Conventional portfolio construction theory positions equities as the primary driver of returns, while fixed income typically takes a back seat as a low-return and low-risk asset class. However, this perspective often overlooks a crucial aspect of fixed income: its role in dampening portfolio volatility.

Protecting portfolios through the storm

Contrary to the notion that fixed income should exhibit a negative correlation to equities, suggesting that when one goes up, the other goes down, in our view, it's more accurate to view fixed income as a stabilising force within a portfolio. Instead of focusing solely on returns, investors should also consider the invaluable function of fixed income can have in reducing overall portfolio volatility and improving risk-adjusted returns.

Historically, equities have exhibited higher volatility, compared to bonds, reflecting the relatively stable income streams of bonds and their fixed coupon payments. While bonds can still experience price fluctuations, especially in response to changes in interest rates or credit risk, these movements are generally less pronounced compared to equities.

Even small bond allocations in a portfolio can help dampen portfolio volatility for a small reduction in overall return and improving risk adjusted returns (Sharpe ratio).

Chart 1: Historical risk adjusted return comparison of bonds and equities

Source: Bloomberg, Yarra Capital Management

If equities and bonds were negatively correlated, fixed income would never deliver positive returns over the long-term. As shown below (refer Chart 2), the correlation is slightly positive.

Chart 2: Australian equity and bond correlation (post 1989)

Source: Bloomberg, Yarra Capital Management

While it's true that fixed income returns may lag during bull markets, the trade-off can be crucial: in times of market turbulence, fixed income can serve as a critical buffer against sharp declines in equity values, helping to preserve capital and reduce overall portfolio risk (refer Chart 3).

Chart 3: cumulative bond and equity returns

Source: Bloomberg, Yarra Capital Management

For much of the past 30 years, equity and bond returns have tracked each other. However, over the past decade, equity returns have significantly outstripped bonds by a considerable margin. This period coincides with governments and central banks pumping considerable liquidity into economies.

While the relationship between equities and bonds may still hold, (refer Chart 1), a combination of both asset classes can yield high returns while offering some important protection against equity corrections.

In essence, the role of fixed income extends beyond generating returns; it can provide a vital layer of defence against market volatility. By diversifying portfolios with fixed income, investors may achieve a more balanced risk-return profile, thereby enhancing long-term wealth preservation and stability.

Investing is not just about chasing high returns--it's about safeguarding against the inevitable storms that come our way. Rather than viewing fixed income solely through the lens of negative correlation, in our view, investors would be wise to remember its true value as a potential dampener of volatility and a of prudent portfolio construction. And in that regard, in our view, fixed income remains an indispensable ally.

As investment managers, one of the most important - but also one of the hardest - things to do is knowing when to admit you've made a mistake. And errors of judgment can happen frequently in investment - in-depth research, strictly applied investment philosophies and disciplined portfolio execution are all critical tools that can help minimise risk and create robust investment portfolios capable of generating strong long-term returns, but they can't predict the future.

So, recognising the need to revisit an investment thesis, or when to reverse a trade entirely, is a lesson all investment managers need to learn. For us, that time came midway through last year.

AI: a technology game changer

We started 2023 being wary of the technology sector. Many firms within the sector had benefited from the prior cycle of cheap money, leading us to have concerns that such firms would suffer in a tighter spending environment compounded by higher capital costs.

What we hadn't anticipated was the rapid emergence of a new form of technology that would structurally change the prospects not only for the tech sector itself, but could also have much wider economic and social implications.

AI is not new a technology. In fact, its history can be traced back to the 1950s. But what changed on 30 November 2022, with the launch of ChatGPT, was the emergence of usable generative AI and machine-learning tools that have the potential to completely transform the business world in the decades ahead.

Suddenly, the future pathway for the technology sector shifted dramatically. AI will likely define a new era of technology adoption, making it a secular driver of growth that is independent of broader economic trends. Businesses and governments will need to invest in AI or risk being left behind. AI has become the new arms race.

Applying a Future Quality lens to AI

Having discerned that there's more to AI than hype, we conducted rational and focused research to ascertain the extent to which AI overlaps with the principles of our Future Quality philosophy. Not only did we conclude that AI is a tangible, long-term trend, but we were also able to identify a host of reasons for why capital expenditure on AI should grow rapidly.

The cost of undertaking machine learning and AI is massive; leading-edge computers are required to handle these models and datacentres will need to be scaled up. The tech titans are leading this AI spending, dipping into their deep pockets as they perceive AI as a way to deepen the moats around their franchises. Similarly, governments are also allocating funds to capture the military capabilities of AI and its utilisation in modern warfare.

This deep dive into AI clearly established that the sector would benefit from a very real and tangible tailwind that would likely endure for the next decade or longer. While our bottom-up, stock-picking investment approach centres around finding Future Quality companies - those which are able to grow, attain and sustain superior returns on invested capital and have key quality pillars in place (Franchise, Management, Balance Sheet and Valuation) - we are not averse to harnessing long-term structural themes that will help drive that growth.

AI undoubtedly represents one such driver, but we also track several other so-called 'mega themes' in order to identify other investment prospects and ensure our portfolio benefits from a diversified set of independent growth drivers. At present, we see long-term alpha opportunities from enablers of the energy transition; the normalisation and structural growth in global travel following pandemic-imposed restrictions; and among the providers of more efficient healthcare at a time when the world's population is ageing rapidly and there is a great need to reduce the cost of health services worldwide.

A Future Quality case study: Nvidia

Once a trend has been robustly ascertained, the next step is to look at the set of players to identify who will be the likely winners and losers. To do this, we looked back at previous waves of technology adoption - there have already been several over the last few decades - and found that leading hardware providers have dominated. They have had first mover advantage and have taken the lion's share of profitability. In the mainframe era, the winner was IBM. In terms of PC adoption it was Intel, and for smartphones it has undoubtedly been Apple.

So, when we looked at hardware spend on AI, we found that one name currently leads the pack: Nvidia.

Nvidia ticks all the boxes of our Future Quality thesis. It has long-term leadership in the provision of the GPU/DPU technology needed for leading-edge AI, making it the partner of choice for many key technology customers (Franchise). It has stable management and scores highly in terms of both corporate governance and human capital development (Management). Its balance sheet is strong, with net cash, high free cash flow returns and further share buybacks are expected (Balance Sheet). As one of the magnificent seven stocks that led the stock market advance last year, its share price may have already appreciated significantly, but we forecast an enduring period of high growth (Valuation).

Chart 1: Nvidia cash return on equity (%), 2023 - 2027

Source: Nikko AM forecast, as of August 2023.

Having affirmed Nvidia's Future Quality credentials, we purchased the stock in August 2023. As the dominant semiconductor provider, we believe Nvidia will maintain its growth trajectory amid an acceleration in the market for AI-compatible chips, as well as its additional software services. In short, we see this as a US$1trillion opportunity.

Chart 2: The opportunity for Nvidia 

Source: Nvidia, August, 2023.

How AI helped re-focus a business: Meta

We also considered how AI is being applied by other technology businesses.

While Meta - the owner of Facebook and Instagram - was always on our watchlist, we no longer held the stock within our portfolio as we felt its heavy investment in developing the metaverse represented a poor return on capital and perceived that the business had taken its eye off the real revenue driver of its business model of selling advertising to large and small businesses around the world.

Fortunately, Meta's management recognised the error of its ways, redeploying capital into AI and using AI to reinforce its core franchise. This is already delivering a notable impact; people are spending more time on its platforms and Meta has already seen its share of global advertising revenue go up - a particularly notable feat during a time when the advertising cycle is under strain from a more depressed economic environment.

This change in business strategy has resulted in a notable improvement in Meta's returns on capital and better growth prospects. We now believe that Meta once again meets our Future Quality criteria, as its outlook now aligns with our expectations of sustained and superior returns, and as a result we have reintroduced the stock back into our portfolio.

Identifying the leaders of the AI revolution

Investing isn't an exact science. Trying to pick winning businesses over a 5-10 year horizon is not an easy task and errors will inevitably be made, especially when new trends emerge. However, for seasoned investors, the ability to acknowledge such mistakes and take appropriate action is the key to long-term, successful investing. For us, that means re-evaluating an investment thesis based on our Future Quality criteria. Our research shows that AI is a new paradigm that will have significant investment implications for the future and shouldn't be ignored or avoided. However, as with every nascent development, the successful adopters of AI and the ultimate winners are not yet evident, so we will proceed with caution rather than run with the herd. Our focus remains on finding Future Quality businesses with a visible pathway to future growth, regardless of whether they are AI-aligned, affiliated with another megatrend or have their own robust idiosyncratic business case, but all are connected by our Future Quality investment philosophy.

In times of change, new market leaders will emerge

Financial regulators like to say that past investment performance is not a clear indicator of future performance. Yet, we investors often look to the past to gain insights into potential future market conditions. There are patterns that can be exploited or traps that may be avoided. However, as we head into 2024, the past may not offer the usual useful insights.

From a macro perspective, central banks' experimentation with quantitative easing―which provided relatively benign market conditions since the Global Financial Crisis--is being unwound, and this "quantitative tightening" presents a new territory for policymakers and investors. Simultaneously, we appear to be approaching a peak in monetary tightening, and inflation appears to be in retreat, but the end game for this battle remains opaque. Recent market actions suggest a turning point is approaching, yet when it comes to timing key events, markets can often be wrong.

Geopolitics also offers few signs of stability. The peace dividend that has prevailed for several decades has abruptly ended, with ongoing developments in the Middle East being the latest addition to broader uncertainty. In addition, a series of national elections in 2024--culminating with a possible second presidential term for Donald Trump in the US--will ensure further drama unfolds.

With all of this in mind, investors will need to adjust their expectations, and portfolios, to account for higher for longer interest rates, the challenges of slower economic growth, stickier inflation, and a testing geopolitical environment. So, in this sea of uncertainty, where can we find a stable port in which to anchor with confidence? For us, we stand by our philosophy of Future Quality--the belief that companies which can grow, attain and sustain superior returns on invested capital, and have all the key quality pillars in place (Franchise, Management, Balance sheet and Valuation), will be the best candidates for capturing longer-term alpha.

While each company will embark on its own, unique journey to Future Quality, there are also common pathways, often driven by structural requirements. Therefore, these companies are less dependent on macro cycles, which we can leverage over the long term. These include the following:

AI Adoption

The emergence of artificial intelligence (AI) was a dominant market force in 2023. We were initially hesitant about joining this party, but our subsequent research has led us to reappraise this position. While we still believe AI contains an element of hype, it has the potential to transform technology for the next generation. It is too early to define the longterm winners from the new business models and use cases being inspired by AI, but there are market leaders already benefitting from the rapid adoption of this new technology that fit our Future Quality criteria. Over recent months, we have added Synopsys, Nvidia, and Meta to the portfolio.

Enablers of the energy transition

There is a need to reduce humankind's reliance on fossil fuels and create cleaner alternatives through renewable sources of energy, but this transition is not straightforward. Increased spending is needed to sustain existing energy production at the same time as mitigating carbon missions. While there is a fruitful pool of investment opportunities on both sides of this equation, the transition is heavily reliant on fiscal spending and political support could prove to be fickle. Portfolio winners in this space have been Schneider, Linde and Chart Industries (sold in Q3 2023).

Normalisation and structural growth in global travel

The travel industry is still in the process of recovering from pandemic-imposed restrictions, with countries at differing stages of normalisation. Yet, when you look at the core consumers of travel, demand remains robust. This is particularly true for younger generations, who place greater value on "experiences". Furthermore, a new travel cohort is emerging from developing countries where rising gross domestic product per capita means more people will be able to afford to travel in the future. Booking Holdings, Amadeus and Samsonite have been positive contributors to the portfolio in 2023.

Providers and enablers of healthcare efficiency

With an ageing population, providing sufficient and efficient healthcare, as well as reducing the cost of such services, will be one of the world's most important challenges going forward. In our view, this demographic test will--and has been--a great hunting ground for investment ideas as healthcare companies innovate to deliver much-needed solutions. That said, some subindustries within the healthcare sector have underperformed of late because of the pandemic pulling demand forward and creating ongoing staff shortages.

We are heading into a changing world, where the more recent past can no longer be relied on to guide our path forward. There are tools we can use to provide a greater degree of certainty. Our Future Quality approach is designed to help us identify franchises that are set to endure. Some of these companies may not have been in the vanguard of market leadership over the last decade. However, in this instance, we can more reliably believe history when it tells us that in times of change, the market leaders at the start are rarely the same as the ones leading us out of it.