rose to be as high as 63% of global market capitalization last year and only 50% of profits. So said another way, international equities are effectively trading at a 40% discount. So you have a currency story, you have a valuation story. But I think one of the most interesting things, because is you have to balance out some of these short-term dislocations in market with what we see as longer-term opportunities. We have something that we refer to as our long-term unstoppable trends, and that's everything from investing in longevity, investing in digitization, robotics, artificial intelligence, as well as the energy transition. And when we think of those trends, what is going to dominate the next 10 years is very different than what dominated the past 10, which you could say are, you know, social media, smartphones, which was largely a US story. We see much more of a global story when it comes to capitalizing on those trends. So it's not just about these short-term dislocations that we see from a valuation and currency standpoint, but some of those opportunities to really get involved in those long-term trends internationally as well.

They should just say artificial intelligence a lot in those earnings calls in Europe because they know that makes your stocks go higher. We've proven that out here. For, for investors who are putting money to work now in the US and they're following your advice and they're moving some overseas, what should they expect in terms of their long-term returns? 10 years on average, is it going to be ordinary returns or do you think they might be subpar or very good returns?

No, I think they're, they're going to be strong returns. I think they're going to be in the ballpark of high single digits when we look at our strategic return estimates for, for global equities. I think there's going to be areas, especially when you look at some of the more innovative parts of the market, that you could see higher returns and you could also see some higher returns within subsectors. So I'll give a couple of examples of that. One area that we really like, especially with all of the buzz around AI, is cybersecurity. Cybersecurity is an area that's lagged when you look at it from a valuation perspective. It hasn't caught the bid just like those large 7 stocks have. But it's something that when you think of if AI is going to contribute, you know, close to $17 trillion to the global economy by 2030, And $7 trillion of that is going to be productivity gains. What is everyone talking about? They're talking about the safety of it. They're talking about the regulation of it. And that's going to come with continued investment in cybersecurity. So that's an area where you could see returns that are going to be much stronger. I think something else, longevity and healthcare, something that's actually been a defensive play is in pharmaceuticals and global pharmaceuticals. Healthcare is known as one of those sectors that's actually quite resilient being able to grow their earnings in recessionary environments. But part of it that's lagged, areas like life sciences and biotech, that can become quite interesting in terms of these long-term trends. So I think the overall story, strong and solid in terms of equity exposure, but you're going to have some of these opportunities within some of the subsectors where you could see really outsized returns over the next 5, 7, 10 years.

So you think it's a good time to put a a healthy weighting on pharmaceutical companies for the long term. You think we're going to go into an age of, you know, better drug discovery or new drugs, things like that? I was, you know, everybody's talking about these obesity medicines, and I read that not only do they take people who are overweight and they, they make them thin, but it's like it seems to wipe away their bad habits. Like people are saying, well, I was having a couple too many drinks, but I went on this drug and now I don't do that anymore. And I was eating this or that kind of food, I don't Seems to be a magical medicine. Are we going to see more magical medicines like this going forward?

Look, I cannot speak to personal experience with that. However, I do believe that in terms of the longer-term trend in investing in longevity and this idea that people are living longer, when you look at the population above 65, that's anticipated to double by 2030. Over 80 is expected to triple. And this isn't just a uniquely US story. This is something around the globe, right? You're seeing the same type of population dynamics dynamics in Asia as well. And so with that, it goes broader than just pharma and healthcare. You're really looking into some of the innovations when it comes to biotech, life sciences, as I, as I mentioned, and everything from immunotherapy. I mean, look at what happened during COVID in terms of the rapid development of the mRNA vaccine. Obviously, that's based on science that has existed for quite some time, but the ability to react quickly and bring that to market and bringing this full circle, as I have to, Artificial intelligence has a big part to do with that too, in terms of the ability to run trials, to actually kind of iterate on the results, to actually create new solutions. I think there's like really interesting things that are happening in that space where you— it's not replacing a human and obviously you need those in-person clinical trials. But the interesting part is this ability to kind of think of different solutions or different formulas that haven't been created by a human being prior and then have the human capital then be able to analyze that, that's going to create a much quicker cycle in terms of some of these solutions to problems that have existed for a really long time.

It makes sense to me. I think that people are going to say, wait a second, we just watched you guys make vaccines in like a year because it was an emergency. So just pretend that it's an emergency all the time and make everything fast. Why can't you just go 10 times as fast all the time? Well, we'll see. This has been most informative, and thank you for your time. Is there anything I neglected to ask you that you want to add?

The only thing that I'll mention too is some of this rotation within US equity market. I think with the rally that we've seen, it leaves a lot of people asking the question, you know, have I missed it? Is it too late? And this is where, you know, ultimately when the Fed does pause, when, when the Fed does get to a position where they do see a need to pivot, there's areas of the market that are undervalued. And so one of the areas that we've been looking at pretty closely is really within mid-cap and, and even not quite small-cap yet. But when you look at some some of the indices, they already screen for profitability. So when you start to look at mid-cap stocks and ones that are profitable and ones that are able to withstand some of the pressures of a higher interest rate environment, from a valuation perspective, they're trading at, you know, close to a 26 to 28% discount to the broader market. So there's some great companies in sectors that we mentioned that we like that you haven't really seen that run-up this year. So there are opportunities today and opportunities certainly to come. If and when the Fed changes trajectory.

Thank you, Kristin. I did just see a report from JPMorgan about mid-caps. They say they do look attractively priced. They say they tend to underperform over summer. Make of that what you will. But they also say that the time to back up the truck, in other words, the time to load up on mid-cap stocks, seems to be approaching. They have a screen for promising mid-caps, and the names that it turned up recently include Boot Barn. They sell boots, as you might imagine, really Western wear, which JPMorgan calls a fragmented market.

Hang on, what does that mean?

I think it means they sell a little bit of Western wear over here, a little bit of Western wear over there, but there's, there's, there's room for somebody to come in, come in and consolidate.

Validate.

Anyhow, they say there's low fixed costs and room for margin expansion. And another name, it's also a retailer, is Hibbett, which is a sporting goods retailer. They say it's down big. They say it's shielded from rising wages because their sales are high relative to the number of employees. And they say it's cheap based on earnings estimates and there's been decent growth since hiring a new CEO. It's also thinly covered. Hibbett Sports. I haven't looked at either of those companies. I have no idea, but those are JP Morgan's model mid-cap portfolio. Is that a good place to leave it, Matter?

Yeah, I think so.

Am I ending on strength? You know what? I'm going to win him back in the outro. I want to thank Kristen Bitterly and thank all of you for listening. If you have a question you'd like answered on the podcast, you can just tape it on your phone, use the voice memo app. You can send it to jack.hough. That's H-O-U-G-H. @barons.com. Meta Lutzoff is our producer. She says you can take your fancy new mixed reality headsets and stick it. She's stayed in the real world. Have I summed that up? Have I summed up your position?

I never said that.

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Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.