The Zen Innovation Investor, Volume 29

This time: The Big Picture, Company Chronicles, and Mindset

This blog aims to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision-making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece!

The Big Picture

Many of my recent discussions with industry friends and contacts have centered around how challenging it is to play the same game that has created value for a long time but seemingly disappeared.

When the investment industry was in its growth phase, 1975-1995, many investors were trained to look for undervalued stocks, and when they achieved their price target, sell and replaced them with another great idea. In this phase, many strategies were created to diversify a balanced portfolio, targeted primarily to large pension funds. Morningstar came up with the concept of style boxes to provide a framework for consultants and managers to enable a balanced portfolio to benefit from the skill of the manager (alpha) over different segments of the market, which, up to that time, had largely shown similar long-term returns but would vary each year. Utilizing a balanced approach would help to smooth out the inevitable fluctuations that asset classes had each year as conditions in the economy changed, such as GDP growth and interest rates.

This was a good framework for large allocators, and it worked well for decades. Skilled investors added alpha against their respective benchmarks, and the overall returns remained about the same over the long term.

Something has changed over the last 10-15 years that has frustrated many in the industry and left them wondering if what we have experienced is cyclical or secular.

For context, a small number of companies have provided most of the returns across the market. The so-called Magnificent 7 have had an average return of 34% over the last 10 years. At the same time, the S&P 500 has returned 11%. Still, it's good, but one must also consider that the Magnificent 7 is a big driver of those returns.

Other asset classes have lagged significantly, averaging 6-8% annually during the same period. I have seen a fair number of posts and whitepapers arguing for a valuation disparity and the likelihood of catch-up or mean reversion.

This argument has good quantitative foundations, and markets tend to swing too far in a direction and then tend to correct back. This is the argument for this phenomenon being cyclical.

We have written here a lot about the conditions that have favored the companies in Big Tech and why it is likely to persist. That has a lot to do with the disparity, we believe, where the conditions have been ripe for companies with strong innovation, market position, and an aggressive attitude toward reinvestment on the part of the management teams have enabled unprecedented stacking of intrinsic value on top of an already high level not seen in prior eras.

The secular argument centers around a few basic tenets:

· The Internet changed the dynamics of the economy. It lowered barriers to entry and increased competition, plus enabled efficient global distribution that used to take companies decades to execute.

· Once the all-important base layer of technology and the Internet were established, those who were able to leverage its benefits had a tremendous advantage over those who relied more on fixed assets.

· Leveraging intangible assets provides much better economics per unit of investment and generates very high margins and cash flow at scale.

· The aggressive utilization of resources, i.e., cash generation, toward expansion into adjacencies has created companies with a reach and scale that was not previously imagined.

So, Mag 7 companies are returning 34% compounded over the last 10 years, while others are returning much lower than their long-term averages. Is this cyclical or secular?

We believe it is secular due to changes in the economy and markets. The primary driver of the disparity in returns is changes in the economy due to digital transformation and the wide adoption of the Internet.

Two of the best companies in the world in their respective industries, Walmart and JP Morgan, have returned 15% and 13%, respectively, exceeding the S&P 500. That is still a good result, but with many other companies well below that level and a handful significantly above, it is worth rethinking how the world works.

Company Chronicles

One of the things we wrote about months ago was our belief that large companies would report to investors that they were seeing revenue and expense benefits from using Gen AI. We don't think this is a particularly controversial take, but the pace of the results could surprise investors.

This past quarter, a few software companies spoke on their earnings release conference calls about tangible benefits that they are seeing in their businesses. Investors showed enthusiasm for this, and many of these companies saw nice price appreciation on the news.

While we are not surprised by these reports, we are struck by how much the management teams are now talking about actual tangible results rather than promises.

Some of the companies that we would highlight as particularly important to monitor are Microsoft, Meta, Salesforce, and Service Now. There are others, of course, but these companies are worth the time to review their latest transcripts to get a feel for customer demand and the use of internal AI applications.

We still believe that the software industry has the most to gain and the most to lose as AI is tacked on top of the cloud stack. As such, we are on the lookout for those driving change and those denying change.

Note: Arrowside Capital owns a position in Meta and Service Now.

Mindset

One controversial topic related to investing is the role of the investment manager in protecting the downside when markets encounter inevitable corrections or bear markets. This is often referred to as downside capture.

Traditionally, some of the best managers in each style box category (see above) would not only add alpha but also provide downside protection. For a long time, owning higher quality companies (high margins, earnings, and returns on capital) would enable the portfolio to weather downturns in the market better than other managers and indices. This was a strong causal relationship as the best companies sold off less than the average company (or worse) as investors got cautious and raised cash. Makes perfect sense. Institutional managers would keep their positions in the best companies and sell off marginal positions in companies with less conviction.

This causal relationship has broken down with the rise in passive investing and the proliferation of investment funds. When the market corrects or has sharp drawdowns, passive funds that get liquidations sell some of all their positions. In addition, alternative funds that use leverage are forced sellers, and often, they sell off what's easier to sell namely broadly owned high-quality companies.

This has resulted in highly correlated selloffs, making it difficult for managers to have much lower drawdowns than in past eras.

In addition, companies with smaller drawdowns tend to have less growth and, when considered over a longer measurement period, are inferior investments to other companies that grow and create economic value.

We believe that this is a key concept to watch as the economy and market continue to evolve. It has become much more difficult for active managers to engineer the idea of losing less in drawdowns and adding additional return in bull markets. It is important for investors and allocators to consider what they want to live within the short term relative to the longer-term objective.

My story

I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital (http://www.arrowside.com), based in Boston, MA. I have more than 30 years of experience in the investment business, investing in companies geared toward innovation and growth. The blog is named The Zen Innovation Investor because it is essential to remain calm and focused during the rapid pace of change in today's world. I am keeping a view of the long term while also keeping abreast of developments in innovative companies. This is a place to sharpen my thinking and provide some thought-provoking insights.

Disclosures

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