By Alex Pollak, CIO Loftus Peak
Key Takeaways:
- Short-term thinking has triggered a sell-off of some of the best companies in the market.
- Short-term volatility is unnerving, but it doesn’t alter the end result – significant secular themes (data and machine learning, energy as a technology not a fuel) are challenging the status quo.
- To invest in some of the best companies in the world, see the Loftus Peak Global Disruption Fund
The US market wiped out a whole year’s gains in the past two months, with the S&P 500 falling 10.3% from the year high on 20 September (2934) to a low of 2631 a few days ago.
It has since rallied 2.3% courtesy of a re-assessment in the speed of US interest rate rises in 2019.
Picking good companies
Caught up in the general equities fall were some of the best performing names of the past few years, like Apple, Google, Amazon, Nvidia and others. One line of popular commentary derives from the idea that these “new fangled” companies “deserved” it. But that idea is simplistic at best and doesn’t do justice to the facts.
These facts are that the world, which naturally includes business, is rapidly changing course as a result of new trends. Together, these trends form investible thematics, which are the core of our investment philosophy. Where we see companies playing into these thematics, and outclassing and outperforming competitors, we invest.
The death of Moore’s law
A good example of this can be found in the area of machine learning (one of our five thematics), and in particular Nvidia, which halved to US$150/share in the sell-off.
Why is this company so important? As we have written previously, the miniaturisation of processing power and its falling cost, which has come to be known as Moore’s Law, has come to an end. Improvements will now come from a whole new and different architecture for processing power, and they will not be measured in percentages, but integers like 10 times or 100 times.
Google searches that auto-complete do so because of this new architecture. Ditto mapping and facial recognition (used by Facebook and border security forces), lane change warnings on cars and electric grid management. It may seem trivial, but this can amount to millions of requests a second, hence the need for speed.
And so it was that Nvidia’s market capitalisation dropped to US$97b, around 40% of the value of Intel (which authored Moore’s Law) on the disclosure last month by the company of a US$700m reduction in revenue in the fourth quarter to US$2.7b.
We understand the complex set of reasons for this, but we strongly doubt whether Nvidia’s importance in global business in the next ten years will be damaged as a result of these revenue adjustments. We continue to hold the company because of its position in the value chain of disruption.
For the record, we first bought Nvidia at a price of US$26.81/share, and had sold some of the position as the value topped US$283/share earlier this year. But we didn’t sell out, and nor are we likely to.
What about Apple?
It’s the same with Apple, where two salient pieces of news led to the 20% sell-off. First, the decision by the company to no longer break out sales by product (iPhone, iPad, Mac, services) hurt the company. This may seem trivial – it’s not like disclosure actually affects sales – but it has been taken as a signal that Apple is nervous that its hardware sales are no longer in the ascendant (so management’s best course is to obfuscate on the numbers).
Our sympathies are not with Apple – like all investors, we prefer more disclosure, especially about products as important as these. And it is highly likely that we have hit peak iPhone, with handset sales unlikely to grow, especially in the face of very credible competition from Google, Huawei and Samsung, the latter two of which already sell more units than the Big A.
But Apple isn’t standing around waiting for a beating. It logged a 16% contribution to revenue from services, representing the app store generally, as well as music, video, payments, advertising and maybe health. Most forecasts have this number at least doubling in the coming few years.
Apple is one of the easiest companies to value in a way, since as a hardware maker it will mostly fit into a well-populated comparator set which trade on PE mutiples, and includes groups like laptop maker Lenovo (on a PE of 13x trailing earnings).
It is commonly held that services companies trade on double the multiple of hardware companies.
(We don’t use measures like these, preferring a longer period discounted cashflow analysis, which we find has worked better in this market given its skew toward companies which, because of changes in technology, break the historical mold, reinvesting back into the company and sacrificing short term profit. But some investors do use PE’s, so it isn’t irrelevant as a short term tool.)
At an extreme, it is possible to see Apple heavily subsidising hardware prices in a bid to gain access to the lifetime value of the services which run on its hardware, with an expanding multiple driving the share price higher.
Amazon – is it still expensive?
Another company caught in the downdraft is Amazon, now down 18.3% to US$1674/share from its peak this year (having been down 30% a few days ago).
We remain broadly positive on this company, and certainly don’t hold with the huffing and puffing on its lack of profitability. Earnings from US cable companies were wiped out in the early years because of the depreciation on their heavy investment, but that didn’t stop them from creating hundreds of billions of dollars of value.
The importance of Amazon lies in the distribution network it is building outside of the physical supermarket. By fulfilling straight from a warehouse Amazon has an immediate cost advantage in that it doesn’t pay rent to a shopping mall owner. Utilising this saving it is able to invest in a home delivery network – a superior experience, for the same cost to the consumer.
The systems underlying this proposition are expensive to set up, leading to heavy depreciation which hurts near term earnings. But these same systems also imply significant advantages once they hit scale. For example, supermarkets charge fees to suppliers for space on the shelves, which they take in the form of purchase discounts. Amazon charges its own suppliers fees for access to the network, charged for services from web space to front door delivery. It is these rising fees which has driven the re-rating of the company toward US$2000/share. That, and the strength of its very profitable cloud, or web services, business.
But Amazon’s stock price did get ahead of its valuation – we even saw one analysis which suggested that its Prime subscribers had a US$100b value separate from the retail business of which they are part.
These three companies all moved differing amounts, for different reasons, not just as “new fangled companies that deserve a rout”. They remain a key part of the portfolio for our investors because of their long term prospects and hold on global business. They are not going away any time soon, and will be delivering value to shareholders far into the future.
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