10.20.26 - How to spot hidden value stock opportunities

Jurrien Timmer · Fidelity Investments

The non-AI half of the S&P 500 is only about 30% correlated with the index, so it diversifies AI risk.

Timmer splits the S&P 500 into an AI half, about 50% of the index, and a non-AI half. He says the non-AI side has almost no correlation with the index, about 30%. If the AI story keeps winning, the market does well. If it does not, the market beta could fall, and income-producing equities would then be a useful counterweight alongside bonds. He says this is why he sees Ramona's income-oriented style as a good diversifier.

“the AI side, which is about half the index, and the non AI side, which is the other half. The non AI side has almost no correlation to the S and P, which is remarkable. It's only about 30% correlated.”at 18:08

Ramona Persaud · Fidelity Investments

Healthcare and staples are strongly anti-correlated with the AI basket, making them useful diversifiers.

Persaud says the most stable parts of the market, healthcare and consumer staples, are currently negatively correlated with an AI basket, at roughly -60% to -80%. She says the effect is even stronger over longer periods. Both are large dividend-paying sectors, so she sees their negative correlation to AI as a reason to hold dividend stocks alongside an AI-heavy market.

“So health care and staples are right now negative 60 to negative 80% correlated or call it anti correlated with an AI basket”at 19:17

Ramona Persaud · Fidelity Investments

Dividend stocks offer both valuation and inflation protection, unlike hyper-growth stocks and bonds.

Persaud compares three income sources. Hyper-growth stocks lack the valuation protection she wants. Bonds lack inflation protection because their payments are fixed. Dividend stocks give both. Companies with real pricing power can raise prices above inflation, and with cost control, earnings and dividends grow in real terms. Dividends come from free cash flow, which gives investors a cash stream that grows in real terms, unlike a fixed bond coupon. She finds this in consumer and healthcare names, which are cheap and high-yielding.

“Hyper growth typically does not have the valuation protection that I would like. Bonds do not have the inflation protection that I would like. Dividend stocks currently have both.”at 23:16

Jurrien Timmer · Fidelity Investments

Bond yields falling as AI stocks corrected suggests the bond market fears AI risk is systemic.

For years rising rates were the main worry for stocks. Last week, when AI names fell further, Treasury yields moved the other way. Timmer reads this as the bond market pricing in the risk that AI is so large it is systemic. If the AI boom went wrong, it could hit the economy, earnings growth, Fed policy and interest rates. He presents this as a shift in what drives yields, from rate pressure to growth fear, and expects to watch whether bonds move from inflation worry to growth worry.

“it almost is like the bond market is getting concerned that the AI story is so big, what we call systemic, that if something goes wrong there, it's going to affect the economy, earnings growth, Fed policy, and interest rates.”at 4:26

Jurrien Timmer · Fidelity Investments

Investment-grade hyperscalers can absorb AI capex, but non-investment-grade, single-purpose AI builders are the credit pressure point.

Timmer says the massive AI capex boom raises two questions: whether hyperscalers earn enough return on that spending, and whether too much is borrowed relative to the cost of debt. Large investment-grade companies such as Amazon, Meta or Google, which have strong cash flows and other businesses, have so far been relatively immune. The pressure is in 'one trick ponies' that exist only to fund this capex and are not investment grade. He does not know how contagious that stress is and says he suspects it won't spread, but he cites the 1990s fiber build-out and subprime mortgages as cases where people also expected no contagion and were wrong.

“if you're a big investment grade company building out this compute infrastructure, and you're investment grade, and you have good cash flows... then so far, they've been relatively immune. But if you have these sort of one trick ponies that are only in this space to do this CapEx and they're not investment grade, that's where the pressure is right now.”at 5:47

Ramona Persaud · Fidelity Investments

Pharma stocks are cheap because the market doubts their pipelines, which creates a buying opportunity.

Persaud says the market is skeptical of pharma pipelines right now, and she calls it one of the clearest examples of the apathy she looks for. In her example, a large drugmaker lost exclusivity on a major drug. The market fixates on that loss and does not believe the rest of the portfolio can outgrow it. That leaves the stock much cheaper and higher-yielding than the market, with less volatility. She sees the same setup in many pharma companies, supported by strong research.

“An example right now is in pharma. There's a lot of skepticism over their pipelines.”at 10:01

Ramona Persaud · Fidelity Investments

AI stocks have not offered valuation protection, so she waits for fear to buy AI at derated prices.

Persaud says AI can be treated as its own basket, but valuation has not protected investors in it. Tech is about 20% of her universe, so she cannot ignore it. Instead she waits for periods of heavy fear to consider derated valuations. She argues that in fast-moving innovation like AI, sentiment swings between fear and exuberance quickly, so patient investors get chances to buy strong businesses at depressed prices. Hyper-growth stocks, in her view, typically lack the valuation protection she wants.

“We can also argue that AI itself is a basket, but for me, valuation has not been protective.”at 12:02

Jurrien Timmer · Fidelity Investments

Mega-cap firms burning cash on AI capex instead of buybacks and dividends makes shareholder income less predictable.

Timmer argues the trillion-dollar mega-cap stocks, which led the market for the past decade, are now spending their cash flow on capex rather than returning it through dividends and buybacks. He calls this neither bad nor clearly good, but says it creates a more uncertain income stream for shareholders. A buyback is a known return, while capex depends on whether the spending pays off. This is why he sees income-oriented stocks as an important diversifier.

“the mag [seven], big mega cap trillion dollar stocks are actually burning through their cash flow. Rather than returning the cash flow to shareholders as dividends and buybacks, they're spending it on CapEx... It creates a more unknown income stream to investors.”at 17:28

Ramona Persaud · Fidelity Investments

Home improvement stocks are high quality and cheap because housing activity is low; a coiled spring for easing.

Persaud says housing affordability is poor because rates are high, which is driven by inflation. Consumer stocks are under pressure from affordability, and housing and retail show it. Home improvement stocks are among the higher-quality parts of housing, but they trade cheaply because housing activity is so depressed. She calls them a coiled spring: if inflation eases, or the geopolitical conflict that is adding to inflation fades, they could rebound with long-term business durability.

“Home improvement stocks are some of the higher quality parts of housing, and they're fairly cheap because housing activity is so low. So to me, this is like a coiled spring”at 23:38