03 March 2024

Nvidia – A Case Study in Quality

By Matthew McKee, CFA, CFP®

March 3, 2024

The news is abuzz about the AI revolution and the rise of Nvidia. We’d like to discuss the role of a “hot stock” in the context of a diversified portfolio.

Nvidia was founded in 1993 specializing in GPUs, a more sophisticated chip than the CPUs churned out by larger rivals Intel and AMD. GPUs were overkill for most computing applications at the time, but they found their niche in the early video game industry.

GPUs process tasks in parallel instead of sequentially, so they are well-suited for the incredibly high computational demands of all these new AI applications, forming a supply-chain bottleneck right at Nvidia’s doorstep. With its decades of specialization in this space, Nvidia enjoys a lead on rivals that will take some time to erode.

Nvidia’s recent earnings report blew analysts’ expectations out of the water. Its revenue grew 22% from only a quarter earlier, and 265% from a year ago.

As a result, investors have bid up shares of NVDA almost 60% year-to-date, and a stunning 249% over the last year ended 2/29/2024. This compares to the S&P 500 Index’s (healthy!) return of 7% and 31% respectively.

Is it too late to buy?

Of course, the best time to buy a stock is before it quickly triples, not after. Predicting moves like that is extremely difficult. But Nvidia will likely be a critical company in the global economy for years to come, so long-term investors should still own some.

Whether it’s “too late” is the wrong question, unless you are a day trader looking to make a quick buck, in which case we have little guidance for you.

The better question is, “how much should I own as a percentage of my overall portfolio?”.

To answer this you need a reference point – a benchmark. In our investment process we use benchmarks that are globally diversified and include companies of all sizes (also, bonds), but for simplicity we’ll refer to the S&P 500 Index, which focuses on 500 of the largest US-based companies.

Nvidia has catapulted to the third-largest component of the index at 4.5%, behind Apple (6.24%) and Microsoft (7.08%). In January 2023, it was the 7th largest component at 1.42%, since leap-frogging Amazon, Berkshire Hathaway, and Alphabet.

If you own the S&P 500 Index, you’ve enjoyed some decent exposure to NVDA and now hold more than you did a year ago. If you wanted to invest $100,000 cash into a portfolio of stocks today, allocating $4,500 to NVDA is a sensible starting point.

(Read our last newsletter Chutzpah to learn how we think about individual stock bets against an S&P 500 benchmark.)

In our investment process, we’ve liked NVDA not because we attempted to predict its rapid ascendancy, but because it exhibits measurable characteristics of a “quality company.”

We’ve been leaning into higher-quality companies as interest rates rose, with the belief that they are better suited to endure the challenges of a higher interest rate environment, which we expect to persist for some time.

What is a “quality company”?

Quality companies have three specific characteristics: high return on equity, low debt, and consistent, growing earnings.

Let’s look at NVDA on these three dimensions versus the benchmark:

Source: Y Charts as of 2/29/24

We could go much deeper on the nuances of these data points and other ways to measure quality, but it’s clear that NVDA has much stronger “quality” attributes than the benchmark across the board.

So what’s the downside of investing in quality? Two answers.

First, there are market environments that favor lower-quality companies. For example, after the pandemic, massive government stimulus fueled a “junk rally” where speculative assets rose the most.

Second, valuations matter. In certain environments, quality companies can be bid up to higher prices per dollar of earnings than the broad market. This can either reduce return potential or require faster earnings growth to justify. On that front, Nvidia sports a forward price-to-earnings ratio of 33, versus the market’s 23.

Some might deem this a reasonable premium for the higher growth prospects, but it’s not without risk. There’s no guarantee that projected earnings growth will come to pass. For example, what if China invades Tiawan, where Nvidia currently manufacturers its chips?

As always, be careful with single stock risk!

It wouldn’t be a Target Rock Take without some warning about the perils of excessive single stock risk.

We want to remind our readers that successful long-term investing is not about uncovering the next hot stock that is going to pop like NVDA. It’s about consistently making diversified investments that pay off reasonably well and compound over time, while avoiding meltdowns from concentrated exposures.

It’s hard to tell what the next NVDA will be, but the only way to ensure that you own it is to be as diversified as possible.