How Fund Managers Should Think About Market Concentration

On this episode of The Long View, T. Rowe Price Investment Management’s head of investment strategy and chief investment officer David Giroux talks about stock-picking, T. Rowe Price’s new exchange-traded fund, fund management, and more.

Here are a few excerpts from Giroux’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Valuation and Position Management

Christine Benz: We wanted to ask you about valuation and position management through the lens of two holdings that might look pricey by traditional valuation measures: Amazon.com AMZN being one and automotive technology maker Mobileye MBLY the other. Let’s start with valuation. What do the traditional valuation measures not convey about the potential reward for the risk you court with those investments?

David Giroux: It’s a great question. What I would say is, I spend probably 99% of my time trying to identify stocks with excellent risk-adjusted return potential over the next four to five years. So, really what I’m focused on is trying to think about what is the earnings power, what is the price/book value, what is the free cash flow power in 2028, five years down the road, and what is a very reasonable multiple the stock would trade for at the end of 2027? And that leads to an expected return that we’re going to generate from that stock over that period of time. Again, that internal rate of return drives a lot of our decision-making, not how the stock is going to outperform tomorrow, next week, next month, but that five-year IRR that really drives a lot of our decision-making. As you think about TCAF [T. Rowe Price Capital Appreciation Equity ETF TCAF] and CAF [T. Rowe Price Capital Appreciation PRWCX], we tend to have a large—a very, very large—overweight in companies that have more predictable numbers, GARP utilities where earnings growth is more predictable. The multiple assumption even four to five years out has a more narrow range of outcomes. And again, as we talked about before, 40% to 50% of the portfolio today is in GARP utilities, which, again, is more than 2 times the weight of the market.

The two names you’ve identified, don’t look as attractive on what we would call a near-term, next-couple-of-months P/E, or even a price/book measure. I think it’s quite clear that Amazon is massively underearning from a margin perspective, especially in its core retail business both in North America and outside the United States, and outside the U.S., they’re still losing money. They added a lot of capacity during COVID-19; their distribution infrastructure was not optimized. And with demand slow post-COVID, they were also losing a ton of money on noncore projects.

If we look out five years, we think Amazon can get to high-single-digit operating margins in North American retail, as they have this high-margin advertising business that we think generates 50% to 60% operating margins, that continues to grow faster than the core retail business. So, that high-single-digit margin actually implies a very low-single-digit margin in their core retail business, which again, probably is a little bit conservative on our behalf. We also think the core retail business can grow in the high single digits. The cloud-computing business can grow in the low teens over that period of time. And so, what happens is, when you go out to 2027, and their margins are more normalized and maybe their growth rate is slowing a little bit, we’re targeting a very reasonable valuation of a low-20s multiple for retail, actually close to where a Walmart WMT might trade, and a mid-20s multiple for the cloud business. And when you do all that math, it leads you to a low- to midteens IRR from here, which is pretty compelling relative to what we think the market will do.

Mobileye is a little bit different. Mobileye is just very, very early in their adoption of the core technology. As you highlight, they’re a leading manufacturer basically of semiconductors and systems that enable what we call L2+ all the way to L4 autonomous driving. They’ve already signed five large original equipment manufacturers. They clearly have the leading share here, and they’re in active discussion with another nine OEMs. So, when we look out to 2028, the stock is trading today in the low-teens multiple on earnings, so again, a very reasonable multiple. Even if you go out to 2028, the penetration of things like their L4 Chauffeur solution, which is hands-off driving, will still be in the very low single digits in developed markets. And L2, which is their supervision product, which is you can take your hands off the wheel, but you still have to be aware, even in our model, we only assume a 5% or 6% penetration in 2028. So, we think even five years in the future, they’re going to still be very early in their adoption curve. We think the company can actually maintain a 25 and 30 multiple. If it does that, the stock is going to more than double over the next five years from here. So, again, trying to think five years out is really how we’re approaching with Amazon and Mobileye.

Tech Stocks and Mobileye

Jeff Ptak: I wanted to stick with Mobileye. It looks like various T. Rowe funds owned it for a little while between 2015 and 2017. But then I think it was acquired by Intel INTC. Intel spun it off last year. Can you talk about the arc that your research process followed and how you and your team came to the conclusion that it merited investment in the fund?

Giroux: We were involved in Mobileye in 2015 and 2017. The stock was a little more expensive at the time. If you remember, higher multiples. It was early in the adoption. It was less clear how successful they were going to be. So, Intel took it out at a very, very elevated price, and it brought it back to the market. I think we were a little bit surprised, pleasantly surprised, at the valuation. I think Mobileye ended up coming out in the low 20s. So, we were aggressive, bought a lot of the stock, as much as we could. There’s not a great float with Mobileye. But again, we were doing the same analysis looking at, OK, what kind of penetration rate do we need to generate a really attractive return from here till 2028? And at 22, the assumptions were, “Boy, we think they can get to 5% market share or 5% penetration. Boy, we think we’re going to make 4 times our money.” Now, the stock has doubled since then. Now, we’re only going to make twice our money, probably in the next four or five years.

I think if you have a 10-year view, there’s no reason why L2 penetration on most of the vehicles that are sold in most developed markets out there between China, the U.S., Europe, Japan, and Australia should all have Level 2 technology. And I would argue probably a good portion of those, especially at the high end, will have L4 technology that really allows the driver to do other things in the car, especially on the highway. And that L4 solution is a $3,000-$4,000 solution that provides a lot of value for both the driver and the OEM. And I think penetration is going to be a lot higher than people think on a long-term basis.

How to Approach Market Concentration

Benz: The S&P is very bunched in its top names and the tech sector was recently consuming almost 30% of the benchmark. This can present a challenge, or maybe an opportunity, as managers might be reluctant to concentrate to that degree. How have you approached this?

Giroux: Well, what I would say is, again, our goal, especially in TCAF, and obviously in CAF as well, our aim is to outperform the market. So, we look at all these through the lens of bets. You might have a small position, you might have a small name like Mobileye, which is not in the S&P 500, and you’re owning 30 or 40 basis points of it, given maybe the risk profile and also maybe liquidity in that kind of name. And then, you have some of these companies—Apple AAPL 7% or 8% of the market, Amazon 3% of the market—and what you’re really trying to do is you’re still making bets. So, I would say, I’m not worried about the concentration. We’re going to make bets relative to that. And if those stocks do well regardless of whether they’re 10% of the market or 30% of the market or 40% of the market, we just got to make sure we’re owning the right ones and making the right bets relative to the market so we can have a pretty good odds of outperforming the market. And if you look at some of those big names, we don’t own any Tesla TSLA. We think Tesla is extremely overvalued today, whereas we think Amazon and Microsoft MSFT, where we are roughly about 100 basis points overweight, both in CAF and TCAF combined, are quite compelling. We have a modest overweight in Google GOOGL and a modest underweight in Apple in TCAF. So, I don’t worry about the concentration. We just have to make sure we’re making bets where we see the best relative value and make sure that we’re aware of the risks involved in all those names.