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Interview on new technologies with more potential to grow

Thomas Rice is Portfolio Manager for the Perpetual Global Innovation Share Fund, a long-only global fund focused on investing in new trends in innovation and technology. This article first appeared under the title, 'Interview Series: What's new in a global innovation fund?'

 

GH: Managing an innovation fund must be the best job in funds management. What have been your big winners in the last year and why did you buy them?

TR: Yes, the Perpetual Global Innovation Share Fund returned 43% net in the year to end August so there have been many winners. We’ve held 31 different stocks that each added 0.5% or more. Three of the biggest were Zoom, Axon Enterprise and Vestas Wind Systems.

I’ll start with Zoom, which the Fund first bought in April 2019, the day it listed. What struck me about the company was it was one of the fastest growing SaaS (Software as a Service) companies in the world while having positive margins which is incredibly rare. Most SaaS companies have negative margins because they spend so much on customer acquisition. Videoconferencing seemed like a mature market, but Zoom was winning significant market share for two reasons. First, an incredible focus on the customer experience made it easy to use, which was new at the time. And second, Zoom was built for the cloud, and technically, it was far more reliable than competitors with efficient switching and routing. Then in March 2020 as video conferencing grew during COVID-19, I invested further in Zoom, and it became the biggest position of the Fund at 6.5% at the time.

GH: What about the impact of COVID on other parts of your portfolio?

TR: In February, my focus honed in on the potential impacts of COVID on the portfolio when the virus moved beyond China. I sold out of travel company Expedia and Disney. But I also went on the offensive and Zoom looked like a major beneficiary. I increased it to 10% of the Fund as I gained more confidence in the stock. Zoom went from 10 million daily meeting participants in December to 200 million a month then 300 million.

GH: But didn’t you then have a problem about the maximum proportion of the Fund which can be held in one stock?

TR: The Fund can hold up to 12% of one stock at the time of purchase or up to 15% with a market movement. We only hold that when I have a lot of confidence in the position. With Zoom, I talked to their existing customers and estimated how many the S&P500 companies had signed up by tracking subdomains. For example, a large customer like Nike will have a subdomain like nike.zoom.us. This allows you to check if those domain names exist and therefore, if they are Zoom customers.

GH: And you had strong confidence in another name?

TR: Yes, Axon Enterprise was the biggest contributor to the Fund in its first year in 2018. When I found this company in 2017, their main focus was Tasers, but they were also investing heavily in body cameras. I had previously done a lot of work on AI and machine learning, and I knew technology was improving and that they could interpret videos and images better than ever before. I also knew that transparency in policing was becoming important and I thought police body cameras would become the norm.

These body cameras are not like a GoPro camera, as some people assume. It's more of a data management business. It’s not about selling devices, it’s selling a monthly plan where a police officer puts the camera on a dock which uploads the evidence into a cloud platform on evidence.com. It's a subscription software business managed where they can tack on AI processing to add value. Axon’s service allows tracking of police officers in the field and livestreaming of videos in real time, at say, high-profile events.

Body cameras are already used in Queensland and Victoria, and internationally they recently won their first contract in India. Axon cameras are also expanding into new areas, such as forestry services, border patrols and prisons. In fact, Corrective Services NSW deployed 336 body cameras in December. I view Axon as a perfect blend of understanding the technology plus knowing the space they operate in. The Founder and CEO is doing his life's work running this business. He wrote a book called ‘The End of Killing’ where he talks about his mission to make the bullet obsolete.

Axon's focus on AI includes an AI Ethics Committee with independent third parties. They’ve committed to not using face recognition in any of their cameras because they don't believe the technology provides a fair outcome.

GH: How has the share price performed?

TR: The Fund first invested in Axon in June 2017 at $24 and it’s now $84 and a large part of the portfolio. Just think how often you now see body camera footage in the news.

GH: And your third best stock?

TR: That's Vestas Wind Systems, a renewables company. I became interested in wind power when the cost of energy for onshore wind power dropped below fossil fuels in many parts of the world. Vestas Wind Systems is the largest onshore wind turbine manufacturer in a business where scale matters. I think that wind will become an increasingly important part of the energy mix.

GH: We know that many tech and innovation companies trade on extremely high PEs or make a loss. How do you value a company that makes a loss?

TR: In my career, I've bought value stocks and yield stocks and growth stocks and bonds, and I personally invest in startups. And I don't think about them very differently. I go back to first principles, the present value and future cash flows. As long as you understand the underlying assumptions, it’s about what the business will earn over time. For a mature company, the near-term earnings are a better proxy for earnings, but for a growing company, you might need to decide how the business will generate a profit in 10 years’ time.

For example, what is the value of a company adding customers and how are they monetising it? Take the example of Facebook, where early on, they weren't showing many ads, but they have increased that overtime and monetised their asset. You need a good understanding of costs. How do the costs change over time, are there scale benefits? Put all those pieces together into how you believe the economics will transform in the next five to 10 years. Then you can get a sense of valuation.

I also like to invert the question. Based on where the stock is trading today, what would have to happen to justify the price here? That’s often better than a point estimate of valuation which can give you a false sense of security.

GH: Is there an example of a company that the market loves, and you don't.

TR: It’s hard to say the market is clearly wrong at any time, but I feel with companies like Uber or Tesla, much of the valuation is based on something that may or may not happen, such as the rolling out of an autonomous car network. I can imagine scenarios where that will happen, but I wouldn't want to bet on that outcome. I want more confidence that something beneficial will happen.


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GH: So, the good outcome is already in the price. How do you feel about the big techs, the Facebooks, Apples and Googles?

TR: Apple has clearly gone from being seen as a hardware company to a services company. It's rerated from 15 times to 33 times earnings, but I think it’s fully priced now. Facebook still offers reasonable value. I don’t think Google, Amazon or Microsoft are too expensive.

GH: Among these many successes, what has been a poor stock for the fund?

TR: Vivendi. It’s a conglomerate and their biggest asset is the Universal Music Group. I like this due to the rapid growth of music streaming where content is dominated by only three players: Universal, Sony Music and Warner Music. But other assets in the conglomerate aren't as attractive and the share price has not done so well.

GH: To manage an innovation fund, do you need to be an optimist, even a dreamer, with a lot of faith in the future?

TR: No, not an optimist, more a realist. You need to see the truth in how the world is changing and invest according to that, rather than hoping for the best.

GH: Is there an innovation the market has not recognised enough?

TR: I still think the market is underestimating the shift to renewables. We have reached a tipping point on cost comparisons versus conventional energy. Every year that passes, renewable costs will decline, especially with improvements in batteries and solar.

GH: What has been the biggest miss or act of omission in your portfolio?

TR: My biggest miss has been Apple and the way they have built a services business. Also, Shopify has done incredibly well as an alternative infrastructure provider in the way it competes with Amazon. COVID has been a real accelerant for e-commerce generally. It’s a company that I've watched closely but always wanted it a bit cheaper.

GH: Do you own any Australian stocks?

TR: We own Nitro Software, a PDF software company that’s also into e-signatures, which I think the market has undervalued. With COVID, you need to understand how behaviours are changing, including the digitisation of office documents. But I tend to focus outside Australia while staying close to the Perpetual Australian Equities team here.

GH: Would you like to see a market pullback to buy into some stocks at better levels?

TR: Not really, I love how the portfolio is positioned, we own a lot of great stocks where we have bought in at cheap prices. The Fund is underweight in the US and I'd like to own some big tech stocks at cheaper prices, say down 10% to 20% from here. But for me, it's more about what are the best companies in the world today based on where prices are now.

This is the way I frame it - there are 10,000 stocks in the world that are liquid with a market cap of over $1 billion. You should always be able to find something that's good value for a portfolio of around 40 stocks. You will never hear me say I can't find anything worth buying.

GH: What about e-sports and the gaming industries?

TR: Gaming has always been a part of the portfolio and the quality of games is now amazing. It's a growing segment of the entertainment industry with excellent ongoing demographic shifts. And it's also an area that a lot of fund managers tend to ignore which I find very surprising. I've always had 10% or so of the portfolio in video games. The ubiquity of mobile devices that can be used for gaming has been a huge driver as well. One way to get exposure to that is Unity Software, which is a game engine company that powers 53% of the top 1,000 mobile games. They just listed last Friday.

GH: Before we close, we should address the shadow that hangs over companies such as Facebook and Google, and that’s the threat of regulation. This extends to AI where people are concerned about privacy. How do you factor that in?

TR: Yes, it’s an important question and one that has a way to play out. There have been a number of instances where companies like Facebook have been too slow to understand their social license to operate. Data is a good example of that. There are huge benefits in using data to better understand your clients' needs but at what point does that use of data actually become unethical or a breach of privacy? In the absence of self-regulation, there will ultimately be a regulatory response. The more recent issue of spreading misinformation is complex and addressing it will be difficult and costly as companies build the systems to better manage it.

 

Graham Hand is Managing Editor of Firstlinks. Perpetual is a sponsor of Firstlinks and more details on the Global Innovation Share Fund can be found here. This article is general information and does not consider the circumstances of any investor.

For more articles and papers from Perpetual, please click here.

 

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