Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond soundbites and headlines and looks deeper into their processes,
Speaker 1: challenges and philosophies and security selection. I'm David Cohne, i
Speaker 1: lead mutual fund and active research at Bloomberg Intelligence. Today
Speaker 1: my co host is Michael casper Us, small cap and
Speaker 1: sector strategist at Bloomberg Intelligence. Mike, thanks for joining me today.
Speaker 2: Thank you, David.
Speaker 1: So you wrote an interesting note last week on the
Speaker 1: connection between small cap stocks and M and A. So
Speaker 1: how to merge his and acquisitions affect Russell two thousand performance?
Speaker 2: Yeah, Well, first a recap of what happened in twenty
Speaker 2: twenty four, and it was the weakest year we had
Speaker 2: on record going back to about two thousand, with the
Speaker 2: last quarter of twenty twenty four being particularly bad, just
Speaker 2: two deals worth a paltry four point four billion in
Speaker 2: the fourth quarter, But that caped a year where there
Speaker 2: was only about fifty two deals that was worse than
Speaker 2: two thousand and eight sixty one deals and making it
Speaker 2: the worst going back to two thousand. Now you might
Speaker 2: be wondering where did that dip come from. It was
Speaker 2: definitely in financials, they made up just nine point three
Speaker 2: percent of last year's fifty four deals. Typically they average
Speaker 2: around eighteen point three percent or so of deals annually
Speaker 2: going back to again two thousand, So really the big
Speaker 2: departure was in financials only. Energy, though saw more deals
Speaker 2: than its pre pandemic and X Great Financial Crisis average.
Speaker 2: But why does this really matter for small cap stocks?
Speaker 2: At the end of the day, small cap performance and
Speaker 2: the amount of M and A, so the amount of
Speaker 2: targets in the small cap index are pretty closely linked.
Speaker 2: So if you look at calendar year performance of the
Speaker 2: rest of two thousand and deal count and value in
Speaker 2: the correlation between the two Russell two thousand annual performance,
Speaker 2: calendar year performance is point five two correlated with count
Speaker 2: and it's point four correlated to deal value. So a
Speaker 2: pretty significant positive correlation there. Obviously is takeouts to accumulate.
Speaker 2: It drives a premium for some of these small cap
Speaker 2: stocks in some of these sectors. And one of the
Speaker 2: cool things just before I give up on this, one
Speaker 2: of the cool things we did that I want to
Speaker 2: mention is that we tried to look for commonality across
Speaker 2: these takeout targets in the Russell two thousand, going back
Speaker 2: to again two thousand or two thousand and one, and
Speaker 2: what we found the commonality amongst them was most of
Speaker 2: them had positive EBADA for the year prior to the
Speaker 2: deal's announcement. Over sixty percent of all those deals going
Speaker 2: back to two thousand had positive EBADA seventy two percent
Speaker 2: or so. We're cheaper than the index median ev to
Speaker 2: EBADA and about seventy percent had lower net debt to ebadas,
Speaker 2: a lower leverage leverage than the median stock in the
Speaker 2: Russell two thousand. So we did a nice little takeover
Speaker 2: target screen looking at companies in the Russell two thousand today.
Speaker 1: That's great. So if we are talking about small caps,
Speaker 1: I think it's a great time to welcome our guest.
Speaker 1: I'd like to welcome Brian Wong to the podcast. Brian
Speaker 1: is vice president and small cap growth portfolio manager at
Speaker 1: Ostrowis and a manager for the Austrowis Opportunity Fund ticker OSTGX. Brian,
Speaker 1: thanks for joining us today.
Speaker 3: Thanks for having me.
Speaker 1: David, So I'd like to begin by asking you how
Speaker 1: you got your start in the investment business.
Speaker 4: Sure, well, I went to college at Yale. I was
Speaker 4: a political science major, so a great great training for investments,
Speaker 4: of course, and really what I was focused on studying
Speaker 4: in college was the Grand Strategy of Countries. So I
Speaker 4: wrote my senior essay on the Grand Strategy of Dung Dungshaoping,
Speaker 4: who's really China sort of modern leader following Mount Malzaedong
Speaker 4: really opened up the economy there, but still preserved capitalism
Speaker 4: with Chinese characteristics. And when I was graduating from college,
Speaker 4: I got a great opportunity to join a long short
Speaker 4: hedge fund run by Yale history major Dan, who really
Speaker 4: saw how my skill set might translate, and so the
Speaker 4: first book he gave me was Competitive Strategy by Michael Porter.
Speaker 4: So really I went from studying the Grand strategy of
Speaker 4: countries and leaders to companies. That was just a tremendous
Speaker 4: opportunity to learn the craft of investing. The senior analyst
Speaker 4: that the firm was a fellow by the name of
Speaker 4: Sal Khon, who went on to found the con Academy.
Speaker 4: And so I remember just sitting with Sal after work
Speaker 4: many days, seeing him watch him record these videos of
Speaker 4: him tutoring his cousin in math, and really sort of
Speaker 4: grew to appreciate the power of technology, obviously leveraging a
Speaker 4: new model of distribution YouTube to reach a much broader
Speaker 4: audience of millions of people. And the idea of using
Speaker 4: technology as this efficiency driver. You can record something once,
Speaker 4: but obviously the content is forever. And then additionally, I
Speaker 4: think just this idea of scaling by creating value for others.
Speaker 4: You know, dominant companies don't start out that way. Every
Speaker 4: entrepreneur has humble, humble beginnings. UH an idea. You know,
Speaker 4: it requires very hard work.
Speaker 3: So that was a neat experience to see very early
Speaker 3: on in my career.
Speaker 4: And so when Sal left to start kN Academy and
Speaker 4: and Dan retired, I joined the Packard Foundation, which is
Speaker 4: now run by Kim Sargent, a disciple formerly of the
Speaker 4: Yale Endowment, and and there I learned the value of
Speaker 4: long term investing uh and and for the past decade
Speaker 4: I've been at Osterweiss applying sort of what I've learned
Speaker 4: through those three to two former stages of my career.
Speaker 4: First the idea of strategy and competitive advantage, second the
Speaker 4: long term focus, and third this idea of you know,
Speaker 4: how how do these companies start out from from something
Speaker 4: small and scale to become something very significant. So I'm
Speaker 4: very I'm very fascinated by that, and that's what I've
Speaker 4: been applying for the past decade.
Speaker 1: So let's let's kind of dig into the opportunity fund.
Speaker 1: You know, it sounds like you started getting into the philosophy,
Speaker 1: you know, behind the fund strategy. Can you, I guess,
Speaker 1: give us a little bit more about that philosophy that
Speaker 1: you're using, I guess for the investment process of this.
Speaker 4: Yeah, I guess just to take a step back even
Speaker 4: before we kind of talk about the philosophy. I mean,
Speaker 4: why being sort of small caps at all? I think
Speaker 4: it has to do with this, you know, defining characteristic
Speaker 4: of capitalism, right, which is this this what makes America exceptional?
Speaker 3: Right?
Speaker 4: It's innovation and sort of this process of creative destruction
Speaker 4: whereby smaller companies and entrepreneurs come up with newer, more
Speaker 4: innovative ways of doing things, they offer superior value to
Speaker 4: customers and improve lives. So I think, you know, I
Speaker 4: very much believe in that fundamental process. And then if
Speaker 4: we kind of move to active management, right, we firmly
Speaker 4: believe there's there's a value of active in small cap
Speaker 4: And you start with the idea that small cap is inefficient.
Speaker 4: You have a universe of emerging companies with limited analyst coverage.
Speaker 4: So it's certainly an area where active management can add value.
Speaker 4: I think Morgan Stanley did a great study where they
Speaker 4: found the cumulative media and alpha by active managers and
Speaker 4: small cap was nearly sixty percent over the past thirty years. It's,
Speaker 4: you know, very different versus sort of mid MidCap and
Speaker 4: large cap. And then third, similar to private markets, the
Speaker 4: best managers and I'm really talking about sort of the
Speaker 4: top quartile, the top descl can add tremendous value. And
Speaker 4: that's similar to kind of like an institutional investor looking
Speaker 4: at private equity or venture capital. You don't want to
Speaker 4: be in sort of venture capital just for the sake
Speaker 4: of being in venture capital. You really want to be
Speaker 4: in a top quartile type manager. And so those those
Speaker 4: are the things we believe. And if you then layer
Speaker 4: into kind of our strategy, you know, we think we
Speaker 4: have a few key advantages. First, all we do is
Speaker 4: small cap, at least my team of four, we focus
Speaker 4: on this emerging company universe. We happen to be located
Speaker 4: in San Francisco, which obviously gives us a backdoor seat
Speaker 4: to a lot of the innovation, particularly in the tech,
Speaker 4: technology and healthcare sector. Second, our team experience. Again I
Speaker 4: mentioned the four of us as industry specific sector analysts.
Speaker 4: Third and absolute valuation discipline, which I'm sure we'll get
Speaker 4: into later, but every name has to have at least
Speaker 4: one hundred percent upside at the time of our purchase
Speaker 4: over a five year time horizon. We use no more
Speaker 4: than a thirty times pee multiple and our five year
Speaker 4: model estimates. And then finally, fourth, a high conviction portfolio.
Speaker 4: So on average we have about forty names in our portfolios,
Speaker 4: so fairly concentrated. And so what that gives us is
Speaker 4: this portfolio of innovation and growth, but it's also tethered
Speaker 4: to reality and valuations, and we think that's the secret
Speaker 4: sauce to full cycle returns and the alpha that we've
Speaker 4: been able to generate over time.
Speaker 1: So I know quality is an aspect that you're looking for.
Speaker 1: Is there anything that you would you define quality as?
Speaker 1: Any specific characteristics?
Speaker 4: Yeah, I think I think traditional managers would certainly look
Speaker 4: on you know, wide modes, high an uninvested capital, that
Speaker 4: sort of thing. And I think quality has a number
Speaker 4: of different dimensions. As you said, you know, we like
Speaker 4: high return on invested capital businesses just as much as
Speaker 4: everyone else. But I think sometimes the opportunity in this
Speaker 4: emerging company universe is to have a more forward definition
Speaker 4: of quality and sort of, you know it s Gretzky said,
Speaker 4: skating to where the puck is going to be. So
Speaker 4: we're much more forward looking than sort of backward looking.
Speaker 4: So in addition to kind of the playbook of being
Speaker 4: able to buy high return on invested capital businesses when
Speaker 4: they sell off, you know, we want to kind of
Speaker 4: be diving into the mystery of the emerging company universe
Speaker 4: and think about these future, forward looking quality metrics, and so,
Speaker 4: you know, certainly we care about competitive advantage, but I
Speaker 4: think frequently there's an innovation component which we're looking for.
Speaker 4: There's a strong margin expansion component, so we're often focused
Speaker 4: on incremental margin as opposed to just kind of current margin.
Speaker 4: And then we're focused a lot on management, obviously, and
Speaker 4: trying to invest with these entrepreneurial management teams that set
Speaker 4: ambitious objectives but also have a clear plan and track
Speaker 4: record upon which they can execute towards those objectives.
Speaker 2: And you mentioned PES as one of the metrics that
Speaker 2: you use. How do you feel about equity valuations broadly
Speaker 2: and are there any other metrics that you like to
Speaker 2: use for valuing stocks.
Speaker 4: Yeah, our primary valuation metric is long term earnings power,
Speaker 4: and so we have a process we call it this
Speaker 4: anchor point, where we're focused on intrinsic value five years out.
Speaker 4: So we're oftentimes looking, we're trying to understand the unit
Speaker 4: economics of these companies. Everything we do is focused on
Speaker 4: fundamental bottoms up research, and so if you break down
Speaker 4: revenue of any company, right, there's often a volume component
Speaker 4: and a price component. A company can sell a certain
Speaker 4: amount of widgets and charge a certain price per widget,
Speaker 4: and then you layer on the incremental margins. I've on
Speaker 4: the earnings per share target and so upon which we
Speaker 4: applied no more than a thirty times p multiple to
Speaker 4: those five year estimates, and every company to enter the
Speaker 4: portfolio has to have at least one hundred percent upset
Speaker 4: on those on those metrics. So that is the primary
Speaker 4: valuation metric we use. We do look at other relative
Speaker 4: valuation metrics, you know EVD sales, EVD, EBITDA, things like that,
Speaker 4: but the primary metric is really the five year earnings
Speaker 4: power and the intrinsic value of these companies.
Speaker 1: I wanted to do a follow up on you know,
Speaker 1: you were talking about management teams just a few moments ago.
Speaker 1: You know, what are the exact qualities? I know you
Speaker 1: mentioned you know, having ambition and you know having you know,
Speaker 1: good products. Are there any other I guess qualities you
Speaker 1: look for in management teams?
Speaker 3: Yeah?
Speaker 4: Management, I mean it is there's kind of the science
Speaker 4: of investing, and I guess there's the art, right, and
Speaker 4: I think management is much more of an art than
Speaker 4: than a science, uh to to say there's one way
Speaker 4: of managing a companyany Obviously, every company can be very different.
Speaker 4: But I think the best entrepreneurs do tech. If you
Speaker 4: look at just the Magnificent seven for incentra right, I mean,
Speaker 4: the most successful companies were all sort of founder led.
Speaker 4: These these folks who are driven to change the world
Speaker 4: and and and and have been able to scale the
Speaker 4: company's in remarkable ways. I don't I don't think every
Speaker 4: founder has the capability to scale to those levels, obviously,
Speaker 4: but those are the most successful outcomes. But we do,
Speaker 4: we do analyze culture of companies, uh, you know, even
Speaker 4: glassdoor reviews, things like that. We certainly like to take
Speaker 4: advantage of our location, again being in the B area,
Speaker 4: being able to access private companies, venture capitalists, competitors, suppliers,
Speaker 4: kind of the traditional Fisher scuttle butt work, and and
Speaker 4: then ultimately I think somebody once told me the best
Speaker 4: managers do set low expectations.
Speaker 3: And constantly sort of surpass them.
Speaker 4: Right, Not not to say that they're unambitious expectations, but
Speaker 4: if you can consistently kind of outperform relative to the
Speaker 4: expectations you set, that's a very good thing.
Speaker 2: Are there any sectors you currently find particularly compelling? And
Speaker 2: one of the things I've focused on in twenty twenty
Speaker 2: five is the sector rotation that kind of moved away
Speaker 2: from tech, especially in large caps. Do you think that
Speaker 2: could last in twenty twenty five?
Speaker 3: I am hopeful.
Speaker 4: I personally spend a lot of time in the technology sector.
Speaker 4: But you're absolutely correct that when you look at the
Speaker 4: drivers of the s and P five hundred, obviously they're
Speaker 4: very much concentrated in the magnificent seven or eight. One
Speaker 4: of the interesting things about the small cap universes, to
Speaker 4: some extent, we've seen that broadening. So if you look
Speaker 4: at the drivers of the returns in the small cap space.
Speaker 4: It is not solely technology, and certainly for our strategy,
Speaker 4: we've seen great performance in consumer and healthcare and in
Speaker 4: industrials and other sectors. So I think we're already starting
Speaker 4: to see some of that broadening. We haven't seen it
Speaker 4: to the extent in the S and P. Five hundred,
Speaker 4: but I think some of that will depend on, obviously,
Speaker 4: whether technology can maintain its leadership, particularly in AI, and
Speaker 4: whether some of these other sectors can broaden out. Certainly
Speaker 4: with the new administration, that that that there is some
Speaker 4: reason to be supportive of the overall economy.
Speaker 2: Yeah, and it's it's good that you bring up the
Speaker 2: new administration.
Speaker 4: Uh.
Speaker 2: Do you think that any of the election results changed
Speaker 2: any of your investment theses?
Speaker 3: Yeah, yes, and no.
Speaker 4: I mean I think we are much more focused on
Speaker 4: these secular growth themes of technology, healthcare. Uh, you know,
Speaker 4: just just more innovation throughout the economy. Consumer businesses have
Speaker 4: are offering, you know, always offering better value to customers.
Speaker 4: New companies like sweet greens and restaurants along healthier living
Speaker 4: trends or elf and beauty and cosmetics offering sort of
Speaker 4: you know, value at at a good price point. And
Speaker 4: so those those don't tend to be correlated as much,
Speaker 4: uh with sort of administration changes, where you might have
Speaker 4: more cyclical factors of you know, industrials being more in
Speaker 4: or out of favor. But I do think on the margin,
Speaker 4: obviously we're paying attention to tariffs, we're paying attention to
Speaker 4: the drive towards government efficiency. But I think the most
Speaker 4: positive factor with the administration is there does seem to
Speaker 4: be a renewed focus on innovation and technology in general.
Speaker 4: So obviously you have JD. Vance who is formerly a
Speaker 4: venture capitalist. There's reasons to think he might be better
Speaker 4: for little tech as opposed to just big tech, which
Speaker 4: would benefit the small cap space as well as venture capital.
Speaker 4: And you have Elon and and other folks are who
Speaker 4: are driving efficiency and innovation, which I think is good
Speaker 4: good for America and good good for a small cap.
Speaker 2: And I've been really focused on rates, and obviously the
Speaker 2: rate pictures increasingly more up in the air as we
Speaker 2: get into twenty twenty five, but I've been really focused
Speaker 2: on rates as a catalyst for small cap stucks to
Speaker 2: kind of inherrow the gap with the S and P
Speaker 2: five hundred, What do you think the catalysts are for
Speaker 2: you know, maybe a small cap resurgence this year.
Speaker 3: Yeah, I think.
Speaker 4: I think a stabilization in rates is really the key.
Speaker 4: We've never wanted to make explicit bets on rate cuts
Speaker 4: and things like that, although we understand the market does
Speaker 4: that for us and and may have gotten a little
Speaker 4: bit ahead of itself maybe let's say six six months ago,
Speaker 4: But now I think the general consensus will see maybe
Speaker 4: one or zero rate cuts. Again, I think putting putting
Speaker 4: sort of the past five years in context. You know,
Speaker 4: rates on the ten year went from close to zero,
Speaker 4: maybe fifty basis points to four and a half percent,
Speaker 4: and so that was a big headwind for small caps.
Speaker 4: And now I think there's a debate of you know,
Speaker 4: do rates stick down a bit or take up a bit? Again,
Speaker 4: putting putting this all in the context of the past
Speaker 4: five years, I think the most important takeaway is we're
Speaker 4: not nobody's expecting a four or five hundred basis point
Speaker 4: increase in rates, right. We seem to be entering a
Speaker 4: more stabilized period of interest rates broadly, and I think
Speaker 4: along combined with the strong economy, that's going to be
Speaker 4: a very positive thing for small caps.
Speaker 2: And since I talked about it at the beginning of
Speaker 2: the segment, What do you see as the outlook for
Speaker 2: IPO and M and A D see a comeback after
Speaker 2: this really week two year stretch that we've had.
Speaker 4: Certainly so, I think we're already starting to see it.
Speaker 4: We've seen a trickle of technology IPOs, but you're correct
Speaker 4: that following a ro us twenty twenty and twenty twenty one,
Speaker 4: twenty two, twenty three, and twenty four were fairly meager.
Speaker 3: That window is beginning to lift.
Speaker 4: I follow the private technology ecosystem very closely. Supposedly there
Speaker 4: are fifteen hundred private unicorns with valuations of a billion
Speaker 4: or higher, and I think there's been a strike by
Speaker 4: the private markets to really underwrite the lower valuations that
Speaker 4: are necessary in some cases to take those companies public. Obviously,
Speaker 4: many of these companies were funded during a period of
Speaker 4: very low interest rates, and so there's been a disparity
Speaker 4: in terms of private versus public market valuations. I think
Speaker 4: certainly the lower regulatory environment going forward, the certainty of
Speaker 4: the new administration will be positive catalysts for that, and
Speaker 4: I think that's necessary. I think there's been this trend
Speaker 4: of companies staying private for longer. I'm not sure that's
Speaker 4: such such.
Speaker 3: A good thing.
Speaker 4: Uh, And I think I think we'll want to see
Speaker 4: smaller companies come come come public sooner.
Speaker 1: You had mentioned you know the portfolio is pretty concentrated.
Speaker 1: Do you have any I guess things in place to
Speaker 1: manage portfolio risk?
Speaker 3: Yes, I think.
Speaker 4: I think when we look at portfolio risk first and foremost,
Speaker 4: we are we are looking at the the risk of
Speaker 4: losing capital as opposed to to solely volatility. Although you know,
Speaker 4: you can screen our portfolio on sharp ratios and downside
Speaker 4: capture ratios and we happen to look pretty attractive on
Speaker 4: those metrics. I think part of that is due to
Speaker 4: our absolute valuation discipline and our general each company has
Speaker 4: to have at least one hundred percent upside. Again, at
Speaker 4: the time of purchase, we use no more than a
Speaker 4: thirty times pe on those price starting's estimates, and then
Speaker 4: we're generally trimming when the upside falls to fifty percent
Speaker 4: or lower. As opposed to a pure buy and hold manager,
Speaker 4: We're not willing to hold an exceptional company at an
Speaker 4: infinite price, and so we're quite disciplined about that. The
Speaker 4: best companies that stay in the portfolio over multiple years
Speaker 4: have to continuously prove themselves in terms of the upside.
Speaker 4: Otherwise we'll trim and sell the lesser companies as they
Speaker 4: become more fully valued. So our best defense is really
Speaker 4: our knowledge I think of the individual portfolio companies. We
Speaker 4: certainly want to know the key drivers of these companies
Speaker 4: as well or better than anyone else to mitigate the
Speaker 4: constant intration. Though again, we have a five percent max
Speaker 4: position limit, so we're not going to hold companies above
Speaker 4: a five percent weight because we recognize there can be
Speaker 4: additional volatility and risk associated with that. But really it
Speaker 4: is it is our knowledge of these companies and our
Speaker 4: absolute valuation discipline.
Speaker 1: I had one follow up question to that. You mentioned
Speaker 1: trimming companies, and so I'm curious, are there any other
Speaker 1: things you look at? You know, I guess we trigger
Speaker 1: selling the portfolio, not just you know, trimming a company gets.
Speaker 4: Yeah, we sell for one of three reasons, typically one
Speaker 4: the position becomes fully valued, to upgrade to better opportunities,
Speaker 4: or three. I mentioned this anchor points concept we have
Speaker 4: whereby we're really looking out five years into the future
Speaker 4: and trying to anchor it to these estimates of intrinsic.
Speaker 3: Value if those.
Speaker 4: If those companies are failing to meet those objectives over time,
Speaker 4: which does and that's a third reason we sell.
Speaker 2: So I've been following fundamentals for for small caps for
Speaker 2: for some time, and it looks like consensus is very
Speaker 2: weak for the fourth quarter earning season. Are there any
Speaker 2: macro factors you're you're watching that might help turn the
Speaker 2: tide on fundamentals?
Speaker 4: I think interest rates and valuations would be the main
Speaker 4: thing we're focused on, in addition to just company earnings.
Speaker 4: I think, you know, the biggest debate in the market
Speaker 4: right now is technology and AI. I was just at
Speaker 4: a conference the other week, and so I think the
Speaker 4: biggest question in the market right now is you know,
Speaker 4: perhaps AI probably has the most promise of any technology
Speaker 4: we've seen right because it's it's tam unconstrained in terms
Speaker 4: of being able to address labor, labor and services, not
Speaker 4: just tools and software spend. But because of that, it
Speaker 4: can be prone to overhype. And so I think, you know,
Speaker 4: a lot of Fortune one thousand type companies want to
Speaker 4: bet on a technology that's well understood and minimize risk.
Speaker 4: I think with Cloud there was much more, much more
Speaker 4: consensus over the value of cloud, and even then I
Speaker 4: think you saw some companies be resistant for some time.
Speaker 4: So with the risks of hallucinating, you know, I think
Speaker 4: it's hard to see widespread enterprise adoption right now. Certainly
Speaker 4: from a consumer standpoint, it's easier to see adoption there.
Speaker 4: I think another area that folks are wondering about is
Speaker 4: the scaling laws. Right we're quickly exhausting all the data
Speaker 4: upon which we're training these models, and we're using increasingly
Speaker 4: synthetic data and reasoning and trying to see sort of
Speaker 4: how that progresses, as well as well as the return
Speaker 4: on invested capital versus the capex. So these hyperscalers are
Speaker 4: all extremely well funded, the Microsoft's Amazon schools of the world,
Speaker 4: and they can support this capex I think for some time,
Speaker 4: but at a certain point it starts diminishing your free
Speaker 4: cash flow. And so it's striking to me that a
Speaker 4: company like Microsoft is reporting a decline in its free
Speaker 4: cash flow for share this year. I think investors might
Speaker 4: overlook that for a period, but over time, you obviously
Speaker 4: want to see the growth in the free cash flow,
Speaker 4: and so Sequoya put out a good paper I think
Speaker 4: last year on AI's six hundred billion dollar question asking
Speaker 4: whether whether the return on this two hundred billion of Nvidia,
Speaker 4: you know, data data center spend is supported by the
Speaker 4: six hundred billion in revenue software and application revenue, which
Speaker 4: we've yet to seen. So I think that's the biggest
Speaker 4: debate in the market right now. I know that's less
Speaker 4: of a macro factor, but in terms of thinking about
Speaker 4: something I'm watching in terms of secular growth trends, Yeah.
Speaker 2: That's definitely interesting. And did you have any major takeaways
Speaker 2: from the third quarter earning season and is there anything
Speaker 2: you're watching as fourth quarter results start to roll in
Speaker 2: for small cap companies.
Speaker 4: No, I mean, I think it's it's mostly a function
Speaker 4: of what what I just described. I think I think
Speaker 4: we're try to think about the broadening I guess, first
Speaker 4: and foremost what's happening in the technology sector, but second
Speaker 4: also the broadening of the economy, certainly with industrial industrial economy, ism,
Speaker 4: data like that as well. But again, our focus is
Speaker 4: more on secular growth and whether these companies are tracking
Speaker 4: towards these long term anchor points. I think during the
Speaker 4: dot com bubble, Jeff Bezos said it best. I think
Speaker 4: his stock Amazon was down something like eighty ninety percent
Speaker 4: at one point. But he was talking about how by
Speaker 4: any measure, Amazon was stronger than a year ago. Its
Speaker 4: customer account had increased from fourteen million to twenty million,
Speaker 4: its sales had climbed over sixty eight percent, its operating
Speaker 4: loss had narrowed. And so we're trying to think about
Speaker 4: these fundamental metrics in terms of the drivers of unit
Speaker 4: expansion and incremental margins that are creating heavier and heavier
Speaker 4: businesses over time, because in the short term market is
Speaker 4: a voting machine, but in the long term it's a
Speaker 4: weighing machine, and we're trying to invest in these heavier
Speaker 4: companies over time.
Speaker 2: And you mentioned the AI investment maybe not justified by
Speaker 2: the payoff as a risk. Are there any other big
Speaker 2: risks you see the stocks this year?
Speaker 4: Well, certainly, as we touched on that, I think interest
Speaker 4: rates and valuation metrics would be the concern, so that
Speaker 4: those are factors we will be falling. I think the
Speaker 4: market is relatively expensive by traditional metrics. One of the
Speaker 4: encouraging factors on small cap is relative to large cap
Speaker 4: we are undervalued on a relative basis, and certainly small
Speaker 4: caps have underperformed large caps over the past decade. I
Speaker 4: think it's the longest stretch in history. Traditionally, obviously, there's
Speaker 4: been this small cap premium. I think over the past
Speaker 4: ninety seven years, if you invested a dollar in small
Speaker 4: cap versus large cap, you would have ended up with
Speaker 4: over four times your money in small So that hasn't
Speaker 4: been the case for the past decade. There's good reasons
Speaker 4: why that is the case, with the rise of these
Speaker 4: Magnificent seven companies and so forth. But markets trends don't
Speaker 4: tend to last in one direction forever, and we think
Speaker 4: there's a real opportunity for me and reversion here. As
Speaker 4: a small cap has underperformed and the evaluations are relatively cheaper.
Speaker 4: That should bode well as the economy broadens and we
Speaker 4: could see some momentum and small cap and then again, additionally,
Speaker 4: an active manager doesn't have to invest in the whole
Speaker 4: asset class, but we can really invest in the most
Speaker 4: exceptionally well positioned companies within the asset class.
Speaker 1: It would be something to definitely look forward to. But
Speaker 1: before we let you go, we'd love to hear what
Speaker 1: some of your favorite reads are. You know, any financial
Speaker 1: favorite financial books you like?
Speaker 4: Yeah, I began talking a little bit about the Phil
Speaker 4: Fisher scuttle, but type work, you know, attending conferences, industry events,
Speaker 4: expert networks. We mentioned kind of our location here in
Speaker 4: the Bay. I remember one investment we made in a
Speaker 4: software company called Avalara for sales tax collection. Obviously, there's
Speaker 4: only two certain days in life, death and taxes, and
Speaker 4: so I remember going to one of these some of
Speaker 4: these tax tax conferences and hearing from the California Department
Speaker 4: of Tax and Fees that they were expecting additional you know,
Speaker 4: one a half to two billion revenue back in I
Speaker 4: think the twenty eighteen or twenty nineteen time frame, because
Speaker 4: there was a Supreme Court decision called South Dakota versus Wayfair,
Speaker 4: which ruled that it overturned the physical presence requirement where
Speaker 4: if you bought something on Amazon, let's say, from California,
Speaker 4: but it chipped from Texas, Texas couldn't collect state tax
Speaker 4: on that unless the seller had a presence in Texas.
Speaker 3: And so when the Supreme Court court overturned.
Speaker 4: That ruling, there was a huge rush to sort of
Speaker 4: tax a broader jurisdiction. So Avolara was well positioned for
Speaker 4: that trend and so the scuttle butt I mentioned in
Speaker 4: terms of that primary due diligence really is the craft
Speaker 4: of small cap investing, and Phil Fisher very much pioneered
Speaker 4: that with his book Common Stocks and Uncommon Profits. I
Speaker 4: think one of the questions he always asks management teams
Speaker 4: is what are you doing that your competitors aren't doing right,
Speaker 4: because you really have to sustain innovation to drive future
Speaker 4: appreciation in your business. And then the second book, I
Speaker 4: think is a book called Seven Powers by Hamilton Helmer,
Speaker 4: and it's a little bit an extension of Clay Christensen's
Speaker 4: work on the innovator's dilemma, but he has a concept
Speaker 4: called counter positioning which is very very powerful in small
Speaker 4: cap and a classic example I think is Netflix versus Blockbuster.
Speaker 4: So when you look at Blockbuster's business, they were challenged
Speaker 4: in a couple different ways, not only with sort of
Speaker 4: the internet distribution model changing that from brick and mortar,
Speaker 4: but also if you looked back at their business, I
Speaker 4: think a substantial chunk of their income was derived from
Speaker 4: late ease, and so when you had a newer incumbent
Speaker 4: like Netflix rise, they were able to compete in a
Speaker 4: way that Blockbuster was really powerless to sort of respond
Speaker 4: to because to compete they had to not only change
Speaker 4: their business model in terms of the generation from late fees,
Speaker 4: but also the brick and mortar model to Internet. And
Speaker 4: so we like this idea. But whereby new companies can
Speaker 4: counterposition against legacy incumbents.
Speaker 1: That's an interesting point. I guess I never really thought about,
Speaker 1: you know, all those nights, you know, going to Blockbuster
Speaker 1: years ago, the late fees drove so much of their revenue,
Speaker 1: but definitely makes sense. This is great, Brian, thank you
Speaker 1: so much for joining us today. Thank you, Mike, thanks
Speaker 1: again for being my co host today.
Speaker 2: Thank you both.
Speaker 1: Until our next episode, this is David Cohne with Inside
Speaker 1: Out
Speaker 4: Four No.