This week's interesting finds

This week in charts

S&P 500 Index drawdowns

Housing affordability

Canadian housing prices vs. income

Canadian exports to the U.S.

U.S. oil importers

China EV sales

Crypto funds

S&P 500 Index concentration

Magnificent 7

Entry price dictates returns

Not all European business is a profitless wasteland

Talk to European bosses about their continent and the responses are as varied as the languages they speak. Katastrophe, bark the Germans. The Italians wave their hands in exasperation. The French offer a resigned Gallic shrug. The British change the subject to the weather (which isn’t exactly fabulous, either). With governments collapsing centre-left (in Germany last month) and centre-right (in France on December 4th), plus war raging in next-door Ukraine, chaos is the political watchword.

European business can seem just as dysfunctional. In the past couple of weeks it has been a tale of bankruptcy (of Northvolt, a would-be battery champion), labour unrest (at Volkswagen, the continent’s biggest carmaker, where nearly 100,000 workers downed tools on December 3rd) and CEO defenestration (at Stellantis, a rival whose biggest shareholder, Exor, part-owns The Economist’s parent company). This week an activist investor ratcheted up pressure on Rio Tinto, the world’s second-most-valuable miner, to follow its bigger rival, BHP, in ditching its dual listing in London and settling for good in Australia.

Add a dearth of success stories in artificial intelligence (AI) and no wonder Europe’s chief executives are in a dour mood, made dourer by smug American counterparts whose companies, on average, sell more, turn fatter profits and are valued more richly by markets. The entire STOXX 600 index of large European enterprises is worth a third less than America’s “magnificent seven” technology giants. Shares of firms in the S&P 500, its transatlantic equivalent, trade at 23 times future earnings, far above the 14 or so eked out by STOXX constituents.

Even excluding the AI-fuelled trillion-dollar outliers, investors regard American businesses as more promising than European ones. The price-to-earnings ratio of the 493 firms in the S&P 500 that are not Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia or Tesla is comfortably higher than for the STOXX 600. As a Spanish CEO might put it, ¿Qué diablos?

These jarring disparities in aggregates and averages are real and troubling. However, they may conceal as much as they illuminate. Closer inspection reveals pockets of European corporate strength, some more surprising than others.

In specific areas of commerce, Europeans outmatch even those self-satisfied Americans, sometimes handily. Europe’s drugmakers are collectively worth more than American ones and boast twice the return on capital. Novo Nordisk of Denmark launched Ozempic before Eli Lilly began selling its weight-loss drug. Europe lacks an Nvidia, but the $3.5trn AI-chip designer would not get far without ASML, a Dutch firm whose machines etch Nvidia’s blueprints onto silicon. Ryanair and other European airlines fly rings around American carriers in terms of profitability. And nobody does posh better than the French (think LVMH) and Italians (Ferrari, also controlled by Exor).

An alternative way to look for winners among European companies is to ask what factors might shorten the odds of success. Consider how much a business spends on research and development (R&D). In Europe, the keenest fifth of R&D spenders, a group that devotes at least 12.5% of sales to that end and includes those pharma giants and ASML, outperform less enthusiastic ones when it comes to return on capital. No such regularity is evident in America, perhaps because corporate R&D budgets there are generally higher relative to revenue to begin with.

European companies have two other things going for them. Many have patient shareholders, whose interests are aligned with businesses’ long-term success. For 237 of Europe’s 500 most valuable listed firms, at least 10% of stock is not freely traded (not counting state-controlled enterprises). Plenty of those stakes are in the hands of founders or, this being the old continent, their descendants. For America’s top 500 the equivalent figure is 90.

The other advantage is low expectations. Frothy American valuations may tumble, especially if AI fails to boost productivity in line with investors’ hopes. Sagging European ones could improve merely by reverting to the mean. Bon courage!

This week’s fund find

‘Brain rot’ named Oxford Word of the Year 2024

Our language experts created a shortlist of six words to reflect the moods and conversations that have helped shape the past year. After two weeks of public voting and widespread conversation, our experts came together to consider the public’s input, voting results, and our language data, before declaring ‘brain rot’ as the definitive Word of the Year for 2024.

Our experts noticed that ‘brain rot’ gained new prominence this year as a term used to capture concerns about the impact of consuming excessive amounts of low-quality online content, especially on social media. The term increased in usage frequency by 230% between 2023 and 2024.

This week' interesting finds

Our holiday gift guide – 2024 edition

Don’t let the warmer weather fool you, winter is coming! That also means it’s time for a new list of gift recommendations by your EdgePointers. If you’re looking for something big, small or something in between, our list is full of fun (even efficient) ideas.

This week in charts

French risk premium

Nasdaq 100 vs. S&P 500

Performance by market-cap category

European equities

S&P 500 Index – calendarized performance

S&P 500 Index – trailing P/E ratio

S&P 500 Index – cap-weighted vs. equal-weighted

U.S. household investment allocations

Leveraged ETFs

Household interest payments

Chinese companies rush to tap convertible bond market

Chinese companies are issuing convertible bonds at a record rate this year, as they hunt for cheap forms of financing and a way to boost their offshore cash balances.

Ecommerce company Alibaba, which in May raised one of the largest convertible bonds on record at $5bn, and insurer Ping An, which raised $3.5bn in July, are among companies driving the rush to issue a form of debt that surged in popularity in western markets during the coronavirus pandemic.

Companies in China and Taiwan have issued $18.8bn of convertible and exchangeable bonds in 2024, surpassing the previous record of $18.7bn set in 2021, according to Citigroup data.

“The volume of issuance has increased dramatically,” said Rob Chan, head of Apac equity-linked origination at Citi. “You’re going to see quite a bit more activity going into next year.”

Convertible bonds allow the owner to turn them into a preset amount of equity, meaning that in effect they act as a call option on — or the right to buy — the shares.

The bonds are proving so popular among Chinese corporates because they offer a cheaper form of financing than conventional debt. Companies are able to raise money as much as 4 percentage points cheaper using convertibles compared with conventional dollar bonds, according to Chan.

Column chart of USD convertible bond issuance by Chinese companies ($bn) showing Chinese companies have issued record levels of dollar convertibles

With markets now expecting US rates to remain higher for longer under president-elect Donald Trump, this has become a particularly attractive option for chief financial officers.

Many firms are looking to raise money in order to carry out buybacks of their shares and raise the share price. Despite a recent stimulus-driven rally, China’s CSI 300 index is still down by about one-third since early 2021, with many foreign investors having deserted the market in recent years.

First 24-hour US stock exchange approved

A 24-hour stock exchange has been approved by US regulators, allowing expanded round the clock trading for the first time in any major market.

Start-up 24 Exchange, which is backed by Steve Cohen’s Point72 Ventures fund, was given the nod for a two-part plan by the Securities and Exchange Commission on Wednesday.

It will launch initially in regular hours, then expand to include a nightly back-of the-clock session between Sunday and Thursday once broader market infrastructure is in place.

While Treasuries and major currencies, such as the dollar, are traded almost continuously on weekdays, stocks have been something of a laggard because of tight rules designed to protect investors, and because of the complexities and time needed to settle trades.

But in recent years round-the-clock trading has been given a boost by the rise of retail investors who are keen to trade stocks outside working hours just as they deal in cryptocurrencies, which operate all the time.

Brokers such as Robinhood execute customer out-of-hours stock orders in so-called “dark pools” whose members trade among themselves, and whose prices are not disseminated across the market.

A regulated overnight exchange will mark a big change because it represents the “lit” market where trades and their prices become the official record. This is designed to help investors get the best price but may catch those asleep off-guard.

“Traders are most at-risk when the market is closed in their geographic location,” said Dmitri Galinov, chief executive and founder of 24X. “(We) will seek to alleviate this problem by facilitating around-the-clock US equities trading,” he added, describing the approval as a “thrilling development”.

This was 24X’s second application to the SEC, after a previous attempt in 2023 met with objections and queries. The approved version also modified an original plan to offer trading at weekends.

24X must now work with rival exchanges, which between them manage the consolidated “tape” of market prices, on how to manage and fund its expansion to cover trading between 8pm and 4am before it can launch its overnight session.

This week’s fun find

Making a Snickers bar is a complex science

For some people, including me, one piece stands out – the Snickers bar, especially if it’s full-size. The combination of nougat, caramel and peanuts coated in milk chocolate makes Snickers a popular candy treat.

As a food engineer studying candy and ice cream at the University of Wisconsin-Madison, I now look at candy in a whole different way than I did as a kid. Back then, it was all about shoveling it in as fast as I could.

Now, as a scientist who has made a career studying and writing books about confections, I have a very different take on candy. I have no trouble sacrificing a piece for the microscope or the texture analyzer to better understand how all the components add up. I don’t work for, own stock in, or receive funding from Mars Wrigley, the company that makes Snickers bars. But in my work, I do study the different components that make up lots of popular candy bars. Snickers has many of the most common elements you’ll find in your Halloween candy.

Let’s look at the elements of a Snickers bar as an example of candy science. As with almost everything, once you get into it, each component is more complex than you might think.

This week's interesting finds

 This week in charts

Mutual fund cash balances

Mutual fund sector weights

U.S. dollar dominance

U.S. equity fund flows

Private credit borrowers

Business development companies

MSCI World Index valuations

Before and after the Global Financial Crisis

S&P 500 cumulative returns

Nvidia total market cap

How is private credit weathering its first big rate hiking cycle?

Private credit — basically, bilateral corporate loans made by specialist investment funds rather than banks — has been one of the hottest asset classes over the past decade. Possibly the hottest. Depending on who you believe, there’s somewhere between $2tn and $3tn of money in private credit funds. 

The problem is that they make floating rate loans — typically priced at 5-10 percentage points above SOFR — and that can be a double-edged sword. Higher rates mean interest income balloons, but at some point it becomes a challenge for even a healthy, growing company to keep servicing its debts. And for many companies the weight of their debt burdens have almost doubled in just a few years. 

FT Alphaville has been sceptical over the argument that private credit now poses systemic risks, but we’ve long thought that there was probably a lot of dumb stuff happening in the space, given how hot it became. So how is private credit actually faring through the first proper interest rate hiking cycle in its life as a “proper” trillion-dollar-plus asset class?

By its nature it will be hard to know exactly how things are going, because private credit is, well, private. Moreover, the locked-up money of private credit funds means that there are a lot of ways for them to keep any distress hidden away. As the old saying goes, a rolling loan gathers no loss.

Even when there are outright defaults it will in many cases be handled discreetly, with no one outside the company and its lender knowing about it. It will therefore probably take many years before we discover the full extent of the pain.

The latest data indicates that private credit funds continue to report impressive returns, boosted by higher interest rates. In fact, MSCI’s data indicates that they notched up another 2.1 per cent gain in the second quarter, putting private equity in the shade.

However, there are other signs of deeper stress if you look closely enough. First and foremost, the growing use of “payment-in-kind” loans — where interest payments are rolled into the principal rather than paid to lenders — is a sign that all is not well in privatecreditland.

PIKs can be a perfectly acceptable tool in fast-growing companies that are better off investing in their core business than spending valuable cash on servicing onerous interest payments. But when a company that previously made interest payments in cash switches to a PIK loan it is not a great sign of health. And that is what appears to be happening a lot in the private credit ecosystem.

The problems can be compounded by the fact that private credit loans seem to do a lot worse than commonly thought when they go bad.

Private credit funds often tout how they can get restrictive, bespoke loan agreement clauses to protect themselves, but recoveries have lately actually been worse than for traditional syndicated loans, and only slightly better than from unsecured junk bonds.

To us, the massive drop in private credit loan prices from just three months before default to default us also noteworthy. It indicates that there is a lot of denial and fantastical marking going on in private credit, even as companies are clearly hurtling towards default.

This week’s fun finds

Santa came early for our little EdgePoint helpers this year. Thanks to all the partners who helped bring the spirit of the holiday season to our Toronto office.

LEGO ZH1 - Working and Functional 35mm Film Camera

The camera proudly features the classic LEGO logo from 1934, adding a nostalgic touch. The main lens is based on an existing magnifying piece, while I also developed a special pinhole lens that produces unique and stylish effects, as seen in the samples.

This week's interesting finds

This week in charts 

U.S. equity risk premium

Manufacturing construction

U.S. presidents and the S&P 500 Index

PMR portfolio defaults

Trailing return contribution by region

U.S. vs global equities relative performance

European stocks

U.S. government expenditures

U.S.-China trade

Patents by region

10-year U.S. Treasuries

AI’s math problem: FrontierMath benchmark shows how far technology still has to go

Artificial intelligence systems may be good at generating text, recognizing images, and even solving basic math problems—but when it comes to advanced mathematical reasoning, they are hitting a wall. A groundbreaking new benchmark, FrontierMath, is exposing just how far today’s AI is from mastering the complexities of higher mathematics.

Developed by the research group Epoch AI, FrontierMath is a collection of hundreds of original, research-level math problems that require deep reasoning and creativity—qualities that AI still sorely lacks. Despite the growing power of large language models like GPT-4o and Gemini 1.5 Pro, these systems are solving fewer than 2% of the FrontierMath problems, even with extensive support.

FrontierMath was designed to be much tougher than the traditional math benchmarks that AI models have already conquered. On benchmarks like GSM-8K and MATH, leading AI systems now score over 90%, but those tests are starting to approach saturation. One major issue is data contamination—AI models are often trained on problems that closely resemble those in the test sets, making their performance less impressive than it might seem at first glance.

Mathematical reasoning of this caliber demands more than just brute-force computation or simple algorithms. It requires what Fields Medalist Terence Tao calls “deep domain expertise” and creative insight. After reviewing the benchmark, Tao remarked, “These are extremely challenging. I think that in the near term, basically the only way to solve them is by a combination of a semi-expert like a graduate student in a related field, maybe paired with some combination of a modern AI and lots of other algebra packages.”

Mathematics, especially at the research level, is a unique domain for testing AI. Unlike natural language or image recognition, math requires precise, logical thinking, often over many steps. Each step in a proof or solution builds on the one before it, meaning that a single error can render the entire solution incorrect.

This makes math an ideal testbed for AI’s reasoning capabilities. It’s not enough for the system to generate an answer—it has to understand the structure of the problem and navigate through multiple layers of logic to arrive at the correct solution. And unlike other domains, where evaluation can be subjective or noisy, math provides a clean, verifiable standard: either the problem is solved or it isn’t.

Ivy League endowments struggle with private market downturn

The drawn-out downturn in private market returns is hitting one group of investors especially hard: Ivy League university endowments.

Leading US university endowments, many of which allocate outsized portions of their portfolios to private equity and venture capital, have underperformed the university average for the second year in a row, with prominent ones like Yale and Princeton lagging far behind their smaller peers, as the once lucrative asset class suffers from a plunge in dealmaking and stock listings.

Top endowments have long used aggressive exposure to private investments in pursuit of excess returns they believe are out of reach through public markets. Now, as those investments have yet to pay off, some large endowments like Princeton have issued bonds to meet funding needs, according to the New Jersey Educational Facilities Authority.

Six of the eight Ivy League universities reported returns in the 12 months ended June that stood below the higher education average of 10.3%, according to Cambridge Associates, an investment consultancy. Yale and Princeton fared the worst by respectively yielding 5.7% and 3.9%.

The underperformance follows an even weaker 2023 when no Ivy League school was able to match the 6.8% industry average. Yale gained 1.8% while Princeton lost 1.7% last year. Ivy League endowments, which are among the wealthiest in the world, reported mediocre returns due in large part to their aggressive bets on the illiquid yet high return alternative investments that had fallen victim to the prolonged high interest rate environment.

And the paltry returns are coming at a time when public markets have soared, with the S&P 500 equity index up 57 per cent in the last two years and interest rates on bonds frequently returning more than 4 per cent.

Most Ivy League endowments had earmarked more than 30%, and in the case of Yale and Princeton at least 40%, of their assets to PE and VC by the first half of this year, according to Old Well Labs, a consultancy. In contrast, a survey of 121 university endowments by Cambridge Associates found their allocation to PE and VC had averaged 22% over the same period.

The struggle by elite university endowments to generate excess returns has raised fresh concerns about their investment model that has been emulated by asset allocators from sovereign wealth funds to community foundations around the world.

This week’s fun finds

The Shipwreck Detective

Nigel Pickford has spent a lifetime searching for sunken treasure—without leaving dry land.

This Atlantic wreck was beguiling. An R.O.V.—a remotely operated vehicle, connected by a cable to the exploration vessel—was sent down to take a closer look. It was the remains of an old wooden sailing ship, stuffed with cargo, lying some six thousand metres below the surface—much deeper than the Titanic. The contents seemed to be Asian in origin: intricate lacquered screens and bolts of cloth, thousands of slender rattan canes, and an extraordinary array of porcelain, all preserved in the darkness of the ocean. “It was just cascading in these spills down around the slopes and undulations of the seabed,” [marine archaeologist Mensun] Bound recalled. “And there were barrels there, which hadn’t been opened. They were sitting there intact.”

There is something almost dangerously tantalizing about an undiscovered shipwreck. It exists on the edge of the real, containing death and desire. Lost ships are lost knowledge, waiting to be regained. “It’s like popping the locks on an old suitcase and you lift the lid,” Bound told me. Bound grew up on the Falkland Islands in the nineteen-fifties. In 2022, he found the Endurance, Ernest Shackleton’s polar-exploration ship, under the ice of the Weddell Sea, off Antarctica. “On a shipwreck, everything, in theory, that was there on that ship when it went down is still there,” he said. “It’s all the product of one unpremeditated instant of time.”

What was the ship? There was an obvious person to ask. In 1993, Bound had been searching for the remains of a nineteenth-century English trading vessel, the Caroline, in the Straits of Malacca, in Southeast Asia, when he and his colleagues pulled up a much older, bronze cannon instead. The cannon was marked with a relief of a sailing ship, the name of the Dutch East India Company, and a date, 1604. “I had no idea what it was doing there or anything,” Bound said. But he had heard of a self-taught shipwreck researcher, based in England, who was said to have an unusually broad grasp of the world’s lost vessels. Bound contacted the researcher, Nigel Pickford, by satellite phone from the ship.

Within twenty-four hours, Pickford replied, saying that Bound and his team were on the site of the Battle of Cape Rachado, which was fought between Portuguese and Dutch fleets over several days in August, 1606. The cannon probably belonged to a ship called the Nassau. “He said, ‘O.K., you found one wreck by itself,’” Bound recalled. “‘There should be three wrecks nearby.’ And he even gave us a rough direction.”

This week's interesting finds

 This week in charts

P/E ratios

Berkshire’s cash levels

EM vs. U.S. equities

Valuations by country

Post-election day returns

U.S. dollar impact by sector

China’s % share of global commodity demand

Immigration and unemployment rates

Earnings impact on 1 percentage point change in tax rate

Primary budget deficit

Wall Street frenzy creates $11bn debt market for AI groups buying Nvidia chips

Wall Street’s largest financial institutions have loaned more than $11bn to a niche group of tech companies based on their possession of the world’s hottest commodity: Nvidia’s artificial intelligence chips.

Blackstone, Pimco, Carlyle and BlackRock are among those that have created a lucrative new debt market over the past year by lending to “neocloud” companies, which provide cloud computing to tech groups building AI products.

Neocloud groups such as CoreWeave, Crusoe and Lambda Labs have acquired tens of thousands of Nvidia’s high-performance computer chips, known as GPUs, that are crucial for developing generative AI models. Those Nvidia chips are now also being used as collateral for huge loans.

The frenzied dealmaking has shone a light on a rampant GPU economy in Silicon Valley that is increasingly being supported by deep-pocketed financiers in New York. However, its rapidly growth has raised concerns about the potential for more risky lending, circular financing and Nvidia’s chokehold on the AI market.

The $3tn tech group’s allocation of chips to neocloud groups has given confidence to Wall Street lenders to lend billions of dollars to the companies that are then used to buy more Nvidia chips. Nvidia is itself an investor in neocloud companies that in turn are among its largest customers.

Critics have questioned the ongoing value of the collateralised chips as new advanced versions come to market — or if the current high spending on AI begins to retract.

The future value of Nvidia’s chips being used as collateral for loans has also been called into question. Leasing contracts that neoclouds have with tech groups will begin to expire in the next few years, probably resulting in a glut of chips available on the market.

Listed tech giants which have spent billions on AI infrastructure, are also under pressure to produce significant returns. In June, David Cahn, partner at venture firm Sequoia Capital, said there was a $500bn gap between the revenue expectations implied by technology companies’ AI infrastructure buildout, and actual revenue growth in the AI ecosystem.

Neocloud lenders, however, are betting on AI’s continued advancement.

Solar Panel-Backed Bond Deals Are Heading for Europe’s Market

European investors accustomed to buying repackaged mortgages and car loans are getting another type of asset-backed security to invest in: bonds backed by solar panel loans.

Perfecta Energia and HomeTree Marketplace Ltd. are both planning to sell repackaged solar panel loans in the public debt market, according to executives at the companies. They would follow a successful deal by Enpal GmbH, which recently became the first company to sell a solar panel-backed security in Europe’s broadly-syndicated market. The German renewables firm also plans more issuance in future.

The deals are set to open up a new frontier for asset-backed debt in Europe, where securitization has been used for years to sell mortgages, car and consumer loans to investors. Such deals package up loans into a new instrument and sell them via a special purpose vehicle, taking risk off the company’s balance sheet. They’re also seen as a way to drive adoption of solar panels by lowering upfront costs for consumers.

While demand for Enpal’s deal was strong, the nascent nature of the asset class means that risks are hard to measure, leaving some questions around this type of debt. Ultimately, the technology that these ABS is based on is still in its infancy, and there are issues with both the lack of sun and power storage facilities in Europe.

Investors assessing the new asset class may also look to the US, where solar-panel backed deals by renewables companies have been growing for some time.

Still, the market for solar ABS in the US is currently going through a somewhat turbulent time, with SunPower Corp., one of the country’s top five residential solar installers, filing for bankruptcy earlier this year and raising concerns about the industry at large. Victory for Donald Trump in the US presidential election also means that the US will likely prioritize fossil fuels over renewables in coming years, potentially hurting demand for solar panels.

But European incumbents are hoping that investors take into account differentiating factors between the two regions.

This week’s fun finds

The EdgePoint film crew made their way to the TIFF Lightbox this week. Our inspiring and unique company culture resonated with a couple of fellow moviegoers. It made such an impact that they wondered when the next outing would be and asked if they could join. Good times had by all.

Painting With Thread: New Work by Cayce Zavaglia

A few years ago Cayce “discovered” the back of her work – a chaotic network of thread that forms as she works on the front. This show features the BACK side (or “verso”) to a greater degree, recognizing the beauty of these happy accidents and the metaphor of our private messy inner selves.