QPD Podcast – Tech Through the Lens of a Value Investor

KEY TAKEAWAYS:

• Successful value investors in technology should embrace the concept of disruptive innovation while staying grounded in a cash flow valuation framework
• Technology company fundamentals are influenced by disruption. Disruptive innovation is the result of investments. And tech investments are in the form of intangible assets
• Cheap isn’t value especially in technology.  It requires a strong understanding of tech architectures and where the puck is going to avoid value traps

 

TRANSCRIPT

Joe Chin:

When it comes to investing in technology, I think the QPD discipline or a QPD-like style of looking at the world is absolutely critical for generating superior returns in the tech sector. That’s fundamentally because the technology industry is characterized by constant change. The pace of innovation, the pace of change, the pace of disruption in technology, I would argue, is greater than any other sector. Therefore, a traditional value approach which focuses on traditional income statements and balance sheet heuristics is not a comprehensive view on the quality of the business nor its valuation.

Host:

Hello and welcome to the latest episode of the QPD Podcast. On today’s show, we have investment principal, Joe Chin. Mr. Chin has over 22 years of industry experience and his primary analytical responsibility includes U.S. company coverage within the technology, energy, and retail sectors. Joe is responsible for many integral investment positions within the Cambiar domestic suite of products and he’s here today to discuss technology and how to evaluate the sector from the lens of a value investor. Joe, welcome to the show.

Joe Chin:

Thanks, Jim.

Host:

Joe, let’s first begin how you’re viewing the world today. When I say that, a lot has been discussed about how the pandemic itself has accelerated the adoption of tech in various industries and how this shift has affected how a potential investor would think about technology. I think just a big picture perspective on tech as it stands today would be valued by our listeners.

Joe Chin:

Yeah, sure. It’s a good question, Jim. I think it’s been pretty well acknowledged that the pandemic has basically accelerated many of the secular trends that were already in place before the pandemic. Work from home, e-learning e-health, cloud computing, these were all trends that we were all aware of before the pandemic, and adoption and demand has been pulled forward anywhere between probably three and five years depending on which sector you’re talking about. Now in the short term, I think it’s important to be cognizant of the base of comparison and the fact that we are now entering the stage of the recovery where the growth rates of these various technologies are going to moderate.

However, the longer-term view on these trends is still very bullish. It’s still up and to the right. As one thinks about valuing businesses that have exposure to these trends, those longer-term growth rates are still applicable. To be honest, I would say we didn’t do a lot of position changing during the pandemic. We were already levered to areas that wanted to be levered in. The pandemic gave us an opportunity to own more of the businesses that we already like.

Host:

Joe, that’s a good segue maybe into talking specifically about Cambiar and that quality, price, discipline investment process, or QPD as like to call it internally. Again, thinking about how a value investor attacks, the technology space, where many investors kind of correlate technology with growth investing. So when you think about the areas that you talked about being leveraged to, what’s compelling about it, how do you think about it within our QPD process?

Joe Chin:

Yeah, I think one thing we do really well at Cambiar is we thread the needle of quality and value in technology. What I mean by that is the tech sector in particular is defined by change. There’s no sector that experiences as much rapid pace of innovation and rapid pace of change as technology. That requires one to have a more flexible view of business models and valuation than what I would argue as a traditional value approach. With that said, that doesn’t mean we go chase every shiny new bulb. It doesn’t mean we throw valuation to the wind. It doesn’t mean we chase down every speculative idea. We still will subject every hypothesis to a rigorous bottoms-up analysis and we stay true to some time-honored corporate finance principles such as cashflow evaluation models.

Host:

You’ve made comments in recent presentations that value investing is not the same as the value factor. Can you elaborate for those who maybe not be familiar with this concept?

Joe Chin:

Yeah. A lot of ink has been spilled on this topic in recent years. Several value investing luminaries have written on the topic. Internally here, our CIO, Brian Barish, published a white paper titled The Virus Plaguing Value last year and one of our small cap PMs, Colin Dunn, published a blog titled The False Narrative Between Growth and Value Investing. At the essence of it all, I think what everyone is saying is that value investing is not the same thing as the value factor.

In other words, the traditional Russell and Morningstar definition of value which is based on factors or heuristics around low price to book, low price to earnings and low price to sales, I don’t think those are a comprehensive analysis of value. Certainly when it comes to the technology sector, I think those heuristics are lacking. So in a nutshell, I think the unique perspective that I bring to this conversation is being focused on technology, I’ve found that owning businesses that are just cheap is not the same as value. That’s due to the tremendous rate of change that we referred to earlier.

In terms of defining value in technology, I’ve come to lean on thought leaders such as Mike Mauboussin who, as you know, is a well regarded investment strategist, business school professor and author. He likes to say that value investing is simply buying an asset for less than its worth. What is a stock worth? A stock is worth the present value of the cash flows that it can distribute to its owners over time. I just love that answer because it just is such a pure return to first principles thinking in terms of investing, not growth investing or value investing, but just investing.

I use that lens when looking at technology stocks because on a fundamental level, I just agree with the definition. Secondly, the sort of unique angle that I bring to the table is in my experience with technology, technology company fundamentals are influenced by disruption and therefore the rate of growth of cash flows, and more importantly, the sustainability of those cash flows is a function of being on the right side of that disruption.

So I’d say the critical point of view that we bring to the table in technology is the intersection of these two ideas, which is that a stock is undervalued when it’s trading at a discount to the present value of its potential future free cash flows. While at the same time, a technology company’s cash flows are dictated by its technology platform and how relevant it is to the paradigm of its time.

Host:

That’s great and that’s a good segue. I’ve got another question. You mentioned disruption. If you remember, you contributed a few years back to a blog series on that topic. Fast forward to today, we are specifically talking about 5G in that disruption. So when you think about some of these trends accelerating, like you mentioned, due to the pandemic, where are you seeing the most meaningful disruption occurring today?

Joe Chin:

Yeah, if you look at the holdings of the Cambiar funds in the technology sector, you’ll see a number of disruptive trends expressed in the stocks that we own. I mean, I would call out things like cloud computing, 5G wireless ubiquity, Moore’s law stress in the semiconductor area. These are all well-known I would say consensus trends in the tech sector today.

What’s interesting is, Jim, you and I did a presentation not too long ago and we had a slide that described various disruptions that we were monitoring. What was fun about putting that slide together was it forced us to go back on our notes and look at what we were thinking about many years ago. What’s fascinating is that the consensus viewed toward disruption today, these trends were being called out as early as a decade ago. At the time, they were viewed as speculative and radical and unlikely.

Today, they’re the basis of several 500 billion and trillion-dollar market cap companies. So what’s always interesting about these conversations is to think about what are the things that are toys today that could be the basis of the next trillion-dollar market cap company tomorrow.

As far as your original question is concerned, for sure. I mean, in the near and medium-term, the secular forces around, again, cloud and wireless and the semiconductor ecosystem are very powerful. I think they are still underappreciated in many of the investments that we own. Going forward, we continue to play around with some new ideas and try to think creatively around how to get levered to the next big disruptions, while at the same time being extremely aware of risk management, valuation, and prude innvestor concerns.

Host:

That’s great. Maybe it’d be a good time just to discuss a specific name that fits the Cambiar QPD process. Again, you’ve outlined some of the key factors that you consider when making investments. Maybe walking through an actual example of something that fits that quality, fits the disruption, but also is priced well enough for our investors to have the downside protection we want and also the upside of the individual name.

Joe Chin:

Yeah. Yeah, sure. It’s a great question. Again, if anyone looks at our holdings, you’ll see that we’ve been very active in the semiconductor space. One of our favorite ideas, one of our names that we’ve owned for a long time is Applied Materials. As most people might realize, Applied is the leading semi cap equipment manufacturer in the world by revenue. As somebody who spends his entire day researching companies and spending time in the minutia, I could make your eyes gloss over with all the dirty details of the business and the industry.

But for the sake of this conversation, I think it’s important to frame the idea in terms of our investment process, how we went about identifying the disruption, how we quantified the impact to the business and then wrapping it all up as an actionable investment idea. So in describing the idea for this podcast, I’ll talk about Applied Materials in terms of how we found the idea and how we synthesized it into an investment.

So, Jim, you’ve heard me say this before, but one thing that I find helpful in the investment business is, is sometimes we use pattern recognition. Most people, especially value investors are fully aware of what happened to the energy industry from the early 2000’s to 2015’s. That was essentially a 20-year bull run supercycle no less in oil prices. The two disruptions that impacted the energy sector during that time was a structural step up in demand which came in the form of China’s entry into the WTO and their multi-decade run of double-digit GDP growth, which had the impact of structurally changing the demand profile for oil during that time.

That just happened to coincide with a supply-side phenomenon known as peak oil. That was best described by Matt Simmons in his landmark Twilight in the Desert. The combination of structurally higher demand in the form of China and the emerging markets with structurally lower supply in the form of peak oil from conventional wells resulted in a disruption in the supply-demand equilibrium of that industry that resulted again in a 20 year bull run in that sector.

When we were looking at semiconductors, what struck us was the similarities between what we had observed in energy during that time and what we are seeing in semiconductors today. The analogy today, internally what we’re using sort of tongue in cheek, we call it peak semiconductor, is on the demand side of the equation you have the rise, the acceleration of the digital economy that was pulled forward by COVID, but is no less powerful today than it was pre-COVID.

The rise of AI and cloud, what Applied Materials calls the fourth wave of computing, that represents a structurally higher growth rate in demand for semiconductors. On the supply side, we have a phenomenon known as Moore’s law stress. Jim, as you know, Moore’s law is actually not a law. It’s an observation. It’s an observation that’s been a real truism in the technology industry for over 40 years, and that’s simply that it’s the observation by Gordon Moore who is a co-founder of Intel who observed that the semiconductor computing power doubled every 12 to 24 months.

That fundamental law or observation has been the foundation of many of the technology trends for decades. It’s been an assumption that has underlied a lot of the innovations in the stack above semiconductors during that time. What many people didn’t realize or perhaps still don’t appreciate is that right around 2012, Moore’s law hit the wall. Since then the rate of change in semiconductor processing power has slowed down and the cost of manufacturing semiconductors has gone parabolic. What that means is that the transistor is fundamentally more scarce today than it was several years ago.

So the analogy to energy is structurally higher demand in the form of big data, cloud, and AI and structurally lower supply due to Moore’s low stress. This is peak semiconductor, and it’s a disruptive force that has fundamentally changed the supply-demand equation in the semiconductor industry.

Again, if you look at our holdings, you’ll find that we’ve invested across semiconductors on the back of this thesis. But one of our favorite investments has been Applied Materials which, again, is an equipment manufacturer. The reason why it’s one of our favorite ideas is because as an equipment manufacturer, they address the primary pain point of the industry, which is Moore’s law stress.

From a valuation point of view, the business was one of the most deeply discounted. It had understood or it had synthesized the disruption the least. That’s because historically, semiconductor manufacturing was viewed as the more cyclical part of the industry, bottom of the stack, and was therefore valued at a much lower level than the rest of the semiconductor ecosystem. But in this new paradigm that we’ve described, this disruption, the value proposition has been completely inverted.

Now, what was the dregs of the industry is enabling technology, mission-critical technology. Even though Applied Materials has been a good performing stock, the market still hasn’t come to an appreciation for this structural change and what it means for the long-term free cash flow growth of the business over the next decade.

Identify the disruption, we’ve talked about that. I just mentioned how we quantified it. So how do we build that back into an investment decision? Well, we do the blocking and tackling on the financial analysis and we derive a proprietary view of intrinsic value that is different than the market and remains different than the market and it continues to be an idea that we like.

Host:

Real quick on that topic still, it’s been well documented the supply challenges within semiconductors just more recently. Are you attributing that to this peak semiconductor kind of paradigm right now?

Joe Chin:

Yeah, that’s a great question. I was just on an investment webcast with the CEO of GlobalFoundries and he made the comment that this shortage that we are experiencing today was on the come several years ago, and that he had anticipated that we would hit this wall or that we would hit this crisis three or four years out. But what COVID did was it simply accelerated it, it pulled forward that event due to the nature of the pandemic.

The point he was trying to make was that this issue of Moore’s law stress, this issue of increasing transistor scarcity was always out there and the industry was going to have to deal with it at one point or another. We simply have pulled it forward due to COVID. But just because we pulled it forward, that doesn’t make it any less relevant for the long term.

Host:

Interesting. Quick pivot here, just talking a little bit about it, we’ve discussed it in some podcasts in the past, we’ve discussed it in some blogs, of just the importance in general of intangible assets, not only the importance for how some of these companies… I think the valuation’s been extended for a lot of them, but even also thinking about the benchmarks too, their lack of ability to maybe reflect on intangible assets inside valuations. So maybe just, again, a high-level thought on maybe thinking about how you value them or just, in general, the perspective of those types of assets within certain companies.

Joe Chin:

Yeah, sure. In terms of intangibles, this is a really interesting topic that’s been getting a lot of play in the academic community. As you know, Jim, I’m a huge fan of Mike Mauboussin who is an investment strategist and author and professor. He published a newsletter back in June titled The Impact Of Intangibles On Base Rates, which really rocked my world because he made some really enlightening observations around the increasing role of intangible investments across the economy and how that’s enabling some companies to grow at rates that exceed historical growth rates and to sustain at those levels for a long period of time.

But he goes on to mention that the role of intangibles has also increased the role of obsolescence. Businesses built on intangible assets are inherently… They have less salvage value in the case of obsolescence, and therefore when a business that’s built on intangible assets becomes obsolete or is replaced by a better option, it can decline much more rapidly than historic base rates would imply.

When I read that newsletter, again, it just rocked my world because even though he wasn’t writing about the technology sector per se, he might as well have been based on my experience over the last 20 years investing in technology. I don’t know why it didn’t dawn on me earlier, but when I read his piece, I just started to connect the dots and it makes sense because in terms of industries in the economy, no industry utilizes intangible assets more than the technology sector.

So it would make sense that technology companies, again, when they’re on the right side of history, when they’re investing in intangible assets that are productive assets that they would be able to maintain growth rates that might surprise one based on historic standards. Conversely, when they’re disrupted, they are disrupted quite dramatically. Though Mauboussin doesn’t use this terminology, I think what he’s describing is the process of creative disruption that, again, has characterized technology from the beginning.

Put another way, this is the process of disruptive innovation that has been a hallmark of technology. This is one of the things that we try to keep in mind very closely when we’re analyzing technology businesses, because just because a technology company is growing at a high rate and it might “look expensive”, again, if it has the tailwinds of disruption, it may not be as expensive as you think it is based on a cash flow analysis.

Conversely, a business that’s disrupted, or as I like to say, in technology, when you’re offsides, you’re really offsides. That’s the classic value trap situation. So it takes a strong understanding of technology architectures, it takes a strong understanding of how these systems work in order to make these judgments. I’d like to think that we do a good job of that.

Host:

That’s interesting, Joe. I actually thought of intangibles almost only on the upside, that there’s always value in those, but not really recognizing that the potential downside for being disrupted with all these intangibles, there’s nothing really material there. So an interesting perspective. Lastly, we’ve talked a lot about different issues and topics with respect to valuing technology stocks as an investor. I thought I’d give you an opportunity to close. If there’s anything maybe you wanted to elaborate on a little bit more on what are some of the key attributes that an investor needs to understand and possess to invest in technology effectively?

Joe Chin:

Sure. So our philosophy is that a successful investor in technology is open-minded about the future while inflexible toward a cash flow evaluation framework. Okay, that’s the boilerplate answer. What does that really mean? In my opinion, I think a good technology investor, frankly, just a good investor needs to have just the raw intellectual horsepower and the work ethic to get the work done, but you also have to be creative, and frankly, intellectually curious, and then wrap that all up with some intellectual honesty to maintain risk management as well.

I’ll elaborate. In terms of how we’ve been in discussing how we invest in technology, we want to identify disruptions early, we want to quantify them and then we want to make the right investment decision. Identifying disruptions, I would argue, is more about being creative and just curious and constantly asking the question why does this it exist in this form? What could change it? What could happen? What would be a meteor that could hit this industry and completely turn it upside down the way that Moore’s law hitting the wall completely turned the semiconductor industry upside down? What do I need to be looking for in order to recognize that the world just changed?

When Apple introduced their original iPhone, people thought it was just a high-end toy for celebrities and sports stars. But in hindsight, we all know now, the world literally changed when that product was introduced. What are the new products or services that are on the horizon that when they show up I’ll know are world-changing events and not just fickle toys or fads. That requires, again, I think creativity and just a lot of intellectual curiosity to research the topics in a way that go beyond sell-side reports and 10Ks and 10Qs, and to really think about, again, how industries and systems fundamentally work, what’s the fundamental economic utility that these new products are adding and are they compelling.

If we come to the conclusion or if we come to the qualitative judgment that we think these are important, then you got to bring in just the intellectual horsepower, the work ethic, the basic accounting, and finance knowledge in order to quantify these into terms that we can then use to translate those into successful investment decisions. Then lastly, just to be intellectually honest, because as much as I’m over here pounding the table on how smart we are and how great we are, the fact of matter is we make plenty of mistakes. Being intellectually honest about when you’re wrong is as important as making good, long picks as well.

Host:

That’s probably especially true in technology I guess.

Joe Chin:

Yeah, especially true in technology. Exactly.

Host:

Great. Thanks, Joe. Well, we are nearing the end of our time on the latest episode of the QPD Podcast. Joe, I really appreciate your insights. I personally am fascinated by technology and I hope our listeners really appreciated your take on a number of different areas. It will be really interesting soon to see how fast some of these technological changes you mentioned earlier will take hold. To all of our listeners, thank you for tuning in. If you’re looking for more information about the blogs we mentioned earlier in the show, please visit Cambiar.com. Until next time. Take care.