Mutual FundsCommentary

Life science and technology stocks in the United States have been steadily climbing for the better part of two years, and valuations on some names are now looking rich.

But Marcello Montanari and Rob Cavallo, who manage the $2 billion Gold medallist RBC Life Science and Technology Fund F, believe that artificial intelligence will be a key driver for returns among the select companies that remain at attractive prices.

“I wouldn’t expect a crash like we had in 2022. That was a unique experience coming out of the COVID pandemic. Conditions were very different than they are now. But I may expect shorter-term corrections like what we have seen recently in the software space,” observes Montanari, managing director and senior portfolio manager and head of North American equities at Toronto-based RBC Global Asset Management Inc.

“When I think about things that keep me up at night, we are always looking at trends and where we think things are going, but we have pretty a high level of confidence about AI and machine-learning generative AI and its eventual effects on robotics,” says Montanari, a 32-year industry veteran who joined RBC in 1997. “We can see that this is going to be pretty important. There is going to be a lot of upside. But what tends to happen in the short term is that the market tends to pull growth forward and expectations get elevated.”

To put things in context, says Montanari, one has to understand what happened in 2022. “Coming out of 2022, there was a hangover from COVID, so that the so-called ‘comparables’ were very difficult, versus 2021. The economy was moving from a goods-orientation back to services. There was also the impact on supply chains which impacted things. In the middle of all that Apple (APPL) implemented its privacy initiative which undermined the digital advertising, payments and e-commerce ecosystem.”

Meanwhile, central banks implemented 11 rate hikes to stem the impact of inflation. “We run long-duration assets, which get impacted disproportionately when long rates are rising or coming off. So 2022 was really difficult, for technology especially,” recalls Montanari. 

Then, contrary to expectations that 2023 would be a recessionary year, the managers believed the economy would thrive as it reverted to a services-orientation. On top of that, “we had a meteor-hits-earth-moment where Microsoft with Open AI released Chat GPT and merged it with Bing, which set off a new tech cycle. That helped to drive the entire tech space.”

The market’s appetite for AI certainly helped to boost the asset class even higher this year, says Rob Cavallo, senior portfolio manager with the North American equities team at RBC GAM, which he joined in 2012. “Earnings growth and revisions were better than the broader market. But then you throw in the AI theme as well as a pause on the Federal Reserve rate hiking cycle. And in March 2023, you had the Silicon Valley and regional bank scare that pushed people towards more defensive names. That fits the mold for a lot of medical-technology names. All this brought us into 2024, with the underlying theme of AI having captivated the market, which became a key driver in the sector over the past 18-24 months.”

Year-to-date through June 11, RBC Life Science & Technology has captured much of the mood in the market as it has returned 24.11%, versus 14.42% for the US equity category. Over three, five and 10-year periods, the fund has been a first quartile performer and returned an annualized 17.33%, 20.16% and 18.88%. In contrast, the US equity category has returned an annualized 9.89%, 12.57% and 12.08 %. Montanari and Cavallo have overseen the portfolio since late 2016.

As for valuations, Cavallo acknowledges that tech stocks are trading at approximately a 20% premium to the broader market. “But it’s only a handful of stocks that seem more expensive than they really are,” says Cavallo, referring to names such as NVIDIA (NVDA), which is trading at around 34 times 2025 earnings, and  Microsoft (MSFT) which is trading at 31 times.

“You are always at risk that expectations may get ahead of themselves so when there are misses on quarterly results and you can get corrections in the stocks,” says Montanari, who reiterates that he and Cavallo are bottom-up stock-pickers. “But we have a thesis on each name and ask ourselves, ‘Is the thesis intact?’ or ‘Did something happen that might puncture the thesis?’ If the answer is ‘The thesis is fine and nothing is wrong,’ we tend to stick with the name. ‘Get it right, and sit tight,’ is something that I like to say.”

Montanari points by way of example to Microsoft, a long-time holding, which had come under pressure in June 2023. “It was clear that they were going to miss their numbers. In that kind of situation, we might tactically sell some stock to soften the blow. But the market might not care if they miss that quarter because it is always discounting the future and looking further out. And Microsoft has been chosen as an AI ‘winner,’” observes Montanari. “So if you are trying to sell something because you want to avoid a trading situation, you might actually trade yourself out of a good position. The market may just shrug it off and the stock continues going higher. That’s the art of this business: trying to understand how the market will react to something, given the background.”

From a strategic perspective, Montanari and Cavallo are running a portfolio with 89 names that are split between 55% in information technology, 22.8% health care, 17.2% communication services, with tiny holdings in areas such as financials and consumer discretionary. Significantly, the top 10 names---which includes Apple (APPL) and Meta Platforms (META)—account for 52.2% of the fund. That is largely attributable to sharing the same investment philosophy as famous investor Warren Buffet, who is known for keeping winning stocks for the very long run, or unless the thesis changes.

In selecting stocks, the managers look for three key attributes. First, they look for revenue growth and quality in that growth. “As we assess these two attributes, there are a whole bunch of sub-segments to that are important,” argues Montanari. “There are six ways to grow revenues: pricing power, new products, geographic expansion, increasing sales capability, (mergers and acquisitions) and friction reduction. You can see that we are focusing on a bunch of sub-elements and then there’s the revenue quality. That is, we ask ourselves, ‘What kind of moat does the business have and does it benefit from network effects? Is there visibility to their revenues? What are the switching costs?’ Is it a financial one, or something that is operationally very hard to replace? Often, technology becomes key infrastructure for many businesses.”

The second attribute revolves around margin potential and cash flow conversion potential, while the third attribute focuses on the company’s track record in reinvesting the capital in their business and earning an adequate return on that capital. “The question is, can they grow revenue for an indefinite period faster than their peers?” asks Cavallo. “Can management convert this growth into free cash flow? And what’s management’s history and credibility in being able to reinvest their cash flow and earn adequate returns on that capital? Understanding those factors is where you can add to the long-term compounding capability in this sector.” 

One of the fund’s top holdings is United Health Group (UHN), a leading health insurance and services firm in the U.S., whose stock is trading at 18 times 2024 earnings and 16 times for 2025. “It should trade in line at least with the market multiple,” argues Cavallo, noting that the firm has a market-capitalization of about US$460 billion. “So we expect expansion of the [share price] multiple over the next few years and believe they are a mid-teens earnings per share grower. But they are going through some short-term dislocation in their business, because of developments in their end-markets, which are somewhat in their control and somewhat out of their control, and could fix themselves. 

“Things might get worse in the next six months. But if we look back in two years, we will see that this is a really good opportunity in a very big market-cap name. It can get back to its earnings growth cadence and see a multiple re-rating potential.” He argues that the stock is trading at about a 10-15% discount to its intrinsic value.

Another pick is Pinterest (PINS), a social media firm which offers a platform where end users upload images and information about products to their own “boards”. The holding is a little different from what the managers usually focus on, since they don’t invest in technology turnarounds. “That’s one of the hardest things on earth,” says Montanari. “Once you lose leadership, it is really hard to regain it. Technology tends to be a winner-take-all in most markets.”

From a technology perspective, the firm was very poorly managed and relied on brand advertising. “Their technology systems that underpin all the advertising technology, and the social network that is built around it, was horribly built. So they brought in a new management team led by a guy named Bill Ready, who came from Google, and he began by addressing the technology shortcomings and he’s re-built the technology stack. It’s still a work-in-progress. But we are seeing the benefits of what’s happening there.”

Pinterest, which has a market-cap of US$28 billion, has seen year-over-year revenue growth go in the last six quarters from 4% to 23% in the most recent quarter. “Is it sustainable? Yes, that’s our bet,” says Montanari. “We come to that conclusion because of the earlier discussion of attributes such as revenue growth and quality. Pinterest has new products and they are going into new geographies. They are reducing the ‘friction’ within the platform. So there are all sorts of things happening that tell you that if they continue to execute like this their revenue growth should continue to maintain a high level for the next while.”