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Great Expectations

Narratives have always had the power to drive markets. For stocks, few narratives are more compelling than those about new technologies, innovations or business models that can produce tremendous profits growth for the foreseeable future. Over the past year, no narrative has had more influence on markets than the potential for artificial intelligence (AI) to transform industries, economies and societies in the 21st century. At present, hyperscalers—the large technology companies that operate large-scale data centers—are locked in an AI arms race and spending huge sums of capital on AI infrastructure.

US equity returns over the past 18 months have been dominated by these mega-cap technology companies. From the October 2022 lows until the July 2024 peak, the Magnificent Six (yes, we admit the Magnificent Seven is catchier, but there are doubts whether Tesla belonged) contributed 45% of the S&P 500® Index’s total return. Of course, the biggest beneficiary of all this capex has been GPU maker NVIDIA, which rose 10-fold over this time (Exhibit 1).

 

Exhibit 1: NVIDIA Has Been a 10-Bagger Stock

 

“History doesn’t repeat itself, but it often rhymes.”

This famous quote is typically attributed to Mark Twain. Regardless of its exact origin, its meaning is clear. The meteoric rise of NVIDIA’s share price, the narrow leadership in US equities, the historically wide valuation spread between growth and value stocks, elevated valuations in US stocks broadly, and “new era” thinking are all reminiscent of the late 1990s tech bubble.

NVIDIA is seen as a quality growth company. It didn’t join Apple and Microsoft as the only $3 trillion companies in history—and briefly the most valuable—by being valued on pure hopium. In its most recent quarter, sales grew to $26 billion on 262% growth from a year ago, with nearly $15 billion in net income.  No, NVIDIA is not Pets.com. Still, other examples from that period may be more apt comparisons. One might be Cisco Systems, the networking equipment company. Cisco was a poster child of the Internet’s “picks and shovels” buildout phase—growing its revenues by 850% between 1995–2000. The stock price was up even more, returning 3,800%! At the peak of the tech bubble in March 2000, Cisco was the most valuable company in the world, valued at over $550 billion.

For investors, the core issue is what NVIDIA is worth. Investing is about expectations. What expectations are embedded in the market’s asking price? Only by understanding the market’s expectations can we, as value investors, determine an appropriate purchase price that provides a margin of safety. At the peak of the tech bubble, Cisco was selling for over 300X P/E on trailing earnings and over 130X next year’s earnings. When the dot-com bubble burst, Cisco shares plunged 88% over the ensuing two years. This occurred even as Cisco—the business—continued to deliver (Exhibit 2).

 

Exhibit 2: Cisco Systems’ Continued Growth

 

Currently, in mid-August, NVIDIA is trading at about 47X next year’s earnings. While not cheap, that seems to be a reasonable valuation given NVIDIA’s dominance in the AI chip market and its growth trajectory. Yet, that growth isn’t guaranteed; there are risks to its growth outlook. How long will NVIDIA maintain its economic moat? How durable is the growth trajectory? How sustainable is its pricing power? These are but a few questions. Any business with high margins generating supernormal profits will attract competition. Other chipmakers are working furiously to catch up. NVIDIA’s large technology customers are also spending heavily on in-house solutions to pare costs.

As it relates to the sustainability of GPU demand, AI technology is expensive, and the benefits need to justify the costs. The realization of these benefits—from gains in productivity to better growth—may take longer to manifest. There is also the law of large numbers. NVIDIA’s growth occurred when it was much smaller. As mentioned, today the market values NVIDIA at $3 trillion. How does one quantify and justify a $3 trillion valuation? We propose inverting the logic by asking the question, “how much pre-tax profit does NVIDIA need to make soon and in perpetuity to justify the asking price?” We would submit NVIDIA needs to earn about $300 billion. To frame the size of a profit of such magnitude for the reader, $300 billion is the equivalent of the profit pools of Apple, Alphabet and Microsoft—the three largest in history—combined! NVIDIA earned $42 billion in the last 12 months and is expected to earn $86 billion in its fiscal year ending January 2026.

When stocks are priced to perfection, any little negative news can have an outsized influence on price action. For example, the reported delay in NVIDIA’s next-generation Blackwell chip caused a healthy selloff in the shares that spread through the semiconductor space. From its July peak to August 5, shares of NVIDIA fell 20%—wiping out $637 billion in market value—compared to -8% for the S&P 500® Index and -4% for the median S&P 500® Index stock. It’s a reminder to investors that valuation matters. 

We require a margin of safety in order to invest. Margin of safety, a concept developed by Benjamin Graham, is the difference between the market price and the estimated intrinsic value of a business. A large margin of safety may help guard against permanent capital loss and improve the probability of capital appreciation.