Podcast Summary
Market shifts and challenges for growth investors: Despite reaching new all-time highs, 2021 proved challenging for most growth-oriented fund managers. Gavin Baker's Atreides Management experienced alpha in 2020 due to market dislocation, but the average tech or consumer-oriented growth stock is likely 40-65% off its all-time high.
Key takeaway from this episode of Invest Like the Best is that the company Atreides Management, led by Gavin Baker, experienced an extremely alpha-rich year in 2020 due to the significant market dislocation caused by the COVID-19 pandemic. However, 2021 proved to be a challenging year for most growth-oriented fund managers, despite the market reaching new all-time highs. Gavin noted that the average tech or consumer-oriented growth stock below $100 billion in market cap is likely between 40% and 65% off its all-time high. The episode also showed the importance of high-quality fundamental data, which is provided by sponsor Canalyst, in the investment process. Overall, the conversation highlighted the significant market shifts and challenges faced by growth investors in the current economic climate.
Market compression challenging smaller companies: Despite market compression, tech subsectors like semiconductors, software, and internet offer potential opportunities due to continued growth and maturity of underlying fundamentals, despite potential earnings challenges in the internet sector.
The market's significant compression of multiples, particularly for small, mid cap companies, has led to a challenging year for many investors, especially those not heavily allocated to a few dominant tech stocks like Google, Microsoft, Nvidia, and Tesla. Multiples have returned to 2018 levels, but the underlying fundamentals of software and internet companies have continued to grow and mature, making the current market environment potentially encouraging for investors. However, it's important to note that the internet sector may face disappointing earnings in the upcoming season due to normalization from COVID-induced trends, while software companies are expected to continue their growth. The current market conditions offer an interesting opportunity set in the major tech subsectors of semiconductors, software, and internet.
Historically, stocks perform well after first rate hike: Despite current high inflation and economic slowdown, history shows stocks tend to perform well post-first rate hike. However, this tightening cycle may differ due to unique economic conditions.
Despite the current focus on inflation and the Federal Reserve, history shows that stocks tend to perform well after the first rate hike. However, the current inflation rate of 7% and the rapid response from suppliers to address supply chain issues do not make this tightening cycle the same as previous ones. The economy is also slowing down, which could lead to a significant shift in consumer spending from goods to services. The massive supply response and the slowing economy could set the stage for a major shift in the market, making it crucial for investors to stay informed of macroeconomic trends.
Economy returning to normal with uncertainty around wage inflation: The economy is recovering, but uncertainty remains around wage inflation and its potential market implications. Reversing pandemic-induced anomalies like debt jubilee and remote work add to the complexity of forecasting.
The economy is expected to normalize as services spending returns to trend and inflationary pressures from sectors like automobiles dissipate. However, wage inflation remains uncertain and could have significant market implications if it persists. The speaker believes that many of the pandemic-induced economic anomalies, such as the debt jubilee and widespread remote work, are reversing, but the future is inherently uncertain. Despite the challenges of forecasting, it's essential to consider the potential implications of these trends for the economy and markets. The speaker emphasizes the importance of humility and acknowledges the limitations of predicting complex systems like the economy. Even the Federal Reserve, with its vast resources and expertise, struggles to forecast the economy more than six months out.
Wage Inflation's Impact on Stock Market ROE and ROIC: Wage inflation can decrease ROE and ROIC, making equities less attractive vs bonds, but tech companies with high ROICs may outperform
Wage inflation can negatively impact the stock market, especially when it comes to the return on equity (ROE) or return on invested capital (ROIC) of companies. This is because inflation can cause an increase in asset values, which can decrease the expected return on investment for equity holders. Buffett's first principles thinking explains this concept well, as inflation can lead to a decrease in the gap between a portfolio's ROE or ROIC and the yield on government bonds. This decrease in the gap can make equities less attractive relative to bonds. However, it's important to note that not all sectors will be equally affected by wage inflation. For example, tech companies, which are asset light and have high ROICs, may perform better in an inflationary environment compared to asset-heavy companies that had poor performance during inflation in the past. Therefore, it's crucial to analyze a company's revenue, gross profit, and free cash flow per employee to understand its resilience to wage inflation. In summary, wage inflation can decrease the expected return on equity investments, but the impact may vary depending on the sector and individual company characteristics.
Tech mid-caps may face further market corrections due to wage inflation and semiconductor industry consolidation: Wage inflation could lead to further ROE compression for tech mid-caps, while semiconductor industry consolidation has resulted in monopolies or duopolies and increased importance due to AI demand
The tech sector, specifically mid-cap growth names, may have already experienced the brunt of market corrections due to their multiple compressions. However, the persistence of wage inflation could lead to further compression of return on equities (ROEs) and potential pain for broader equity markets. The semiconductor industry, a key subsector of tech, has seen significant consolidation over the last 15 years, resulting in monopolies or duopolies in various subsectors. This consolidation has been driven by network effects, economies of scale, and the industry's inherent tendency towards monopolies. The demand for semiconductors has structurally increased due to secular growth and the rise of artificial intelligence, which requires massive amounts of compute and memory. As a result, semiconductors have grown at a multiple of global GDP and have become a secular growth industry. The industry's consolidation and the increasing importance of semiconductors in various sectors make it a critical area to watch.
Growing Importance of Semiconductors and Software Industries: The semiconductor industry's importance grows with AI and electric vehicles, but it's cyclical and currently facing inventory challenges. Software sector saw pandemic growth but volatility, with strong fundamentals but debated valuation.
The semiconductor industry is becoming increasingly important due to the growth of AI and the shift towards electric vehicles, leading to a more compute-intensive world. However, the industry remains cyclical and is currently experiencing a significant inventory cycle, which could lead to decelerating demand and potential challenges for companies. The software sector, on the other hand, has seen incredible growth during the pandemic but also experienced significant volatility. While the fundamentals of software companies remain strong, the industry's valuation relative to semiconductors is a topic of debate. Overall, it's essential to approach both sectors with caution and a deep understanding of their unique dynamics.
From Skepticism to Belief: The Superiority of Software Investments: Software investments offer superior cash flow generation and infrastructure software companies are particularly valuable due to their essential services for tech giants. Companies must differentiate themselves to avoid being overshadowed by in-house solutions from larger competitors.
The speaker has had a change of heart about the future potential of software companies compared to traditional debt. He was previously skeptical but now sees software as a superior investment due to its cash flow generation capabilities. He also has a bias towards infrastructure software companies, as they provide essential services for other tech giants and are less vulnerable to the ease of building custom applications. The speaker believes this trend will continue into the future, as more companies move towards cloud computing and infrastructure software becomes increasingly valuable. He uses the analogy of the scorpion and the elephant to illustrate how even well-intentioned companies like Amazon Web Services (AWS) may try to build in-house solutions instead of buying, ultimately leading to the demise of smaller companies. Therefore, it's crucial for software companies to be aware of this potential threat and differentiate themselves through unique technology or offerings.
Cloud providers collaborate with third-party software providers: Cloud providers expand reach, cater to on-premises businesses, and tap into smaller software companies' innovation through collaboration.
Cloud providers like Google, Microsoft, and Amazon are shifting their strategies to embrace third-party infrastructure software providers, recognizing the value of collaboration and the innovation happening outside their own offerings. This change in approach allows cloud providers to expand their reach, cater to on-premises businesses, and tap into the growing market of smaller software companies that cannot develop their applications on public clouds. Furthermore, the speaker expressed a belief that the software market will not be an oligopoly, and the success of independent software providers is no longer hindered by the size and scale of the industry due to advancements in AI. Additionally, the speaker touched upon the differences between internet and software companies, noting that ecommerce, advertising, and subscription-based businesses are more GDP sensitive and are currently experiencing a slowdown, while software companies are less affected by economic conditions.
Tech Industry Growth Driven by Software and Subscription-Based Businesses: The tech industry is recovering from the pandemic and growing due to software and subscription-based businesses, with recurring revenues and pricing power. The metaverse trend, including companies like Meta and Microsoft, is a long-term growth area.
The resurgence in spending in the tech sector, specifically in software and subscription-based businesses, is driving growth in the industry, while the internet as a whole is still recovering from the COVID-19 pandemic. The speaker emphasizes the similarities between various business models, such as franchises and software companies, due to their recurring revenues and pricing power. The metaverse trend, represented by companies like Facebook (now Meta) and Microsoft's acquisition of Activision, is seen as a long-term growth area as technology companies aim to own the digital spaces where people spend their time. The speaker expresses excitement for the future of metaverses, particularly in the realm of gaming, and believes that the stocks of relevant companies have not yet fully reflected their potential.
Tech Giants and Older Industries in the Metaverse: Tech giants and older industries stand to benefit from the shift towards digital platforms, particularly the metaverse, with Microsoft, Apple, and companies controlling operating systems like Google expected to lead. Retailers and brands integrating online and offline operations and private equity investments in tech assets also contribute to the trend.
Tech giants like Microsoft, Apple, and companies that dominate older industries are well-positioned to benefit from the shift towards digital platforms, particularly the metaverse. Microsoft, with its control of Windows PCs, HoloLens, and first-party video games, is expected to have significant revenue from AR and VR. Older companies, which spend a smaller percentage of their revenue on modern platforms, are also poised to grow as they adapt to the digital age. The metaverse is expected to be the next major platform, and companies that control the operating systems, like Apple and Google, are likely to be key players. Retailers and brands that have successfully integrated their online and offline operations are also in a good position to benefit from the ongoing digital transformation. Private equity firms are also pouring billions into tech assets, ensuring a floor for their value. The world's largest ecommerce companies are even opening physical stores, recognizing the value they bring when integrated with modern IT systems. Overall, the trend towards digital platforms and the metaverse presents significant opportunities for both tech giants and older industries that can adapt.
Trend toward private markets driving higher returns: The shift to private markets due to earnings growth slowdown and illiquidity premium may lead to higher returns for investors, despite challenges in understanding the handoff between private and public markets.
The current trend toward private markets and the resulting illiquidity premium may continue to drive higher returns for investors, as the system as a whole favors less frequent marks and the need to deploy larger amounts of capital. The speaker argues that this shift is due in part to the fact that earnings growth, a key driver of stock returns, has not seen the same demand impulse as during the industrialization of China in the early 2000s. Additionally, the speaker notes that the disconnect between private and public market valuations creates a challenge for understanding the handoff between these stages and the potential impact on private equity and venture capital.
Public market influences private venture valuations: Persistent public market strength or weakness impacts private valuations, with angels, seed-stage to growth investors, and big multistage firms playing distinct roles in the ecosystem, ultimately benefiting LPs
The public market significantly influences private venture valuations. Public market weakness or strength, if persistent for an extended period, will cause private valuations to cool off or recover, respectively. Angels, seed through b specialists, and big multistage investors are the main market participants in the venture scene, each bringing unique value. Angels provide early funding and expertise, seed through b specialists add value and credentialize companies, and big multistage investors compete as crossover investors, offering long-term commitment. This evolving competitive landscape benefits Limited Partners (LPs) by fostering a more efficient and effective venture ecosystem.
Cross-functional investment strategies: Making small investments early and monitoring progress: Investors can maximize returns by adopting a cross-functional approach, making small initial investments, monitoring company progress, and preemptively investing when performing well, enabling perfect communication and information with the CEO.
The investing landscape is evolving towards a more cross-functional approach, with firms and individuals adopting multistage investment strategies. Antonio, a mentor and value-added investor, emphasizes the importance of this approach, which involves making small investments early, monitoring the company's progress, and preemptively investing when the company is performing well. This strategy allows for perfect information and communication with the CEO, enabling timely investment decisions and maximizing returns. As the world moves towards more accessible public markets, competition for alpha increases, making it crucial for investors to have a deep understanding of a company's growth trajectory and potential disruptions. Cross-functional investment strategies offer advantages for both public equity investors and venture capitalists, allowing for a more comprehensive assessment of risks and opportunities.
Public vs Private Equity: Different Skills and Mindsets: Public equity: rationality when wrong, capturing big outcomes. Private equity: building relationships, adding value, strong communication skills, access, and complexity management.
Public equity investing and private equity investing require different skill sets and mindsets. For public equity investors, being rational when wrong is crucial due to the high number of mistakes and the importance of capturing big outcomes. In contrast, private equity investing involves building relationships with founders, adding value, and having strong communication skills. Public equity investing is more about buying and selling stocks, while private equity investing requires access and the ability to add value. The process of private equity investing is also more complex and requires a different approach compared to public equity investing. Ultimately, the ability to succeed in either market depends on an individual's unique strengths and capabilities.
Persuasive skills needed in private investing: Private investing demands persuasive skills due to the need for agreement between parties, unlike public investing. Embrace learning from failures and the value of sci-fi books in inspiring persistence.
Private investing requires more persuasive skills compared to public investing. This was an interesting realization that came up during a conversation with an eight-year-old. The child pointed out that in private investing, both parties need to agree, making it necessary to be convincing. This sales job aspect is less present in public investing. Additionally, the speaker shared some of their favorite sci-fi books, including "Dune" and "The Wizard of Earthsea," which serve as touchstones during challenging periods in their investing career. These books emphasize the importance of acknowledging the role of ego in failures and the value of learning from mistakes. The speaker also expressed gratitude for the impact of the podcast on inspiring the next generation of investors. They noted that young investors today are impressive and well-equipped due to accessible resources like podcasts. Overall, the conversation highlighted the importance of persistence, learning from mistakes, and the power of sharing knowledge.
A new data manipulation tool for fundamental investors: Candace, a new product from Canalys, streamlines data analysis for fundamental investors by making data manipulation and interpretation more accessible and efficient, ultimately helping investment teams make informed decisions.
Canalys' new product, Candace, is a data manipulation tool designed to make data analysis more accessible and understandable for fundamental investors. Named in homage to the popular Python library Pandas, Candace allows users to easily manipulate and interpret data, serving it up like Excel. At Neuberger Berman, the data science team uses Candace to provide curated insights to investing teams, helping them make informed decisions by understanding the relevance of the data to the specific investment thesis. Before Candace, this process involved manually inputting data and calculating earnings changes, which was time-consuming and inefficient. Now, with Candace, these calculations can be made quickly and easily, allowing the team to focus on identifying insights worth sharing. Overall, Candace represents a significant step forward in the intersection of data science and fundamental investing, making complex data analysis more accessible and actionable for investment professionals.
Automating Earning Sensitivity Calculation with Python: Automating processes with Python can significantly reduce errors and save time, even if the automated process is slower than desired.
Automation can significantly reduce errors and save time compared to manual processes. In the discussed use case, it took three days to manually calculate earning sensitivity, but after Jed implemented the functionality into Canvas using Python, the process now takes only a couple of minutes with no errors. Although the automated process is slower than desired, the time saved and accuracy gained make it a worthwhile investment. This example highlights the power of automation and the importance of continuously improving processes for greater efficiency and accuracy. To learn more about this topic and other insights from the interview with Ricky Sandler, visit joincolossus.com for complete episodes, transcripts, show notes, and resources. Don't forget to sign up for Colossus Weekly, our newsletter, to receive the key ideas, quotations, and top content from each episode delivered straight to your inbox.
