This article was first published in the National Post on September 2, 2023. It is being republished with permission.

by Tom Bradley

Every once in a while, a stock comes along that defines who you are as a fund manager. The company is the poster child for a trend that’s changing the economy and constantly in the headlines. The stock is rocketing upward, which means it’s extremely hard to keep up with the market if you don’t own it.

We have one such stock today: Nvidia. The stock is up 240% this year and is now the fifth most valuable company in the world. The company has pulled away from the competition in high-performance computer chips used for, you guessed it, training artificial-intelligence models.

If such a stock is based in Canada, it has an even bigger impact. Our stock market is relatively small, so a successful global company can dominate the returns of the S&P/TSX Composite Index. Nortel grew to be one-third of the Canadian index at its peak. Valeant Pharmaceuticals and Shopify came from nowhere to become the biggest stock on the board (albeit, briefly), moving past financial giant Royal Bank.

To be clear, this isn’t like being on the right or wrong side of BCE versus Telus, or Canadian National Railway versus Canadian Pacific Kansas City. Clients don’t often look for those or ask their manager about them, but they absolutely ask about stocks such as Nvidia. Every meeting.

If you own Nvidia, you’re delighted. The company just reported blowout earnings. Its sales doubled in the second quarter and earnings were up more than eight times compared to the same period last year. And management’s guidance calls for more of the same. The story just keeps getting better.

Owning Nvidia means you can proudly tell the story about when and why you bought it. The only challenge you have is a rather pleasant one: should you trim the position or let it run?

The trim-or-hold decision is a piece of cake compared to the one you have if you don’t own the stock. You likely missed it because it seemed too expensive and, even though the outlook kept improving, the stock price was always ahead of itself. Comparable companies traded at lower price-to-earnings multiples.

For a long time, it didn’t matter. Missing Nvidia didn’t define you as a portfolio manager, but that’s not the case now.

So, what’s holding you back? Well, like any stock decision, there are cross currents and uncertainties. Will the current demand surge for AI chips slow and settle at a lower level? It’s not yet clear what normal volumes will be.

Is this the big inflection point that many experts claim, or just a cyclical surge driven by customers aggressively stocking up? Remember, the overall chip shortage of a year or two ago quickly turned into a glut as customers ran down inventories.

Part of the uncertainty is because there’s no clearcut revenue model for AI businesses. Is it a new product that will generate additional revenue, or just an enhancement to existing products?

Then there’s the competition. Nvidia’s position seems unassailable at this point, but there are other big players with even bigger research budgets working on high-capacity chips.

Meanwhile, the valuation you found challenging has only become worse. There are studies showing that companies trading at more than 25 times sales turn out to be poor investments. Certainly, Nvidia will need a near-heroic performance to justify its current price (that is, sales continue to multiply while maintaining industry-leading profit margins).

There are many potential outcomes to unique situations such as Nvidia’s. The first is winning the day right now. That is, Nvidia proves to be a great company and keeps growing. The stock continues to rise even though it always seems expensive. Think Amazon.

There are other possible scenarios though, such as it’s a great company and keeps thriving, but the stock stagnates for years while catching up to its P/E multiple. Think Cisco, which is still well shy of its 2000 high despite gushing profits for more than two decades.

Or it’s a good company, but its competitive advantage is overstated. Future sales and earnings disappoint and the valuation declines. Shopify is an example of this deadly combination.

Or the really scary scenario: the company isn’t what it seems and eventually proves to be mostly smoke and mirrors. It goes from a high-flying company that’s changing the way business is done to the junk heap. Nortel and Valeant were in this category.

You see the fund manager’s dilemma. Nvidia is a stock that can’t be ignored because it’s impacting performance and regularly being asked about it. But what to do?