“Follow the Money”: Stephen Yiu’s strategy for the AI era

“Our investment philosophy is very simple,” says Stephen Yiu, manager of the Blue Whale Growth Fund. “It’s basically Follow the Money.”

“The way that we understand how the world economy operates is that there are three sources of spending: consumer spending, enterprise [business] spending and government spending. You want to invest into companies that are going to receive incremental spending from one of these three sources.”

That thinking determines where Blue Whale’s highly concentrated and unconstrained portfolio looks like at any point. At present, Yiu is heavily invested in tech stocks and has been for several years – but he is very clear that he is not primarily a tech investor.

He’s simply looking for the type of companies that have the tailwinds to support them. That changes a lot over time, and investors who don’t change in response can get caught out.

Speaking on the MoneyWeek Talks podcast, which is available on all podcast platforms and YouTube, he says: “If I go back in time when we first started in 2017, the leadership – the companies that end up receiving money – are very different,” he says. Consumer spending was a lot more robust in the 10 years up to 2022, helped by factors such as low interest rates, low inflation, the benefits of globalisation and very little geopolitical uncertainty.

“If you look at companies that are exposed to consumer spending, they are in a much more difficult place now.”

Selling software, buying hardware

Since then, technology – more recently artificial intelligence – has been the beneficiary of higher spending. However, even within the tech sector, Blue Whale’s holdings have evolved as the winners and losers changed.

“A very important part of any investor playbook is that you need to sell companies that could have their earnings power disrupted,” says Yiu. So around two years ago, he moved out of the software stocks that had been key parts of his portfolio in the early years for the fund

These companies had been extremely attractive – they had switched away from selling one-time software licences to a subscription model, giving them recurring revenue. Costs of switching away from them were often high, meaning that many users were locked in.

However, while many investors assumed all technology companies were likely to be AI winners, Blue Whale recognised that “AI is actually a big risk to the moats of software companies” because it would make it easier to create rival products – even to the extent of helping smaller firms create their own systems.

So today, while the fund is still heavily weighted towards the tech sector, its actual exposure is principally in hardware stocks – beneficiaries of the huge demand for chips and other components that power the AI boom.

Structural changes

This rotation into stocks that are benefitting from physical shortages is evident in other additions to the fund, some of which may seem surprising for a fund that is associated with high-quality growth stocks.

Blue Whale now holds an oil and gas producer and more recently a refiner, anticipating sustained high oil and fuel prices driven by conflicts and geopolitical tensions – an example of what Yiu calls a shift in the investment regime.

Similarly, the fund has invested in a European defence firm, on the basis that the amount of government spending flowing into the sector has shifted structurally.

“Before 2022, nobody should ever be interested in European defence companies,” he says. Defence budgets were “very much linked to European nominal GDP and European GDP has been very disappointing for many years”.

Now, capital is pouring into the sector, while the fundamentals look better: faster growth, stronger balance sheets and probably a less demanding relationship with their government clients. “Then you look at the return on investment profile, the margins, the shareholder returns, the free cash flow conversion, it’s all completely changed.”

Bottom-up, not top-down

While Blue Whale pays close attention to top-down factors such as geopolitics that shape a company’s prospects, Yiu stresses that they are fundamentally bottom-up investors, focused on understanding what everything means for a company’s earning power.

That’s a crucial part of the firm’s advantage over other investors, he says. After all, Blue Whale invests in very large companies, where everybody has access to the same primary information. Access to management may be limited and unlikely to confer any advantage.

“You have to go back to the basics, which is ‘Do you understand the business or the ecosystem better than the market?’”

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