2nd Quarter 2014

The equity rally resumed during the second quarter with the US Market returning over 7% for the year. Value, lower quality and higher dividend stocks continued to outperform. Growth and momentum strategies continued to underperform. Utilities and Energy, driven by renewed instability in the Middle East, were the best performing sectors. Europe and Japan lagged the US. The Emerging Markets recovered, with India, Indonesia and Brazil outperforming the US equity indexes so far this year. China continued to underperform as concerns about growth and debt levels persisted.

Tech Bubble 2.0?

The Information Technology sector experienced an extraordinary boom and crash in the late 1990s and early 2000s. During this period the basic hardware and software infrastructure of the Internet was developed and adopted by businesses and consumers. Consumers, through their desktop PCs, began utilizing the Internet to exchange information, consume media, and purchase goods and services. The crash came about as IT spending collapsed after corporations and consumers completed their internal and external Internet setup and Y2K upgrades. Massive overvaluation of technology companies compounded the pain to investors. The 2001 recession and subsequent slow recovery, along with investors’ dot-com bust hangovers translated to a persistent lack of demand for new technology and drop in venture capital funding. Behind the scenes, however, another revolution (or evolution) was emerging based around the capabilities that scale could provide the surviving winners of the shakeout of Internet companies, the addition of mobile devices to the ecosystem and the ubiquity of high-speed Internet access.

I recently attended Bloomberg’s Next Big Thing, an invitation-only technology conference outside of San Francisco. The goal of the conference was to provide an overview of emerging and potentially disruptive technologies. The initial panel comprised John Hennessy, president of Stanford University, technology writer Esther Dyson and angel investor Ron Conway and attempted to answer the question of what is the next big thing? Mobile computing in the developing world, the maturing of Artificial Intelligence emerged as the major trends along with the digitization of healthcare and the Internet of things.

A recent McKinsey study that ranked technology trends by their potential economic impact identified the most important trend was that mobile computing was putting the rest of the world on the Internet. Over four billion people, primarily living in the developing world, remain to be connected to the Internet. Perhaps the most important application is improving agricultural productivity by providing farmers in developing countries information on best practices, weather, disease and pests, along with better access to financial services and markets for their products.

For most of us over a certain age, Artificial Intelligence conjures the image of HAL’s malevolent glowing red eye in the movie 2001: A Space Odyssey. Truly sentient artificial intelligence of this sort remains a subject for research and philosophical debate. What the term means today are statistical algorithms (an algorithm is simply a mathematical recipe) that can perform functions such as understanding and responding to human speech, interpreting visual data and medical diagnosis. These techniques allow for the automation of mid-level human knowledge work. A recent McKinsey study projects that by 2025 automated knowledge work could equal the output of as much as 140 million full-time workers. While many mid-level workers will face the need to retrain, much of this productivity will enhance the abilities of the current workforce and allow services, ranging from personal digital assistants to medical diagnosis, to be delivered that would be unaffordable to consumers if performed by a human.

The key, and yet only partially realized, promise of mobile computing is the connection – even the assimilation – of the physical world to the Web and its massive analytical powers. The term Internet of Things encompasses the collection and interaction of massive amounts of data coming from sensors attached to a myriad of physical objects, from personal health devices to satellites. By the next decade there will be over 30 billion devices attached to the Internet – far more than the number of human users. Applications range from monitoring parking and pollution in cities, more efficient irrigation and pest management in agriculture and real-time monitoring of oceans and water quality. The largest gains arise in healthcare. Real time monitoring of healthcare, particularly for people with chronic conditions such as diabetes or kidney disease, will both save lives and save trillions of dollars in medical costs.

Technology Increases Uncertainty

These emerging technologies pose significant threats to existing businesses. It is politically very difficult for corporate management to take actions that would impinge on a core cash cow business. Eastman Kodak understood the threat posed by digital photography but overestimated the time it would take to cut into their core film processing business. Blackberry similarly delayed responding to the threat of smartphones until it was too late. Cash cow businesses currently threatened by technology include payment processing, consumer lending, big tobacco (e-cigarettes), and scientific publishing. It does not matter how cheap a stock may appear based on past earnings if its core business is threatened by a more cost efficient and convenient technology. Accordingly, querying our value managers on their understanding of upcoming threats to the businesses they invest in has become a significant component of our due diligence process.

Identifying stocks of companies that will dominate these new technologies is not an easy prospect. Technology companies follow an evolutionary process; out of thousands of private startups a few will survive several rounds of venture funding to launch a public offering. On average, investing in IPOs has been a losing proposition – in aggregate they have underperformed the broad market. Successful investing in emerging growth companies requires a keen eye for management skill and a willingness to quickly exit positions when new data invalidates an investment thesis.

Short Term Noise Creates Long Term Opportunity

The emergence of thematic Exchange Traded Funds (ETFs) as an investment vehicle has made investing in emerging growth companies even more difficult. These funds now, according to a recent study from the Financial Analysts Journal, account for approximately a third of the trading volume on stock exchanges. The block trading of ETF baskets increases the correlation between individual stocks, particularly those in the same sector as ETF purchases and sales impact all stocks in these baskets equally. This reduces the short term efficacy of stock picking while conversely creating attractive longer term opportunities for patient investors.

While the resurgence of the Technology sector offers opportunities (and threats), the lesson of the 1990s tech bubble is that valuations matter. A growth stock might have a high P/E based on current earnings but offer an attractive opportunity if the market is not adequately discounting its growth potential. However this does not mean that pursuing growth at any price strategy will end any better than it did in the early 2000s. Patience, discipline and attention to fundamentals are characteristics we require of all our equity managers. This may lead to some missed opportunities but minimizes the risk of permanent loss of capital.

Realizing that outcomes under the best of circumstances remain uncertain for investors, particular attention needs to be paid to minimizing losses when things do not work. Often in the financial markets the cost of proactively protecting capital is risking underperforming benchmarks and peers in the short run. Over the long term, a focus on quality and valuation will maximize the upside / downside return tradeoff and will translate into both superior absolute and relative returns. It is here that investors should focus their attention. While predicting macroeconomic outcomes is a fool’s game, attention should be paid to how securities are pricing in the likely range of potential outcomes. It is always easier to win when the likely negative outcomes are already reflected in the price paid for the investment. Contrarily, when an investment is priced such that nothing short of perfection will deliver an acceptable level of return then caution is warranted. Equity valuations that discount a long term continuation of the current environment of low interest rates, high profitability and modest growth contain a large amount of risk if the macroeconomic environment changes. High quality stocks continue to offer the best risk / reward combination across the range of possible futures.

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