WEBVTT - The Perpetual Hunt for ‘Alpha’ 0:00:02.720 --> 0:00:18.320 Bloomberg Audio Studios, Podcasts, Radio News. Welcome to Maren Talks Money, 0:00:18.320 --> 0:00:21.160 the podcast in which people who know the markets explain 0:00:21.239 --> 0:00:21.880 the markets. 0:00:21.960 --> 0:00:23.120 I'm Maren thumset Web. 0:00:23.360 --> 0:00:27.080 This week I'm speaking with Steve how quantitative researcher at Bloomberg. 0:00:27.400 --> 0:00:29.640 Now, Steve, thank you very much for joining us. 0:00:29.680 --> 0:00:32.120 Very good of you, very nice to you are to 0:00:32.120 --> 0:00:33.879 speak with you marine, and thank you for the invitation. 0:00:35.040 --> 0:00:37.080 I wanted to talk to you this week because this week. 0:00:36.920 --> 0:00:39.760 Is macro week, right, everybody else is going to be 0:00:39.800 --> 0:00:43.760 talking Trump, talking tariffs, talking inflation, all this kind of thing, 0:00:44.000 --> 0:00:46.440 and so we're just going to leave that for everybody 0:00:46.440 --> 0:00:48.479 else because, to be honest, no one really knows what's 0:00:48.479 --> 0:00:50.319 going to happen with the tariffs. No one really knows 0:00:50.360 --> 0:00:52.080 what the macro effects are going to be. There's a 0:00:52.120 --> 0:00:54.680 lot written on and we are going to go a 0:00:54.720 --> 0:00:58.880 little bit more micro and talk about things that directly 0:00:59.200 --> 0:01:03.680 affect company that we can understand. So in particular, I 0:01:03.720 --> 0:01:09.160 don't know innovation, how pressing power works, how analysts look 0:01:09.200 --> 0:01:11.000 at companies, all those kind of things, so all the 0:01:11.040 --> 0:01:15.200 areas that are specific to your work. So what we're 0:01:15.200 --> 0:01:18.240 going to try and do is not mentioned tariffs once 0:01:19.120 --> 0:01:20.920 in the whole forty minutes that we're going to speak. 0:01:20.959 --> 0:01:22.720 It's going to be like a challenge between us. Okay, 0:01:22.840 --> 0:01:23.800 no mention of tariffs. 0:01:24.520 --> 0:01:26.000 Can we try? Yes? 0:01:26.080 --> 0:01:29.400 Okay, all right, everyone's going to let us know immediately 0:01:29.440 --> 0:01:31.880 if we fail, of course. And so I want to 0:01:31.880 --> 0:01:34.280 start by talking about the thing that, of course everyone 0:01:34.319 --> 0:01:40.360 talked about last week, about innovation discovery, in particular about AI. 0:01:40.640 --> 0:01:43.520 So everything that's happened over the last couple of years 0:01:43.520 --> 0:01:47.640 with AI has really been the most extraordinary wave of 0:01:48.000 --> 0:01:51.080 innovation and change. And then we had the news on 0:01:51.480 --> 0:01:53.520 Deep Seek of course only hit the market last week. 0:01:53.600 --> 0:01:56.160 Better of fact, WITH was out there several weeks before that, 0:01:56.440 --> 0:02:02.320 and that represents massive change as well. So that's exciting. 0:02:02.360 --> 0:02:04.200 But there's a lot else out there, right, It's not 0:02:04.240 --> 0:02:05.720 just AI at the moment. We're in the middle of 0:02:05.760 --> 0:02:08.600 an extraordinary wave of technological change. One of the most 0:02:08.639 --> 0:02:09.640 interesting parts for you. 0:02:09.960 --> 0:02:11.680 So first of all, a little bit of background myself. 0:02:11.680 --> 0:02:13.880 I'm a quiet researcher at Bloomberugh in disease and I 0:02:14.000 --> 0:02:16.840 create systematic strategies where we use, you know, sort of 0:02:17.680 --> 0:02:22.040 different signals that are trying to identify stocks systematically to 0:02:22.040 --> 0:02:25.320 create investment strategies. And one of the recent wides we've 0:02:25.360 --> 0:02:28.840 created is looking at innovation. How do you identify innovation 0:02:28.919 --> 0:02:31.480 in the systematic fashion? And what we've found this turns 0:02:31.520 --> 0:02:34.760 out that you can use R and D expenditures as 0:02:34.800 --> 0:02:37.880 a signal. And this is not new, right, companies have 0:02:38.560 --> 0:02:41.160 researchers have looked at R and D spending, you know, 0:02:41.240 --> 0:02:44.079 for a long time and indeed identifies companies that are 0:02:44.120 --> 0:02:47.120 exposed innovative. But what we have found is actually the 0:02:47.400 --> 0:02:51.480 more indicative of research capability, innovative capability. It is not 0:02:51.560 --> 0:02:54.680 so much the absolute amount of R and D spending, 0:02:54.720 --> 0:02:57.760 but the persistence. Right when we screen for companies that 0:02:58.120 --> 0:03:01.720 spend and persistently row, they're earned the expanditure year on 0:03:01.840 --> 0:03:05.320 year for say three trailing years. Right, without doing just 0:03:05.360 --> 0:03:09.560 so anything else, right, you autonomously pick up companies that 0:03:09.680 --> 0:03:13.400 are actually exposed very innovative, and should get into details 0:03:13.400 --> 0:03:16.239 as to how we actually show that they are indeed innovative, 0:03:16.280 --> 0:03:18.160 because it's such a you know, sort of abstract thing. 0:03:18.760 --> 0:03:23.520 And what's really remarkable is that if you say, screened 0:03:23.520 --> 0:03:27.639 the US large MidCap companies, you know, by this metric 0:03:27.880 --> 0:03:30.200 right and sort of market cap weave them with some 0:03:30.240 --> 0:03:33.760 sort of camping and weights, so you get back exactly 0:03:33.840 --> 0:03:37.680 the cues the Nasdaq Stock Exchange, which of course is 0:03:37.840 --> 0:03:39.880 just happens to be everything that's listed on the NASTS 0:03:39.880 --> 0:03:43.840 exchange and not you know, explicitly screening for innovation, which 0:03:43.880 --> 0:03:46.680 we think thought it was very fascinating. And along the 0:03:46.680 --> 0:03:49.040 way you also do pick up you know, of course 0:03:49.080 --> 0:03:51.560 AI technology, but you also pick up things such as 0:03:52.000 --> 0:03:55.480 pharmaceutical innovations. You know Eli Lilly, you know which invented 0:03:55.680 --> 0:03:58.360 along with the noval nor disc. You know, the GP 0:03:58.440 --> 0:04:01.680 one drugs, you know, the more weight loss want Wonder drug. 0:04:01.800 --> 0:04:04.000 So you look at companies and you can see trailing 0:04:04.120 --> 0:04:06.560 R and D spend over over three years going up 0:04:06.560 --> 0:04:08.480 and up and up, and that gives you some sense 0:04:08.480 --> 0:04:11.040 that there's interesting innovations going on there, but of course 0:04:11.560 --> 0:04:14.000 that doesn't help you choose between people who are using 0:04:14.040 --> 0:04:18.000 their innovative abilities successfully with the product that will come 0:04:18.040 --> 0:04:20.840 to market and those that are not. And it also 0:04:20.880 --> 0:04:23.200 doesn't help you pick up the companies. So let's go 0:04:23.279 --> 0:04:25.920 back to AI for example. Well, one of the things 0:04:25.960 --> 0:04:28.440 that was much discussed last week was the fact that 0:04:28.600 --> 0:04:32.120 so many companies are spending so much money, possibly on 0:04:32.160 --> 0:04:35.440 the wrong thing. So it's not helping you distinguish between 0:04:35.440 --> 0:04:38.000 good R and D and pointless R and D. And 0:04:38.040 --> 0:04:40.520 particularly when you get, for example, to their bubble situation 0:04:40.920 --> 0:04:44.200 where you get that massive capex spending over a series 0:04:44.200 --> 0:04:46.719 of years, but you only get one winner. 0:04:47.560 --> 0:04:49.840 Well, let's unpack that idea a lot of bits. So 0:04:50.080 --> 0:04:53.000 first of all, let's get back to the idea of 0:04:53.040 --> 0:04:55.320 for just simply screen for companies with persistent R and 0:04:55.400 --> 0:04:57.640 D spending. You will think exactly like, how would I 0:04:57.640 --> 0:05:00.040 be able to tell whether the company is just throwing 0:05:00.080 --> 0:05:02.560 a bunch of money after bad right, you know, and 0:05:02.720 --> 0:05:05.680 there's way one power building and the money is just 0:05:05.800 --> 0:05:08.280 being set on fire. That indeed, that is possibility. And 0:05:08.279 --> 0:05:10.719 what is surprising is it comes out when you screen 0:05:10.760 --> 0:05:13.920 for companies that persistently spend the R and D instead 0:05:13.960 --> 0:05:15.520 of just sort of you know, one. 0:05:16.000 --> 0:05:16.640 On and off. 0:05:17.200 --> 0:05:19.919 Uh, these tend to be companies that actually have the 0:05:19.920 --> 0:05:23.840 ascertainability or knowledge about innovative success. And that has been 0:05:23.839 --> 0:05:27.679 well documented in the academic literature that there is actually 0:05:27.760 --> 0:05:30.960 persistence in skills, whether it's you know, sort of investing 0:05:30.960 --> 0:05:34.600 skills or innovative skills, right, And it turns out without 0:05:34.640 --> 0:05:37.560 explicity screening. So if you look at companies that persistently 0:05:37.560 --> 0:05:39.360 spend R and D, they tend to be companies with 0:05:39.480 --> 0:05:44.400 strong cash flows, internally generated cash flows, strong profitability, and high. 0:05:44.560 --> 0:05:45.800 And low leverage. 0:05:46.440 --> 0:05:49.359 And the reason is it turns out is because R 0:05:49.400 --> 0:05:53.760 and D is a fundamentally opaque and asymmetric information activity. Right. 0:05:53.880 --> 0:05:58.400 It is highly uncertain, it's extremely cost costly, So companies 0:05:58.400 --> 0:06:01.680 are going to struggle to raise external financing, whether it's 0:06:01.880 --> 0:06:05.560 debt or issue. You know, you should equity definance it. 0:06:06.000 --> 0:06:09.960 So only companies that are confident in its own ability 0:06:09.960 --> 0:06:12.480 to innovate to translate that innovatives that R and D 0:06:12.760 --> 0:06:16.240 into valuable intensible capital that will produce cash flow streams 0:06:16.279 --> 0:06:19.200 down the road, will actually do it in a persistent fashion. 0:06:19.400 --> 0:06:21.200 And that's one thing. For example, you see when you 0:06:21.240 --> 0:06:24.600 take a company, say R ETF for example, right, look 0:06:24.600 --> 0:06:26.840 at the companies that are in the ETF. You know 0:06:26.880 --> 0:06:30.680 they actually have very high percentage of R and D 0:06:30.800 --> 0:06:33.280 expanditures as a share of net sales. Right, that's a 0:06:33.320 --> 0:06:35.680 typical way people measure R and D. But if you 0:06:35.680 --> 0:06:38.440 look at the companies that have persistent R and D 0:06:38.520 --> 0:06:41.800 spending in that profolio is not very high because those 0:06:41.839 --> 0:06:44.760 companies are not persistently profitable. So the R and D 0:06:44.800 --> 0:06:46.640 spending is on and off. Right in one year they 0:06:46.640 --> 0:06:48.279 spend a time and the next year run out of money, 0:06:48.279 --> 0:06:50.400 they don't spend any And the companies that we do 0:06:50.520 --> 0:06:53.600 pick up, you know, in our you know, methodology, then 0:06:53.839 --> 0:06:57.080 is actually the persistence, right there is actually the embedded 0:06:57.160 --> 0:07:00.599 quality screen. And I think that combine that with the 0:07:00.600 --> 0:07:03.000 fact that if you're just doing a market cap waiting, 0:07:03.120 --> 0:07:05.359 which you know sort of people do these days, you know, 0:07:05.400 --> 0:07:08.680 sort of matter of factly because it's become the convention. 0:07:08.760 --> 0:07:10.640 But you think about what it really means is that 0:07:10.920 --> 0:07:14.000 there is a sense of expost market validation, right that 0:07:14.360 --> 0:07:17.559 having spend all this money exposed you got you're getting 0:07:17.600 --> 0:07:22.440 the market valuation because you've produced intensible capital that's actually 0:07:23.680 --> 0:07:26.480 spinning out cash flows, and and and and and and 0:07:26.520 --> 0:07:30.120 That's what's different about today's stock market compared to say 0:07:30.360 --> 0:07:33.480 the bubble of two thousand, is that the bubble today 0:07:33.600 --> 0:07:36.000 is in the quality stocks, right. The bubble today is 0:07:36.040 --> 0:07:39.920 in the companies that are tremendously profitable, so much so 0:07:40.040 --> 0:07:42.920 they seem to have escaped velocity, right, they don't. They 0:07:42.960 --> 0:07:46.960 don't require credit, They don't require financing because they finance themselves. 0:07:47.800 --> 0:07:51.360 Okay, So we have this link between a company that 0:07:51.360 --> 0:07:56.120 that has regular R and D spending and quality and 0:07:56.160 --> 0:07:58.440 that that's that's the important part of the link. That 0:07:58.600 --> 0:08:01.400 R and D spending as long as it's regular, inconsistent, 0:08:01.520 --> 0:08:04.760 and rising, is also indicative of a high quality company. 0:08:05.080 --> 0:08:05.920 M h. Yeah. 0:08:05.960 --> 0:08:09.000 If we're buying those companies in the US at the moment, 0:08:09.200 --> 0:08:10.680 we're really paying up for them. 0:08:10.520 --> 0:08:12.320 Aren't we quite right? 0:08:12.400 --> 0:08:16.400 Yeah, I mean, valuation has absolutely climbed over the last decade, 0:08:16.440 --> 0:08:21.080 I think ten years ago, you know, or more, I guess. 0:08:21.080 --> 0:08:24.280 So when Buffett started buying Apple that you know, tax 0:08:24.320 --> 0:08:27.880 stocks were really cheap, right, and you know how many 0:08:27.920 --> 0:08:31.240 years have we heard, you know, the sort of forecasts 0:08:31.280 --> 0:08:35.200 of EXCA returns for US equities being lower than the 0:08:35.240 --> 0:08:37.480 rest of the world and keeps being proven wrong. Is 0:08:37.480 --> 0:08:42.520 because profitability keeps surprising to the upside, and along with it, 0:08:42.679 --> 0:08:45.840 valuation paid for them because there was this you know, 0:08:45.960 --> 0:08:47.880 desire for quality assets. 0:08:48.760 --> 0:08:51.520 And do you think that that rising and persistent R 0:08:51.640 --> 0:08:54.160 and D is a thing that is driving earnings forward. 0:08:55.440 --> 0:08:58.760 Oh, just and justifies the valuations. 0:08:59.040 --> 0:09:02.000 Yeah, absolutely, thing we do in our white paper, which 0:09:02.679 --> 0:09:05.520 your listeners can look up when they just search a 0:09:05.520 --> 0:09:08.280 Bloomberok innovation factor and they'll find a blog. 0:09:08.360 --> 0:09:10.160 In the blog, we'll put a link in the show notes. 0:09:10.400 --> 0:09:12.719 We don't have to search, no searching required. It will 0:09:12.760 --> 0:09:13.800 be in the show notes. 0:09:14.440 --> 0:09:18.480 Perfect for you. So you can take a look at 0:09:18.480 --> 0:09:21.320 the paper. And what we show is that if you 0:09:21.360 --> 0:09:24.120 sort of you know, do an experiment where you go 0:09:24.240 --> 0:09:28.480 back in history and identify companies that were persistently innovative 0:09:28.600 --> 0:09:31.960 in biomasure right, having spent three consecutive years of growing 0:09:32.120 --> 0:09:34.480 R and D, and look at that subsequent five year 0:09:34.880 --> 0:09:37.760 sort of key fundamental performances, you will see that these 0:09:37.800 --> 0:09:44.199 companies showed our strongest growth in revenue, net income free, 0:09:44.200 --> 0:09:47.960 cash flow free cash for pressure and you know, just 0:09:48.000 --> 0:09:53.680 along all the fundamental metrics, and that particularly accelerated over 0:09:53.720 --> 0:09:58.960 the last ten years. And so, in other words, the 0:09:59.000 --> 0:10:03.720 selection is not just based on valuation expansion. We actually 0:10:03.760 --> 0:10:09.000 identified companies that produced intention by capital that translated into 0:10:09.400 --> 0:10:12.040 our earnings and that is the reason why these companies 0:10:12.080 --> 0:10:14.280 are being rewarded by the market and This is what 0:10:14.640 --> 0:10:17.480 is really particularly reassuring is that this is a phenomenon 0:10:17.440 --> 0:10:20.360 that we've documented across the globe. It's not just in 0:10:20.400 --> 0:10:22.120 the US. It is in Europe as well, is in 0:10:22.200 --> 0:10:23.000 Asia as well. 0:10:23.320 --> 0:10:26.480 Okay, interesting, but when we look at that, presumably, I'm well, 0:10:26.520 --> 0:10:30.679 presumably you see the majority of the companies that fit 0:10:30.880 --> 0:10:34.079 these fit these factors in the US. I mean, that's 0:10:34.120 --> 0:10:36.680 where we all perceive the main innovation in listed markets 0:10:36.679 --> 0:10:38.600 being let's put China to one side for a moment. 0:10:38.760 --> 0:10:42.480 If we're looking at the US, the UK, Europe, et cetera. 0:10:43.000 --> 0:10:45.720 It is in the US that we see that innovation 0:10:45.840 --> 0:10:48.160 in the main and that's why we've seen that huge 0:10:48.240 --> 0:10:51.120 valuation expansion there, which has been the main driver of 0:10:51.559 --> 0:10:55.120 the US exceptionalism in the US outperformance since twenty fifteen 0:10:55.200 --> 0:10:57.480 or so. It is the perception and possibly the reality 0:10:57.559 --> 0:11:00.840 that all the innovation is in the US. That is 0:11:00.880 --> 0:11:04.079 that the case, or are you actually seeing that persistence 0:11:04.120 --> 0:11:06.400 of R and D spending in companies in say Europe 0:11:06.440 --> 0:11:07.360 or the UK as well. 0:11:08.440 --> 0:11:08.680 Well? 0:11:09.200 --> 0:11:13.520 So you're absolutely right in that the bulk of the 0:11:13.559 --> 0:11:17.440 dollar you know, activity, innovation activity probably takes place in 0:11:17.480 --> 0:11:19.840 the US just because of the size of the market. 0:11:20.040 --> 0:11:24.840 And also I think it was Jeff Bezos who recently 0:11:24.880 --> 0:11:27.640 made it remark that observation that was really insightful is 0:11:27.679 --> 0:11:31.040 because of the US risk capital markets that really finances 0:11:31.080 --> 0:11:36.440 you know, innovative activities. But that being said, there is 0:11:36.640 --> 0:11:41.360 less innovative activities, aren't the activity in Europe, But where 0:11:41.400 --> 0:11:46.319 it does exist, markets actually rewarded those activities similarly as well. Right, 0:11:46.400 --> 0:11:50.480 you saw this dramatic outperformance, and you see, you know, 0:11:51.000 --> 0:11:54.000 market follows wherever the activity takes place. So whereas you 0:11:54.120 --> 0:11:57.600 used to take place more in Germany, Switzerland, you know, 0:11:57.679 --> 0:12:00.360 sort of in a farmer space, now micro it's more 0:12:00.400 --> 0:12:03.440 northward towards US, you know, the Netherlands because of SML, 0:12:03.720 --> 0:12:06.480 or because or Denmark because of a novel nor disc 0:12:06.760 --> 0:12:10.080 and the associate you know, supply chain as well. 0:12:10.600 --> 0:12:12.640 Okay, so the innovation they you see in Europe is 0:12:12.720 --> 0:12:14.239 very much in the farmer area. 0:12:14.440 --> 0:12:18.960 And and AI for that matter, ASML and their suppliers. 0:12:18.360 --> 0:12:22.839 Right, uh huh uh huh okay. And the UK can 0:12:22.880 --> 0:12:23.920 you check us a bone here? 0:12:24.320 --> 0:12:27.720 Well, you know, actually interestingly, you know UK, I recently 0:12:28.000 --> 0:12:30.559 noticed the company in my research on you know, we 0:12:30.960 --> 0:12:32.880 will get you. Later on pressing power, I noticed that 0:12:32.880 --> 0:12:34.800 there was a company called R E l X, and 0:12:34.840 --> 0:12:36.839 I was very curious what it is because the stock 0:12:36.920 --> 0:12:41.000 is absolutely ripping, and I realized it's actually a massive 0:12:41.040 --> 0:12:44.400 AI beneficiary. Because it turns out there, I think you 0:12:44.440 --> 0:12:46.800 may be familiar with the company, they own about half 0:12:46.840 --> 0:12:50.600 the world's academic you know, publications, right, journals. And you 0:12:50.640 --> 0:12:53.360 would have thought before AI that this was a dead 0:12:53.360 --> 0:12:56.960 wood industry like who reads anymore? Led along academic journals, 0:12:57.000 --> 0:13:00.360 but it turns out this is basically a vast of 0:13:00.440 --> 0:13:04.600 extremely valuable data and AI. It's all about the training data. 0:13:05.080 --> 0:13:08.600 Uh and and and they're definitely benefiting from it. 0:13:08.840 --> 0:13:10.199 Okay, that's interesting. 0:13:10.520 --> 0:13:11.920 Oh, I mean beyond that, of course, there is the 0:13:11.960 --> 0:13:14.800 farmer angle and you know Astrosdenaga and so on. But yeah, 0:13:15.080 --> 0:13:16.080 but that's more traditional. 0:13:16.679 --> 0:13:20.240 Okay, let's move on to talk about this pricing power subject. 0:13:20.320 --> 0:13:23.480 But before we get there, how does one invest in 0:13:23.520 --> 0:13:26.600 the companies that you've been talking about? Is there something 0:13:26.640 --> 0:13:29.360 we can do to get access to these persistent R 0:13:29.440 --> 0:13:32.199 and D spending quality companies across the board. 0:13:33.080 --> 0:13:36.320 So with respect to innovation, right you're talking about, Yeah, 0:13:36.360 --> 0:13:40.400 we have a Bloomberg indices launched in the R and 0:13:40.440 --> 0:13:41.080 D industries. 0:13:41.160 --> 0:13:43.760 So B R and D is the index. 0:13:43.800 --> 0:13:46.360 But then we also have a smaller set of companies 0:13:46.600 --> 0:13:49.760 with a higher convication that's called be invent right, so 0:13:49.960 --> 0:13:53.400 easy to remember, Monka. And on the back of that, 0:13:53.880 --> 0:13:57.120 we have actually licensed the indices to ETF features. The 0:13:57.240 --> 0:14:00.920 First Trust, for example, has licensed being then to create 0:14:02.240 --> 0:14:05.240 an ETF with a ticket R and D in America. 0:14:05.480 --> 0:14:10.680 And we're also I personally think that this concept applies 0:14:10.920 --> 0:14:14.480 equally well to Europe. And part of the reason why 0:14:14.520 --> 0:14:17.000 I'm in London this week is to try to persuade 0:14:17.000 --> 0:14:20.040 people that Europe ought to invest in the South and 0:14:20.440 --> 0:14:24.040 or to invest in innovation, because you know, the race 0:14:24.160 --> 0:14:27.920 is on and you know, by both necessity and reward, 0:14:28.080 --> 0:14:31.400 I think this actually presents a very interesting alternative to 0:14:31.640 --> 0:14:33.200 US innovation. 0:14:34.280 --> 0:14:36.520 Okay, so if and if that happens, we might actually 0:14:36.560 --> 0:14:38.520 see the European markets pick up a little, which we 0:14:38.560 --> 0:14:41.040 already are this year, right, we're already seeing great performance 0:14:41.080 --> 0:14:42.840 from European markets relative to the US. 0:14:42.960 --> 0:14:44.560 Oh absolutely abslightly better. 0:14:44.920 --> 0:14:48.000 Yeah, yeah, German stocks are killing it, right, you know, 0:14:48.840 --> 0:14:50.800 everyone's talking about Germany going into a procession. But the 0:14:50.880 --> 0:14:54.000 decks keep hitting a what time highs and you know, 0:14:55.080 --> 0:14:56.880 and I think that's part of the reason why we're 0:14:56.920 --> 0:15:01.760 seeing this pivot of AI broaden out right away from 0:15:02.160 --> 0:15:06.040 the first phase of pigs and shovels to more applications 0:15:06.200 --> 0:15:10.440 software and you know, with you know AI, last week's 0:15:10.520 --> 0:15:14.000 news about AI being much cheaper to implement a much 0:15:14.000 --> 0:15:16.360 more you know, sort of energy efficient, that means that 0:15:16.400 --> 0:15:18.520 everybody else can start getting into the game. And that's 0:15:18.520 --> 0:15:20.960 why software you know is actually doing very well. 0:15:21.800 --> 0:15:24.480 And it's yet another reminder, isn't it, which apparently people 0:15:24.480 --> 0:15:28.120 do continually need that markets are not economies. Economies are 0:15:28.120 --> 0:15:31.880 not markets, and markets can move in completely different directions 0:15:31.920 --> 0:15:34.880 to economies depending on on the starting valuations. 0:15:35.400 --> 0:15:37.840 Hmm absolutely mm. 0:15:38.200 --> 0:15:40.560 Okay, right, So let's go back to what you were 0:15:40.600 --> 0:15:43.200 saying about pricing power. I mean, this is one of 0:15:43.040 --> 0:15:46.720 the basics of investing is that analysts and investors always 0:15:46.720 --> 0:15:50.960 say they're looking for companies with modes with monopoly power 0:15:51.080 --> 0:15:53.960 or agobly power of some kind and with the ability 0:15:54.120 --> 0:15:58.320 to control their own pricing. So you would think that 0:15:58.320 --> 0:16:00.160 that would be the kind of thing that we're be 0:16:00.360 --> 0:16:02.480 very much out there in the market and you wouldn't 0:16:02.520 --> 0:16:05.760 be able to find any pricing anomalies in that area. 0:16:05.800 --> 0:16:07.600 But I think you're going to tell me that I'm wrong. 0:16:09.760 --> 0:16:12.520 Well, we're going to go back to I think you know, 0:16:12.800 --> 0:16:16.480 eventually we'll always go back to the quality paradox. But indeed, 0:16:16.760 --> 0:16:19.440 we've been looking at these accounts of pricing power because 0:16:19.520 --> 0:16:22.120 over the last few years, so we were looking at 0:16:22.120 --> 0:16:24.800 this two three years ago, inflation was all the rage, 0:16:24.800 --> 0:16:27.360 and you know, everyone's asking how do we actually capture 0:16:27.360 --> 0:16:27.960 pricing power? 0:16:28.000 --> 0:16:28.680 Pricing power? 0:16:30.040 --> 0:16:33.280 So everyone has their own ideas and there's qualitative ways 0:16:33.320 --> 0:16:35.880 of you know, capturing it, and people will throw alls 0:16:35.880 --> 0:16:38.840 of company names out there and claim that those companies 0:16:38.920 --> 0:16:41.960 have pricing power. I've seen claims of our Tesla Hast 0:16:41.960 --> 0:16:44.600 pricing power, Apple is pricing power, But does it. 0:16:44.600 --> 0:16:46.000 Really how do we actually know? 0:16:46.680 --> 0:16:48.960 So we sort of did a bit of work and 0:16:49.200 --> 0:16:52.240 found that it turns out it's not so much profitable 0:16:52.280 --> 0:16:56.360 companies that have pricing power, because high profit margins can 0:16:56.400 --> 0:16:59.280 be eroded into right if you don't have pricing power. 0:16:59.320 --> 0:17:02.480 So either if you look at the case of Apple, right, 0:17:03.320 --> 0:17:06.520 you know, the flagship iPhone price has actually not changed 0:17:06.640 --> 0:17:09.720 very much all over the last few years, even though 0:17:09.840 --> 0:17:12.400 I'm sure cost has gone up, you know, tremendously for them. 0:17:13.280 --> 0:17:16.440 So how do we actually then sort of capture companies 0:17:16.480 --> 0:17:18.959 that do have pricing powers, in my opinion, in our opinion, 0:17:19.240 --> 0:17:23.879 you look at not the level, but the stability, in 0:17:23.920 --> 0:17:27.359 other words, the standard deviation of gross margins over the 0:17:27.440 --> 0:17:28.320 last five years. 0:17:28.480 --> 0:17:28.680 Right. 0:17:28.720 --> 0:17:30.720 So again there's a certain theme to how we sort 0:17:30.720 --> 0:17:33.840 of look at to our you know, systematic strategies here. 0:17:34.200 --> 0:17:36.840 And it turns out that the reason we focus on 0:17:36.840 --> 0:17:40.760 gross margins because it's the least manipulated you know, accounting metric, 0:17:41.200 --> 0:17:43.200 you know, because it's just the difference between the top 0:17:43.240 --> 0:17:47.400 line and the subtracting the variable costs, including our wages. 0:17:47.880 --> 0:17:51.920 So the things that are more sensitive to inflationary shocks. Now, 0:17:52.320 --> 0:17:55.240 if you have a company that have pricing power, then 0:17:56.400 --> 0:17:59.639 if there's cost push shock, they can pass on a 0:17:59.680 --> 0:18:05.359 cost to customers, and if gross margins growing indicative of 0:18:05.480 --> 0:18:08.320 a demand shock, then they can supply into it and 0:18:08.440 --> 0:18:11.440 drive down the margin towards their target. So that's why 0:18:11.480 --> 0:18:14.679 we've constructed a measure where we look at companies with 0:18:14.720 --> 0:18:16.200 the most stable gross margins. 0:18:16.680 --> 0:18:18.919 Okay, and so if you're looking at companies like this, 0:18:19.040 --> 0:18:22.520 you're going to expect them to be in relatively niche 0:18:22.560 --> 0:18:25.800 areas like the company you were just disgusting being in 0:18:25.840 --> 0:18:29.240 an academic academic journals. This marcher not in an area 0:18:29.280 --> 0:18:31.240 that other people are going to break into in a hurry, 0:18:31.320 --> 0:18:32.640 is it. 0:18:32.760 --> 0:18:33.160 Indeed? 0:18:33.240 --> 0:18:36.480 Yeah, That's one An interesting thing that emerges from our 0:18:36.640 --> 0:18:39.760 systematic you know so of our screen is that you 0:18:39.800 --> 0:18:41.399 look at the companies that come out of the screen, 0:18:41.480 --> 0:18:46.520 they look incredibly either boring or you know, not really 0:18:46.520 --> 0:18:49.200 one you recognize. For example, one company that keeps popping 0:18:49.280 --> 0:18:51.520 up in the American version of the Oppresing Power Indux 0:18:51.640 --> 0:18:53.800 is this company called Cadence Design Systems. 0:18:53.880 --> 0:18:55.120 Have you heard of it? 0:18:55.240 --> 0:18:57.240 Chugs familiar, But I don't think I can straight up there, 0:18:57.240 --> 0:18:58.960 I have no So. 0:18:59.080 --> 0:19:02.920 Caidence Design system they design software for designing microchips. 0:19:03.200 --> 0:19:05.760 Uh huh that does that boring? Yeah? 0:19:06.200 --> 0:19:06.400 Right? 0:19:06.800 --> 0:19:09.280 So in other words, they are not the ones manufacturing 0:19:09.280 --> 0:19:13.080 the chips. That's a highly cyclical sector, right. Uh, that 0:19:13.440 --> 0:19:17.840 comes with bone and bars of demand of traditionally consumer electronics. 0:19:18.040 --> 0:19:22.520 They design the software with which uh, these manifesture these 0:19:22.560 --> 0:19:26.159 chip designers design chips. In other words, you know, you 0:19:26.200 --> 0:19:28.879 would even if your business is down a lot at 0:19:28.880 --> 0:19:30.680 a MD or wherever you are, you're not going to 0:19:30.840 --> 0:19:34.720 conceive of canceling your subscription to the software with which 0:19:34.760 --> 0:19:37.080 you do your work. Right, So that's really what gives 0:19:37.119 --> 0:19:39.520 them the pressing power is that they are supplier in 0:19:39.560 --> 0:19:43.239 the verified space with which there's maybe a handful of 0:19:43.280 --> 0:19:48.840 companies and continuing consolidation. Uh So that and it doesn't 0:19:48.840 --> 0:19:51.919 attract the attention of regulators because it's not the category 0:19:51.920 --> 0:19:54.359 that people think of because it's not consumer facing or 0:19:54.520 --> 0:19:58.040 very glamorous, right, And that's how the pressing power is 0:19:58.080 --> 0:19:58.880 actually maintained. 0:19:59.760 --> 0:20:03.119 This when you speak about companies like this and in 0:20:03.160 --> 0:20:05.760 the category we were discussing for R and D equality, etc. 0:20:06.080 --> 0:20:09.000 It sounds to me like you're making the case for 0:20:09.080 --> 0:20:11.879 active investment. You're saying this market is it is not 0:20:11.960 --> 0:20:14.760 particularly efficient. There's all sorts of anomalies out there. There's 0:20:14.840 --> 0:20:18.240 lots of places where investors can go to find companies 0:20:18.440 --> 0:20:22.199 that other people aren't looking at. Are you making the 0:20:22.240 --> 0:20:26.439 case here for a shift back towards active investment or 0:20:26.480 --> 0:20:30.520 are you really making the case for factor specifical sector 0:20:30.560 --> 0:20:32.000 specific ETFs. 0:20:33.240 --> 0:20:34.000 That's a great question. 0:20:34.040 --> 0:20:38.720 I mean, so I have a somewhat controversial perhaps view 0:20:38.840 --> 0:20:42.359 on this whole active passive debate. I don't think of 0:20:42.400 --> 0:20:46.040 it as being I mean, I think the better word 0:20:46.119 --> 0:20:50.560 is discretionary versus systematic. Right, Like what I just described 0:20:50.600 --> 0:20:54.320 to you, the methodology, whether it's looking at the stability 0:20:54.520 --> 0:20:58.760 of growth margins or the persistent R and D growth, 0:20:58.800 --> 0:21:03.119