Posts Tagged ‘Investment strategy’

Emerging Growth Companies and Why They Are Important

Thursday, October 21st, 2021

THE DIGITAL FUTURE
Leading up to the Dotcom Crash of 2000, we heard a significant amount about how the future was going to be different and that investing had changed. Companies were going public with minimal capital and little chance of ever being profitable. The Crash happened, and those companies disappeared, much as has happened every time the investment community utters the words “this time it’s different.”

However, if you look at what has happened in the two decades since the crash and its aftermath, there has in fact been significant change, and much of it was not even contemplated by the folks who predicted a digital future. The following graphs were created by the company Global Macro Investor and the commentary by its founder Remi Tetot is incorporated into this analysis.

BIG DATA
We all know that data has grown substantially. The graph below shows that over the past 10 years, data usage has grown from just over one Zettabyte in 2000 to projected to be over 80 Zettabytes for 2021. We have computing moving from on-location mainframes to the cloud and the level of automation advanced to previously unforeseen levels.

Investment implications: cloud storage companies and those that provide software and processes to make work and personal life more digitally advanced and automated will be the megacap stocks in another ten to twenty years. Stocks that today are barely known will be household names that you wish you bought in 2021. Palantir and Snowflake are two of the more widely known names today, but lesser-known names like UiPath that provides robotic process automation which allows robots to emulate human behavior will have wide moats and massive revenues (and hopefully actual earnings per share and free cash flow that will enrich their shareholders much like Google, Microsoft and Amazon’s cloud services today).

SATTELITES
Space exploration will become increasingly important as satellites will be critical to the expansion of networks needed to handle data processing and transmission. There is a reason that Jeff Bezos, Elon Musk and Richard Branson (the three most forward thinkers of our time) have all put billions of dollars into research on space travel and satellite deployment capabilities. They have a vision for what the future will look like, and they are preparing for it now.

The graph above shows the growth of satellites from 1957 to 2020, while the graph below shows projections for just SpaceX satellite deployment forecast through 2030.

Investment implications: traditionally, the large aerospace defense companies would give you exposure to satellites, like L3Harris and Kratos. However, for a more modern take on this we again could look at Palantir whose meta-constellation software provides Artificial Intelligence capabilities to 237 companies in the industry.

5G WIRELESS COMMUNICATIONS
Inherent in the satellite trend is the upcoming 5G wireless revolution. The improved technology will allow for significant advances in more than just person to person communication as the “Internet of Things” moves quickly forward – devices all around us will become “smart” and interconnected to our daily life and with each other.

The graph below shows you the forecast for worldwide 5G mobile subscriptions through 2025.

Investment implications: we have had 5G exposure in client portfolios for a couple of years now, companies like Skyworks Solutions, Qualcomm, Qorvo, and Broadcom that provide components for smart phones, American Towers that provide the cell phone towers, and Uniti Group that has the largest supply of unused fiber optics lines.

INTERNET OF THINGS
he Internet of Things is already all around us. We have everyday devices that connect to the internet, sending and receiving data in a steady stream. Even though I refuse to connect my washing machine to my home wifi, it has the ability to connect to the internet and be operated via an app on my phone. I’ll bet your car is sending data to its manufacturer with details about its operating status – I know that I periodically get text messages from General Motors telling me that I have reached a mileage that requires a certain service or that one of my tires has low air pressure. The advances in 5G and Satellite deployment will make this ubiquitous in our everyday lives.

The graph below shows you the projected growth of the Internet of Things through 2025.

Investment Implications: this may be one of the most widespread of the topics discussed here – many traditional companies that you are familiar with operate in this space, like Hewlett Packard, Intel, Oracle and Microsoft. However there are others, like NXP Semiconductor that you may or may not know about that are big players in this field of providing automobiles with smart capabilities.

ROBOTICS & ARTIFICIAL INTELLEGENCE
The next major step forward in computing power is machine learning. As chip makers continue to develop semiconductors that can learn, the robotics Industry will continue to grow. As machines grow to handle new situations based upon application of past experience and programming, industry will become more efficient and show increased margins (albeit from the removal of human workers from parts of the process).

Over time, the cost for artificial intelligence will fall making it more prevalent and applicable to small and midsized businesses. The graph below shows you how the cost for computing power has trended to zero per “gigaflop” over the past twenty years. A gigaflop is a unit of computing speed equal to one billion floating-point operations per second. As that cost continues to trend down, adoption of artificial intelligence will flourish.

Investment Implications: the graph below shows the increase in investment capital that has flowed into companies that tackle various parts of the artificial intelligence business. Money enables innovation, and companies that have the ability to develop products that improve processes or further automate robotic solutions have the opportunity grow into megacap corporations like Google and Microsoft.

Nvidia, Palantir and Snowflake are examples of newer names in the investment world whose products are advancing the abilities of artificial intelligence. However it is not just prevalent in the tech and industrial world; medical research companies like Astra Zeneca are employing artificial intelligence in their work to develop new medicines and treatments.

MEDICAL TECHNOLOGY
Astra Zeneca using AI to advance their R&D is just one example of what is happening in the medical industry to employ advance technology.

Genome sequencing is on area that has seen significant advancement in the past two decades. The graph below shows you a comparison of R&D cost to generate a single genome sequence to the number of genome sequences that have been identified. The greater the number of genome sequences identified the more likely it is that science will be able to discover not just the causes of diseases like cancer, but what can be done to prevent them.

Investment Implications: there are publicly traded companies working in this area, with the best known being Illumina, Pacific Biosciences, and CRISPR. We do not have positions in any of these yet, but they are on my watch list.

Other medical advancements are coming from companies like INmune Bio that is working to reprogram the body’s immune system to combat Alzheimer’s Disease; Shockwave Medical that has pioneered a process called Intravascular Lithotripsy to clean out arteries and prevent heart attacks and strokes; Leap Therapeutics developed a process to treat cancer by inhibiting tumor growth and using the immune system to kill the cancer cells; and InMode Ltd that developed a minimally invasive technology for aesthetic healthcare to perform liposuction, skin tightening, body and face contouring, with the goal being less pain and faster recovery. Each of these companies has a niche in a specific growing market and may or may not be the big winner. They are, however, leaders in their fields at the present time.

Advancements in medical technology have a direct impact on life expectancy. In the graph below, you can see the path of global life expectancy through the end of the century. The companies above will be a part of that advancement or there will be new entrants to the markets that will improve upon their processes and products to become the dominant players.

This raises questions about the ability of the planet to generate adequate food and water to support the increase population resulting from increased longevity, but the next section touches on the food aspect of that.

BLOCKCHAIN
Most people associate blockchain technology with Bitcoin, the most famous user of it. However, it is much more than a platform for digital assets.

In its simplest form, blockchain technology allows for distributed computing where thousands of different computer networks work together to achieve a computing goal, where the benefit is that if one network fails, the entire system continues on without fail. The power of blockchain is that different tasks within a computing goal can be happening on different networks, exponentially expanding the computing power available to the user.

Digital currency has been one of the initial uses for blockchain technology since each participating network has a copy of digital currency transactions and balances. Below is a graph that shows the adoption of cryptocurrency projected through 2030.

Digital currency is just the tip of what blockchain will impact – below are some examples from 101 Blockchains of current systems that could be positively impacted by blockchain technology to help solve problems:

• Healthcare: transparent system for healthcare that allows for better communication of treatment protocols and coordination of available beds during crises/pandemics, among other things

• Supply Chains: better coordination of goods flowing through the system as businesses can pinpoint exactly where a product is in the process and whether they need to find an alternate source before a shortage becomes a major problem

• Food Supply: tracking food from the farm to the processer to the distributor to the store or restaurant, being able to maintain quality control and supply management – this will be critical, along with advance in farm technology (not discussed in this analysis) to keep the food supply increasing in step with the increasing population resulting from longer lives

• Power Grid: improved process for wholesale energy distribution and peer-to-peer energy trading that can improve pricing for consumers and improve continuity of service

Investment Implications: this is a difficult one – many of the companies working in this area are not yet publicly traded. However, blockchain has moved from the theoretical stage to the implementation stage with companies and systems deployed in several fields today, meaning it is only a matter of time before companies move from venture capital stage to IPO’s. Below is a list from 101 Blockchains detailing functional areas where blockchain systems are in use and the companies providing the technology:

  • Content management/distribution: PeerNova, Brave.
  • Data management: Factom, Essentia.one.
  • Cybersecurity: GuardTime, Remme, Blockverify, PeerNova.
  • Platform: Gem.
  • Healthcare: SimplyVital Health, MedRec.
  • Financial Services: Abra, Barclays, Aeternity.
  • Manufacturing and industrial: Maersk, Provenance, SKUChain, LO3 Energy.
  • Storage: STORJ.io
  • Government: SouthKorea’s project, Govcoin, Democracy.earth, FollowMyVote.
  • Retail: OpenBazaar, Loyyal.
  • Blockchain platform: IBM Blockchain solutions, Decent.
  • Transport and Tourism: Arcade City.
  • Media: KodakOne, Ujomusic, Civil.
  • RealEstate: Ubiquity, Propy.
  • Land Registry: Public Registry.
  • Identification: Uport.
  • Insurance: AIG.
  • Enterprise: Azure.
  • Advertising: NYIAX.
  • Authorship and ownership: Blinded, Stampery, Veisart, Po.et.
  • Social Network: AKASHA, Yours.
  • Diamonds: DeBeers

GREEN ENERGY AND ELECTRIC TRANSPORTATION
The graph below details the projections through 2050 for the sources of electricity production. This appears to be a relatively realistic projection as it shows current sources continuing to grow but at a significantly slower pace than renewables. The one that I think they are underestimating is Nuclear, but that is a debate for a different write-up.

Investment Implications: in the near-term, traditional energy has to be a part of a diversified portfolio, but renewables are a growing factor. From solar companies like First Solar and SolarEdge Technologies and to large conglomerates like Honeywell and General Electric that have gotten into the space, our portfolios have exposure to renewables.

However, the real push is in electric vehicles. The graph below shows the projection of electric vehicle sales through 2040.

Investment Implications: we currently have exposure to electric vehicles through: vehicle production and parts with Ford and Borg Warner; batteries with Compass Minerals; and charging stations with Blink Charging. The companies entering this market is growing exponentially, and significant amounts of money are going into building out the charging networks, so expect that we will increase exposure in due course.

We also have exposure to alternative fuels companies that are not in the EV space with biofuel company Darling Ingredients (who take restaurant cooking oil waste and convert it to biodiesel) and hydrogen fuel cell maker Plug Power whose products are used in delivery vans and long-haul trucking.

In the early stages of development, electric air travel is on the horizon. The leader in it is a publicly traded company from Germany, Lillium NV, that focuses on R&D in Electric Vertical Takeoff and Landing technology for highspeed air transport of people and cargo. They have their technology deployed in Brazil as a test market, and from what I’ve read it is progressing according to plan. This is a company on my watch list that could be added to client portfolios.

METAVERSE
Nvidia’s blog addresses this concept: “What is the metaverse? The metaverse is a shared virtual 3D world, or worlds, that are interactive, immersive, and collaborative. Just as the physical universe is a collection of worlds that are connected in space, the metaverse can be thought of as a bunch of worlds, too. [Initially the metaverse was] Massive online social games, like battle royale juggernaut Fortnite and user-created virtual worlds like Minecraft and Roblox, reflect some elements of the idea. [However, real world uses are now being developed, like ] Video-conferencing tools, which link far-flung colleagues together amidst the global COVID pandemic, are another hint at what’s to come…

“The metaverse will become a platform that’s not tied to any one app or any single place — digital or real, explains Rev Lebaredian, vice president of simulation technology at NVIDIA. And just as virtual places will be persistent, so will the objects and identities of those moving through them, allowing digital goods and identities to move from one virtual world to another, and even into our world, with augmented reality. The metaverse will become a platform that’s not tied to any one place, physical or digital. ‘ “Ultimately we’re talking about creating another reality, another world, that’s as rich as the real world,” ‘ Lebaredian says.

“Those ideas are already being put to work with NVIDIA Omniverse, which, simply put, is a platform for connecting 3D worlds into a shared virtual universe. Omniverse is in use across a growing number of industries for projects such as design collaboration and creating “digital twins,” simulations of real-world buildings and factories.”
The blog post from Nvidia makes it seem more theoretical than possible. Augmented Reality and Virtual Reality are becoming a larger part of everyday life, expanding beyond apps that are already available in the iPhone App Store, expanded beyond the gaming space, and is expected to be used in a number of practical applications.

The graph below details projections of which will be impacted by the disruptive technologies that will help define the Metaverse:

Investment Implications: companies like Apple, Google and Facebook already are at work on Metaverse applications, but other companies like Autodesk (provider of automated drafting software that now incorporates metaverse features in its architecture, engineering, and construction design software) are taking the concept and applying it to business uses. There are also emerging growth companies like Twillio and Unity Software that provide the software backbone for these disruptive technologies that form the infrastructure of the Metaverse.

To give you a feel for how big the Metaverse is likely to become, Facebook announced this week that they are rebranding themselves as a Metaverse-focused company with a new name to be announced soon.

Finally, I owe a hat tip to Puru Saxena for his writings on emerging growth companies and how to successfully manage a portfolio of them as I get ideas for my own further due diligence from those writings.

SUMMARY
Our Growth Stock Portfolio Strategy incorporates many of the companies discussed above. These breakthrough technologies will be critical parts of our future and the companies discussed may or may not end up being the next Google or Amazon – remember at one time Netscape, MySpace and America Online were considered the standard bearers for the digital transformation of the world. However, sometimes the pioneers in an industry do not end up being the winners as new entrants build upon earlier successes and innovate beyond what the pioneers imaginer or the growth they were able to fund.

Because of this, I keep a set of fairly strict rules when investing in emerging growth companies:

  • Revenue growth must exceed 15% annually, and the earlier the company is in the development of the technology the higher the threshold. Lillium NV discussed above is not yet a candidate for purchase as their revenues do no meet this benchmark;
  • The company needs to be the leader or a critical player in the industry;
  • The founder must be present and actively participating in the company. We do not own Pinterest in client accounts, but if we did I’d be a seller this week based upon the co-founder leaving the company for a different venture. I also get concerned if the CFO jumps ship; and
  • The company must focus on its core business and have moved beyond the emerging stage before they start acquiring companies outside their knowledge base that do not have express synergies or vertical integration with their core business. We previously owned Isreal’s Fiverr International, an online retail platform for sellers. Previous acquisitions allowed them to vertically integrate applications to expand the core platform. This week they announced the acquisition of an online education company – this is a red flag and I’d likely be a seller if we hadn’t previously booked profits in this company.

Investing has different purposes for different individuals. It can be for safety in a fixed income portfolio, it can be for income in a dividend stock portfolio, or it can be for wealth creation in a growth stock portfolio (you also get wealth creation from dividend stocks – but the big capital increases come from identifying and owning emerging growth companies that come to dominate their industries and potentially become the next megacap.

Having exposure to emerging growth stocks is important for a long-term growth portfolio; you don’t want the entire portfolio to be composed of them as they are too volatile and do not fit into traditional valuation models, but owning the next Google of Amazon is the catalyst for real wealth creation.

If you have an interest in our managing your investments using the concepts discussed in this blog post or previous ones, you can contact me at mballard@bankchampaign.com and we can discuss it.

–Mark

Disclosure: do not invest in any of the companies described in this blog post without doing your own due diligence. My writing about them is not an investment recommendation and you should not buy them just because I wrote about them. I owe a hat tip to Puru Saxena for his writings on emerging growth companies and how to successfully manage a portfolio of them as I get ideas for my own further due diligence from those writings.

Is Inflation Transitory?

Thursday, June 3rd, 2021

What are the odds that the Fed is correct?

Below is a graph that I saw on an investment site I watch. It struck me that the current level of bond yields for the current level of inflation are so outside the norm and divergent from the mean that either the Federal Reserve is correct and the inflation we are seeing now is a temporary blip up OR we have investors betting on a big return based upon a low probability bet that could end very badly.

If you play the casino game craps, you know that it is all probability-based. You are betting that a number is or is not rolled before the number seven is rolled (seven being the number with the most combinations of the numbers on the dice – one and six, two and five, three and four, four and three, five and two, six and one – making it the highest probability of being rolled. The high probability bets are on the six and the eight since they have the second highest number of combinations. one less than seven. The odds are higher that you will win with a six and an eight, so your winnings are less when they hit. The big money is made betting on two, three, eleven and twelve as the combinations are limited so the odds that they are rolled before a seven are much smaller.

When I look at the chart above, the current plot point shown in red and labeled as such is so far from the mean (as represented by the red line) that its like betting on two or twelve, which are known as the sucker’s bets since the house’s odds of winning are so high that these are the numbers the house encourages you to bet on.

There is an economic concept called Yield Curve Control. Yield Curve Control is a process by which the Federal Reserve buys so many bonds with longer maturities that it keeps yields from rising – it’s simply our old friend supply and demand coming into play. The Fed provides more demand than the required supply so the treasury has no need to issue bonds at higher yields to fund the government. Since the 2008-2009 financial crisis, the Fed has been buying bonds as a way to increase the money supply and thereby stimulate the economy (we’ve written about this Quantitative Easing process on the blog in the past).

So what happens if the artificial demand from the Fed slows down? We can look back to 2013 because the Fed tried to do exactly that thing and it caused them a problem that has become known at the Taper Tantrum in the bond markets. The ten year treasury bond yield roughly double over a three month period in Spring 2013 when the Fed began to slow its purchases of bonds – ie., the demand dropped below the supply required to fund the government so the yield had to rise to entice people to buy the bonds. Before any major damage was done to the economy from the abrupt rise in yields, they resumed buying bonds at the previous level.

In recent statements from the Federal Reserve, certain members of its board have come out with statements saying that the Fed would need to start tapering in the future to ease up on the monetary stimulus that is helping to fuel the rise in inflation. This week, the Fed announced that they would begin to sell off the corporate bonds they purchased last year during the covid recession. Tapering seems to be real, even if it is beginning slowly with the sale of the small number of corporate bonds they own.

Going back to our craps analogy, in the world of economics and bond yields, it appears that the Federal Reserve is the house and they are encouraging you to buy bonds at low yields by saying that inflation is transitory. The big question is whether the bet to buy a ten-year treasury is betting on the six or betting on the twelve, and whether rolling a seven with inflation being higher for longer hits sooner rather than later.

—Mark

Investing During Inflation (Part One)

Wednesday, May 5th, 2021

In my last blog post, I provided some details on why prices are on the rise and inflation is becoming an issue. Since then, I’ve been doing some research on which investments perform positively and which perform negatively during inflation.

Below will be a series of graphs I put together that compare the historic performance of various asset classes to the levels of inflation at that time. I’ve have added a linear regression that will help you see the positive or negative relationship between the level of the Consumer Price Index and the returns on that asset class. Please understand that these graphs do not present the data in chronological order.

S&P 500 Index (Large Cap Stocks)

Below are a series of graphs that analyze the correlation between Large Cap Stocks (as represented by the S&P 500 Index) and the Consumer Price Index. The first graph covers the period for which all data is available, 1926 to today:

I know this graph is difficult to read if you are not used to looking at statistical correlations, so let me walk you through it. (1) Qn the left side, you will note that the Y Axis is the return for the S&P 500, going from -50% to +75%. (2) On the bottom, you will note that the X Axis is the level of inflation for various years and ranges from -10% to + 20%. (3) For each annual inflation reading, there is a blue dot that shows the return of the S&P 500 at that level of inflation. (4) The red line through the dots is a linear regression best fit line that helps us visually define whether there is a positive or negative correlation between inflation and stock market returns.

Looking at the red line, you can sort of make out that there is a slightly negative relationship here, meaning that inflation has a slightly negative impact on stock prices over the long term. To confirm this visual analysis, I also calculated the statistical Correlation at -0.00787, so it is definitely a very slight negative correlation.

This is all well and good, but that doesn’t really get to the heart of how stocks perform during periods of significant inflation. To examine that, I isolated the time period of 1965 to 1986, a 21 year span that saw inflation move from 0.97% in 1964 to high of 13.29% in 1979 ( along with other double digit years during this time span) and back to 1.1% in 1986.

Visually, this is a lot easier to conclude that a period of rising and then falling inflation has a negative impact on large cap stock returns. To confirm that, I calculated the statistical Correlation to be -0.260998, a materially larger number than the Correlation of the 1926 to present day calculation.

The above analysis looks at an entire inflationary cycle. Since we are just at the beginning of a new cycle, lets refine the data further and just examine the period of time from 1965 to 1978, where inflation was building prior to its peak.

As we might guess, the visual examination shows the impact is even greater negative as inflation is building. The calculated correlation is even more revealing at -0.560582.

S&P 600 Index (Small Cap Stocks)

From the above, we see that rising inflation has a negative impact on the returns of Large Cap Stocks. However will it have the same impact on Small Cap Stocks. To determine that, I performed the same analysis on the S&P 600 Index. Unfortunately, there is not the same amount of data available for this index as there is for the much wider known S&P 500. Our data starts in 1975 for this analysis, so it doesn’t make sense to analyze the data prior to the 1979 peak in inflation, so we will examine the 1975 to 1986 period, comparable to the second graph above.

We again see the negative correlation between stock market returns and inflation. The calculated Correlation is -0.217613.

Implications

Based upon this analysis, the broad stock market is a bad place to be during times of inflation. Given the dominance of index funds and passive investing over the past decade or so and their dominant percentage of investment vehicles in the stock market – over half of all stock market investment is now through index funds – any negative impact on the broad market will have an oversized impact on individual investors.

The beta side of the stock market potentially is in trouble so we, as investment managers, need to rely on alpha to provide acceptable stock market returns and to reduce the risk of loss for clients. Beta is emblematic of the saying “a rising tide lifts all boats.” Many stocks have moved higher over the past decade because they were included in an index, and as money came into index funds, their stock prices went up whether they were a desirable investment or not. That is because the index funds have to mimic the make-up of the index so they have to buy the bad with the good.

Over coming days, I will show you various other analyses of markets, sectors, industries, and investment styles that illustrate which benefit from inflation and which do not. We are at the leading edge of this economic change so I want you all to understand what we are doing and to know how to manage your investments that you do not have with us.

Next up, we will look at the proxies for the growth and value styles of investing, the NASDAQ and the Dow Jones Industrial Average. Until then, keep this fact in mind so that you are sure to read the next post: today the 3-year breakeven inflation rate is 2.82%, the highest level in 15 years while the 10-year breakeven inflation rate is the highest in eight years. The breakeven inflation rate is a signal given by the bond market and has proven to be exceptionally accurate over the years.

Inflation is here, we now need to prepare our investment portfolios accordingly.

—Mark