262. How to profit from innovative companies

22 June 2023 (pre-recorded 14 June 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Today we’re focusing on innovation. We look closely at Artificial Intelligence, the Metaverse and FinTech and our guest tells us why it’s important to avoid getting caught up in the hype – why you need to understand how companies can benefit from the developments.

I’m Staci West, and today I’m joined by Ian Mortimer, co-manager of the Guinness Global Innovators fund. Ian, thanks for joining us.

Ian Mortimer (IM): Pleasure. Thanks for hosting.

[INTERVIEW]

SW: As the name suggests, this fund is all about finding and investing in innovative and disruptive businesses, which all sounds very exciting, but how do you actually make money from these types of companies?

IM: Yeah, so it’s a very good point, and I think the word innovation can sometimes throw people. I think it means different things to different people ultimately. But what we are really trying to do effectively is, we’re trying to find companies that can successfully grow sustainably over the longer term and therefore outperform the market. 

We believe the best way to find some of these companies is to start by looking for secular growth themes or areas of innovation within the market, and then find companies that have exposure to those themes. The problem is, if you just stop there, the big risk is you sort of follow the story or the hype cycle – it’s very exciting – but actually is it a very good investment? So, from that initial stage, we then apply quality filters to make sure that this is a strong business, this is a business that’s profitable, a business where we can actually understand how the company’s making money and what that might look like going forward.

The next stage really, and the bigger risk for investing in growth, is that you pay up too much for the future growth. Growth is pretty uncertain. It mean reverts very quickly. So, what we are then trying to do is apply a valuation discipline. So, buy the interesting areas, buy the good companies where they have long pathways for growth, but be aware you want to sort of limit your risk, if you like – the option price you are paying for that future growth – if you can limit it, then hopefully, you’ve got a better potential for a rerating alongside that earnings growth you are looking for. And that’s ultimately what we’re trying to do within the portfolio.

SW: And you mentioned there these stories that come with some of these themes. There’s been a lot of headlines recently around artificial intelligence or AI, which is a theme in this fund. So, what are your thoughts on all of the headlines? Is AI beneficial for investors and, you know, society as a whole? Or are you more worried about some of the risks and this rapid development that we’ve seen? Maybe talk us through that theme a little bit more, and then if you have any examples that you can give us?

IM: Yeah, absolutely. I mean, I think you’re completely right. I mean, it’s sort of, it’s very much sort of hit the zeitgeist over the last, well, really since the ChatGPT, and then I think it really accelerated post the Nvidia [Corporation] results where it wasn’t necessarily just a good idea, it was actually being seen in company profitability. And that was a sort of a step change, I think, in what markets were reacting to. 

We’ve also seen, you know, over the kind of earnings cycle more and more companies therefore talking about AI and how it’s linked to what they’re doing. I think some of that may be somewhat speculative potentially, but you can understand why companies are doing that. And ultimately, the bigger thing for markets is that it has driven a large proportion of the positive returns we’re seeing today. So, I think the concentration of returns is in a handful of stocks ultimately. 

And we did some analysis ourselves where we sort of created a kind of ‘artificial intelligent’ basket, if you like, and we were able to look at what that performed like relative to the benchmark and what the benchmark would’ve performed without those single stocks. It’s really, you know, the benchmark would’ve been about flat and those type of stocks would’ve been up sort of 16 – 20%. So, it’s very interesting how that’s evolved. 

I think the reality is that it does appear to be a very, very important new technological idea that will have significant impacts across large swathes of both businesses and I think individuals, whether that’s jobs, productivity and so on and so forth. And I think like most new technologies, it will have significant benefits and there’ll be concerns about how it’s used. 

I think the bigger thing though as well, is to remember that it is not a new thing. It is really that the the ideas and the processes, even if it’s just large language models and so forth, have been around for a long time, it’s the ability to actually execute that and do those computations. So, I think from a sort of moral standpoint, I don’t think we’re necessarily looking at it as maybe the wider society thinks about, but we obviously recognise as much as other people do, the pros and cons. 

But from a investment perspective, I think the first thing is you have to take a bit of a step back and remember what I was saying before, don’t buy just … buy the story; I think you’ve really got to understand, you know, what this is doing for individual companies. And the way we’ve already had exposure to it in the portfolio, is ultimately through businesses that are already doing quite well. So, it’s sort of an additional benefit to what the company is [already] doing, as opposed to kind of the next big potential thing, you know, the startup or whatever, where that’s very, very uncertain. 

So, companies like Nvidia, we’ve held in the portfolio – we’ve actually owned Nvidia for over a decade. That’s clearly been a very important driver of that share price. We also have a number of semiconductor stocks, things like Taiwan Semiconductor [Taiwan Semiconductor Manufacturing Company Limited], also equipment manufacturers like Applied Materials [, Inc.] Lam Research [Corporation]. We see the demand drivers for their products increasing and being much broader than it was historically. So, maybe these businesses will be a bit less cyclical. 

Obviously, some of the big cap companies like Alphabet and Microsoft are benefiting. And I guess a lot of what I’ve just described are kind of the enablers, kind of the picks and shovels or the kind of computational power, if you like, to provide these services. 

And on the other side, you’ve got more of the integrators, the sort of Adobes [Adobe, Inc.] of this world or Salesforce [Salesforce.com, Inc.] that we also own or Intuit [Inc.], whereby they’re kind of hopefully going to successfully use this new technology to improve their services, grow their revenues and ideally grow their margins alongside.

SW: Last I checked, Meta was your largest holding. Can you tell us more about that and maybe some of the opportunities in the metaverse?

IM: Yeah, so I mean, without trying to correct you, yes, I think it probably technically was our largest holding, but we do run a 30-stock equally-weighted portfolio, so I think that’s quite different. So, we don’t really have sort of our top 10 holdings, if you like. They’re more reflective of maybe stocks that have been performing better over the near-term. And clearly Meta has had an extremely strong run this year from, I might add a relatively low base, having underperformed quite significantly up to that point. So yeah, so it’s definitely one we own and we see very good value in it. 

I think it’s worth noting, from a metaverse perspective, I think this is to some extent what the market was worried about; huge spending on this new area that wasn’t yet shown to be kind of profitable or ‘use’ cases if you like.

I think the way we were looking at it was, that’s an interesting area, but actually its core business remains extremely attractive from an investment perspective, in terms of the advertising revenue and the high margins and essentially, low asset requirements that that business likes. So, that’s really our sort of main reason for holding onto the stock. And then clearly they’ve done a good job of listening to the market and focusing more on margins of profitability. 

And so, I think where that leaves you is – in terms of the metaverse – I think you have a good optionality on an area that could be potentially very attractive. Clearly, you know, companies such as Apple [,Inc.]coming into that sort of market as well is going to be beneficial. And I think really, it is trying to understand how that might then play out if you like – and I think that’s often the case in lots of these types of technologies. It can be quite hard to see in the short term, but for us, in terms of the investment perspective, you’ve got a really great core business that I think is very attractively valued, and I think now you’ve got some optionality on some growth areas because they’ve been less profligate in terms of their spending and that carries less risk.

SW: And another theme in this fund is payments and fintech. So, maybe you can tell us a little bit more about this theme kind of in general, but then also specifically, has the recent banking crisis had any impact on either any of your holdings or just the innovation in this kind of theme or sector in general?

IM: Yeah, so when we’re sort talking about payments and finech, I mean, the themes we are looking at are quite broad ultimately. You know, we’re not putting ourselves out there to be spotting the next big trend before anyone else sees it. For us, it’s all about putting yourself in a position where the companies you’re investing in have good pathways for growth. So, often they’re more established and the things we’ve just been discussing are, you know, probably well known to many people, particularly on the investment side. 

I guess in terms of what we’re seeing is really, you know, the change in sort of demographics, is clearly the change in a cashless society. And then, to some extent, it’s also the sort of plumbing around that. You know, we have avoided any investments in sort of specific kind of crypto, Bitcoin-type companies or products. I think that would absolutely fit into our bucket of being questionable in terms of both from a regulatory perspective, [which] would be a worry, and also that the sort of speculative nature of what those business models may look like in the future. And really, we’ve been looking at more areas such as, you know, companies you’d understand, sort of things like PayPal [Holdings, Inc.], things like Visa [Inc.] and MasterCard [Inc.]. Two examples, Visa and MasterCard, where really, they have essentially an oligopoly on the payment processing ecosystem. And that clearly makes them a very sort of strong competitor and therefore, an interesting investment. 

At the same time, we also own a company called Intercontinental Exchange [Inc.]. ICE is the ticker. So, that’s an exchange group. But they … exchange groups are, I think, interesting investments in general, in terms of their business models; difficult to replicate, quite sort of a high barriers to entry but also essentially very asset light. So, I think that kind of is attractive. But I think latterly, those types of businesses have really benefited from essentially owning lots of data. So, many of these businesses are sort of providing data sets using that data to make further analysis. And I think, you know, going back to that first point, we were talking about AI, clearly large data sets are something that could potentially be a lot more attractive going forward. 

So, there’s lots of ways to look at the financial space. And I think that’s sort of how we are looking at it. And generally speaking, low exposure to the more kind of traditional sort of banking sector. But we don’t see the characteristics that, you know, we are looking for in our kind of quality growth portfolio.

SW: And innovation has been a tough place in the last 18 months or so for investors. So, what’s your long-term outlook for the area?

IM: Yeah, so I think again, I would sort of come back – sort of a broken record slightly! I think when people say innovation, I think they often think kind of disruptive, small companies. And you are absolutely right that we saw, post-pandemic, where we saw effectively I think a bubble – I think it’d be fair to describe it as – many of these sort of early stage kind of pre-earnings, you know, get-big-quick revenue-type growth, what’s the total addressable market-type companies, really become extremely overvalued, relative to their kind of core businesses. And therefore going back to that idea of paying up a lot for the prospective growth profiles these companies may have, which clearly then unwound. And we see that, you know, across markets again and again, particularly in our areas, things like biotech, things like 3D printing for example, have been essentially areas that have got bid up far too far.

And I think it was really those specific areas, those, I’m going to call them more speculative growth companies, that really suffered most over the last, particularly last year. I think they had a little bit of a respite as we came into the beginning of this year. And then that quickly unwound once more as we came through some of those more tricky markets of February with the Fed [Federal Reserve] talking about keeping high rates for longer. And then clearly the kind of the worries around the exogenous shock of the kind of the US banking crisis. 

So, I think there’s certain areas where they probably got bid up too far. I think that the changing interest rate regime on a sort of higher duration asset if you like – in terms of those cash flows being much further out and/or if you’re non-profitable yet, kind of no cash flows – were, you know, … that changes of interest rate regime had a big impact. It was a double header if you like; it was both they’d got ahead of themselves in terms of what the market was expecting for their future growth, which then disappointed, and then you have this valuation derating, which is the sort of the two things that work in combination to fell sort of share prices that go up too far. 

What you’ve then got alongside that is just sort of broader growth companies, as in relative to value companies in simplistic terms. And clearly, they were also affected by that change in interest rate regime and the market, you know, last year very much punished growth if you like. 

That has then changed somewhat; I think a lot of those kind of quality growth companies, particularly those where I think you can make the case for the sort of secular growth – growth through a kind of lower growth environment, maybe not necessarily as affected by sort of recessionary pressures – have started to be rewarded again and I think there was an element of all growth companies falling and maybe the differentiation between those kind of good quality growth companies and others is only starting to be rewarded now. 

And then you clearly had, in the last sort of five or six weeks as we talked about, you know, that massive benefit from kind of exposure to AI, which I think we’ve got to be very cautious on in terms of how quickly and how far some of these businesses have been rerated. 

So, for us, I think, you know, we would definitely argue over, you know, you should be thinking about investing in growth over long periods. We think quality growth companies that compound profitably and successfully are those where you are trying to limit your risks, whether that’s on the story or that’s on the kind of what you’re paying for the future growth, I think still offer an attractive investment proposition as part of a client wider portfolio.

SW: Ian, that’s been great. Thank you so much for joining us today and walking us through a few of those themes and also just giving your outlook on innovation in general.

IM: Pleasure. Thanks very much for having me.

SW: Guinness Global Innovators fund will be of particular interest to investors who are interested in innovation and big themes and, importantly, how to spot the good companies that can benefit from the changes.. As Ian highlighted in this episode, the fund will naturally have a heavy bias in favour of the growth style of investing. For more information on the Guinness Global Innovators fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.