In Episode 122 of the [i3] Podcast, Conversations with Institutional Investors, we speak with Maroun Younes and James Abela, co-portfolio managers of the Fidelity Global Future Leaders strategy, about the attractiveness of small and mid-cap investments, a $12 trillion market with significant growth potential.
They acknowledge the recent underperformance of small caps due to market concentration in large caps, particularly in US tech, but point out that people are starting to wake up to the risks associated with those concentrations. Are we in an AI bubble, driven by these large caps?
The conversation starts at a high level, discussing the importance of quality, value, transition, and momentum, and then we do a deep dive into specific investments, such as Arista and FICO-score provider Fair Isaac Corporation.
We also come back to AI and see how it can be used by asset managers.
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Disclaimer: The content in this podcast is for institutional and wholesale investors and is not for distribution to retail investors. This podcast has been prepared without taking into account any person’s objectives, financial situation or needs. It is provided for general information purposes only and is not intended to constitute advice of any kind. References to specific stocks is for illustrative purposes and is not a recommendation to buy, sell or hold those stocks. You should consider the relevant PDS and TMD for any Fidelity Australia product mentioned before making any investment decisions, available at www.fidelity.com.au.
Podcast Overview
04:00 Large caps outperforming small caps in the US is unusual; historically small caps have outperformed over time. But people are waking up to the risk of concentration, both at a stock level and sector level
07:00 We are not too concerned about US exceptionalism, because we don’t see a huge break point going forward
07:30 It is always hard to tell whether we are in a bubble, but there are early signs of a formation (of an AI bubble). There is a lot of spending in this area and at this stage we don’t see that return on capex coming through
09:00 Fidelity webinar on AI
10:30 We have four focus areas: quality, which is the love quadrant, value is a neglected quadrant, transition is the quadrant of hope and momentum is the hot quadrant
13:30 We have guardrails for allocating to the different areas: 40 per cent quality, plus or minus 10, value 30 per cent, transition 20 per cent and momentum 10 per cent,
17:00 The case of Arista, looking for a catalyst to unlock value
20:00 Another case study, Fico credit scores
23:00 On selling discipline
28:00 We are not looking to make a big market call, but are looking to participate in the continued rally
31:30 We mainly have exposure to China in the healthcare sector. Most Chinese tech companies are too large for us
32:30 Getting compared to the QSML exchange traded fund
37:00 Looking but not buying; the case of Deckers and the Hoka shoe
44:00 White paper on Lessons Learned over the years
45:00 Using AI in our work; you can get to a working knowledge of a company in a matter of minutes
For the Fidelity webinar, ‘Navigating the AI boom: A framework for investing’, please see here.
Full Transcript of Episode
Wouter Klijn 00:00
Welcome to the show.
James and Maroun Thank you, Hi.
Wouter Klijn So why small and mid caps? What got you started in this particular space of investing.
James 00:21
Well, for me, I started in the Australian market, in Aussie mins and smalls, but we were asked by clients to move into the global space. That’s where Marouns joined me to attack this global market, which is huge. The tractions are significant. There is a very, very big market. The size of the market is 9 trillion US, which is huge. So 12 trillion Australian so it’s 5x the size of the Australian market. So the opportunity set is significant. The breadth and depth of stocks is very significant. So the number of stocks you can own in the universe, in each sector or in each theme, is quite broad and diverse. Valuations are very attractive, and one of the other key things is that they are still under researched, and in many cases, under appreciated for what they actually have in terms of quality. So that allows moon and I to find ideas that are often 15 to 20% EPS growth on 15 to 20% roes trading on very reasonable multiples, compared to things that are more discovered in large caps and the size we can now go up to is about 60 billion US, which is our universe scope, which gives us quite a long runway in terms of years of holding stocks before they are large caps. They’re all the key attractions. So it is a very attractive space.
Wouter Klijn 01:32
So we’ve seen a lot of concentration, in particular US equity markets. And we did see that earlier this year’s small and mid caps have underperformed a bit. Are the two linked? Is the concentration in the market affecting the smaller mid cap space?
Maroun 01:47
Yeah, absolutely. So they’re two sides of the same coin. So you’ve basically had in the US market a concentration of maybe half a dozen stocks, predominantly in the technology sector, and they’ve been doing incredibly well. So they’ve propelled the market a lot higher, and they’ve they’ve allowed large caps to outperform small caps. That’s quite unusual. Small caps historically, if you look back 25 – 30, years, small caps historically, have outperformed large caps. They’re smaller. They’re growing off a smaller revenue base. It’s much easier for them to double and triple in size over time, but certainly over the last maybe five or six years, that’s not been the case. So it has tempered some enthusiasm, I guess, in the past, for smaller mid caps. But I think you’re also starting to see people now waking up to the risks associated with the concentration levels, both at a stock level as well as a sector level, and people actively now looking to diversify away from that.
Wouter Klijn 02:44
Yeah. So you don’t see it as a structural change. This, the small cap premium is still out there. It might be just a temporary dislocation.
Maroun 02:51
I think so. If you look back in history, there has been periods in time where, where large caps have done quite well. If you look back to the nifty 50, back in the early 70s, there was that there was a handful of stocks that did incredibly well, predominantly at the top end. So we do go through periods every so often. I think this is another one of those episodes.
Wouter Klijn 03:09
Yeah. So might be a nice buying opportunity then?
Maroun Absolutely, yeah, we definitely think so, yeah.
Wouter So we’ve looked a lot at US exceptionalism, a lot of talk around that, especially the Magnificent Seven. But you know, is it the broader market, or is it just the Magnificent Seven that are exceptional? Or do you see that also extended to the to the smaller mid cap space?
James 03:35
Yeah, with US exceptionalism, it’s a very big topic area. So what we focus on, I guess, in our world is returns, and the return profile of the mega caps is quite high. Still, during that 20% level, in terms of roa’s or Reich’s return on investor capitals, our index is still around a 15 to 16% level, which is quite high, and also the US in aggregate compared to the rest of the world, is very high. So 15 to 20% returns on capital, compared to the world average of around nines to 10s, whatever you want to call it like, the US, is 50% better on average, in terms of returns on capital to the rest of the world. So we are still, you know, half of our fund, at least, is in the US. There’s a lot of talk about the US builds great businesses. The Chinese build great manufacturing, and European builds great regulation. It’s a well known kind of cliche, but the fact is that the US does have great businesses, whether they’re whether whatever you is you want to say, the cause of that is, and that’s expected to continue, especially for the next few years. Yeah, so we don’t think it is a one off, and it’s not just the mag seven either. Mag seven are symptomatic of the US being a leadership marketplace, and we find that’s why we find it very attractive, because in global mids and smalls, we’ve built a portfolio which has returns on capital of in the 20% range as well, and still a very reason. Or valuations. So, you know, we aren’t too concerned about that concept of us exceptionalism, because we don’t think it’s there’s a huge break point that’s obvious coming forward.
Wouter Klijn 05:10
So there has been a lot of talk around whether we are in an AI bubble or not, and whether the Mag Seven isn’t a symptom of that. What’s your take on it? Do you have any views on whether we’re in a bubble, just in an expensive period.
Maroun 05:22
Yeah, it’s always hard to know whether you’re actually in a bubble or not, but certainly there, there are signs, early signs of formation. There’s a lot of spending going into this area, and at this stage, we’re not seeing the return on that, that increased capex come through now it may still Come, come come further down the track, and in which case, all this spending is justified. And you know, things continue as they are, but when you’re seeing an increasing level of CapEx, I mean, some of these companies in the mag seven are spending 10x the amount of CapEx they were 10 years ago. So they were capital like businesses, and now they’re quite capital intensive. Businesses spending a lot more money, that money needs to earn an attractive rate of return, because one of the things these businesses have done historically is deliver very high rates of return. So when you’re investing a whole lot more money and you’re large and you’re dominant, the hurdle rate for you to keep on growing becomes it becomes incredibly high. So I guess we’ll see over time where this ends up being a bubble or not. But certainly there are some early signs that, you know this could head down that path.
Wouter Klijn 06:31
Yeah, yeah. So most people talk about the mech seven when they think about AI and AI development. Are there any opportunities in the smaller myth gap space that stand out?
Maroun 06:40
Yeah, so we’re seeing quite a few of those, and we have a few of those in the fund itself. They don’t dominate the headlines that they’re not household names, but a lot of them are in what we call the enabler space right now. They’re either doing things like advanced packaging and hybrid bonding or certain techniques such as power efficiency in industrial end markets. We go through this in quite a bit of detail. Recently, we did a webinar probably about half an hour. We went through AI in detail and what it means for our universe. And we even had our sector lead, that technology sector lead, dialling from Hong Kong through the webinar as well. So if people are interested, I’d encourage them to have a look at the webinar for quite a bit more detail,
Wouter Klijn 07:23
Yep, and we’ll put a link in the description. So let’s have a look at your process, your investment process. There’s four areas that you focus on, quality, value, transition and momentum. Why these four elements?
James 07:38
They really allow you to keep a balance style through the whole sort of movements of the market. So markets can be like what I call quality momentum cheerleading. It can be a bear market, where value and transition kind of works much better. They can be very thematic elements of the market. So this allows us to be basically balanced, but also have guard rails that makes sure we’re not too extreme in one particular style factor, specifically like quality, is quality compound. It’s a high return businesses that are long duration value. Businesses are typically lower valuation, but at least the balance sheets are good, and they’re not in some strategically declining marketplace. We’re happy to hold those if they’re just out of favour. Transition names can be turnarounds. They can be cyclicals on the recovery. Or they can be innovators, and then momentum can be top of cycle, cyclicals top of cycle, thematics or or things that are just like in in a hot sort of thematic as well. So that those four elements is how we think about it, that we think about it in terms of risk as well. So that allows us to think that your blind spots and your winning spots tend to be governed by where the stocks are on that journey. So we have different sort of funny names, like qualities a love quadrant Valley is a neglected quadrant transitions. The quadrant of hope and momentum is like all like the night club quadrant or the hot quadrant. It’s where things are. Yeah, lots of fun and things are going up.
Wouter Klijn 09:03
Is that how you label stocks as well? These are the hot stocks, and these are,
James 09:07
well, they get labelled in qvtm, so they get labelled by that, but it’s your brain definitely is wired to where that is. So for example, the quality quadrant is love quadrant. Like a long term marriage or a long relationship, you get very comfortable. You get very complacent. So the risk is in, this is business. So this is, you know, competition, capex, complacency, arrogance is what can set in when you’re a high quality stock. If you’ve got something that’s unique, and we’ve found things that are unique have 20% returns for, say, 10 to 20 years. That can happen if you are offering something very unique, but you have to work very hard for that to work for 20 years.
Wouter Klijn 09:43
So does that help you in managing, sort of, also the risk of, like, you know, falling in love with a stock or, yes, developing bias?
James 09:48
Exactly. So at the individual stock level, yes, you are trying to manage the stock, individual stock risk. And then at the portfolio level, you’re trying to manage factor exposure risk, and you’re not. Trying to, for example, in 23 and 24 Those years were very much quality momentum markets where a lot of it was generating alpha from PE expansion or earnings upgrades. So what you end up having, you’re managing risk at the stock level and the portfolio level, and what you also then have is a spread of businesses that are like four sort of types as well. So quality compounders, which are those beautiful compounder stories, cyclicals. So your value transition, momentum, kind of triangle, cyclical, mid cycle, top cycle. Then you have your innovators, which go from transition to momentum when they’re going from generally low returns to high returns. And sometimes they can move over into quality if they can sustain that for many years, and you’ve got your thematics, which are generally momentum. So there’s these four types of stocks that you can can own, and they they’re on very different journeys. What they’re doing in terms of share prices and returns and multiple expansion is very, very different, but that we’ve made alpha in all of those categories, those four stocks types that I mentioned. So we do it for stock picking, for risk, to make sure our heads in the right space, but then also to make sure the portfolio is generally balanced all the time in a market that can do well in up markets and down markets.
Wouter Klijn 11:16
Yeah. And do you have certain ranges that you move in between quality and value and momentum, or do we try to get a style neutral type of…
James 11:24
Yeah, we have a guardrails. It’s based on a 25 year back test. It’s 40/30, 20/10 actually. So quality, 30 plus or minus 10. Value, sorry, 40 plus or minus 10. Value, 30 plus or minus 10. Transition, 20 plus or minus and a momentum, 10 plus or minus 10. And as long as we’re within those ranges where then our rolling three year out performance, you know, should always be positive. That is the goal. And that was based on a 25 year back test using the UBS HOLT system.
Wouter Klijn 11:52
So value has been sort of unloved for quite a while, until, sort of the Ukraine war happened. How do you hold on to that allocation? Because it can be quite painful, I think sometimes during the cycle,
Maroun 12:07
yeah, yeah, it’s, it’s different types of value, so a lot of it is cyclical. So you can have energy going through a different cycle that’s not tied to the broader, you know, value versus growth. We’ve made money in energy. We’ve made money in insurance, getting in and out again. Insurance has its own cycle, depending on when there’s catastrophes and when you have a hardening or an increasing in premiums and a softening that’s taking place. A lot of these things are really related to demand, supply dynamics within their tight little within their tight little industry, because supply is quite lumpy. It comes on in chunks. And so you might get periods where a lot of supply comes on and you get an oversupply, and the respective prices for the industry drop, and then you get a period of no new money coming in, because returns are quite low and lots of companies are losing money, and then you get a demand spike, and that actually pushes up pricing, and supply has got a lag response. So we’re not looking to play the quality versus value macro cycle. You know, when we’re looking at cyclicals and value names, we are looking at them at a stock by stock or industry level basis,
Wouter Klijn 13:22
so quality, value and momentum are probably, you know, well known style factors, style approaches. Transition is a bit different, though, and when you talk about transition, you’re not talking about the energy transition. What do you mean exactly by transition? Yeah,
Maroun 13:38
Look, I think James alluded to a little bit in one of his earlier responses, but transition really is we’re talking about a change in the business model. So it could be a turnaround. You could have had a business that’s been underperforming for a long period of time. You get a new CEO come in place, there’s a cost cutting programme. Potentially there’s divestment of non core assets. The business is going to refocus on areas that it competes well in, and forget everything else. So that would be a transition name. You could also be a biotech stock or an early stage technology name. And you’re going through that journey of you’re still loss making now, but you’re building up scale, and in another six to 12 months, you’re going to hit that profitability mark, and you’re going to be break even self funding, and then, you know, on that path to increasing margins and returns over time. So when we’re talking about transition, it’s not the energy transition, it’s a fundamental transition, or a fundamental shift in the business itself, either the business model, or just moving through that life cycle.
Wouter Klijn 14:46
So you recently wrote a piece on a case study that you invested in Arista, which is a networking equipment company. Now there was sort of an interesting situation there where there were concerns around whether there would keep. Their main client, or whether they were potentially cut out of that ecosystem. And you went there, you talked to management, and you got a clear picture. But is that the type of transition you’re talking about, or is it? Is that just a catalyst that you’re looking for when investing in particular companies?
Maroun 15:16
Yeah, so Arista itself, we actually classified it as a quality name, not a transition name. It was a high quality business that had been doing incredible margins and returns over a long period of time, and it had been outgrowing the broader market. So for us, it was a long term quality compound. But you’re absolutely right, the opportunity was caused by this location, and that this location was so Arista, at that point in time had, and still does have, two large clients, being Microsoft and meta. And this is back to 2020. Meta had basically come out and said that they’re delaying their capex spending, and a lot of the market participants thought that that was meta’s way of saying that they’re going to be spending less with Arista and a few other people now, myself and the technology team went to Silicon Valley. We met with both Arista and Facebook at the time, and it was very clear to us that the issue why meta was actually postponing its spending was to do with the Intel chips that it wanted access to, rather than anything else, and that they were not looking to move away from Arista in the network switches department. So for us, ideally, yes, you want it. You want to look for a dislocation. You want the market to be concerned about something, and then for you to have a differentiated point of view, because that really is where the mispricing occurs, and we’re looking to take advantage of those situations. So even though Arista wasn’t a transition, per se, there was a temporary dislocation for about a year or so, until the market gained comfort that actually Arista is not losing any share from from from Facebook, and Facebook remains a loyal customer. But it was that temporary dislocation in price that we took advantage of and ended up being quite profitable for us.
Wouter Klijn 16:56
Yeah, I presume that it doesn’t happen all the time. Do you stumble upon these occasions regularly, where you find that the market is interpreting certain data in a certain way, but when you actually talk to the company, it turns out to be another way?
Maroun 17:11
Yeah, I can give you a recent example. One that we’re looking at for a long period of time is called Fair Isaac Corporation. So you may or not know, but in the US, there’s a thing called the FICO score, which is effectively your credit score. You need that to get you needed to get home loans, auto loans, you know, lots of different things and and it’s called FICO because it’s Fair Isaac Corporation. So this company has effectively had a monopoly on credit scores for decades. Anytime you need to get a loan, you go to a bank, they request your FICO score from FICO, it comes back, if your credit is worthy enough, then you sort of get the loan. And you know, and off you go. Now, recently, what happened was the head of the Federal Housing Authority, the FHFA, in the US. Bill Pulte, who was appointed by President Trump, came out and tweeted that FICO have been raising their prices quite aggressively, and they have FICO score back in 2019 or 2020, cost cost you 50 cents, and now it cost you $4.50 so it’s gone up nine fold in five years. But $4.50 in terms of the cost of buying a home, when you think about things like land taxes, when you think think about insurance and all sorts of different fees that you paid to real estate agents, it’s actually a tiny part of the entire thing. But in percentage terms, these guys have been increasing pricing, 5060, 70% year on year for the past four or five years. So, you know, the share price in FICO corrected quite aggressively. Was sort of 22 $2,300 a share. And it sort of came down to about 14, $1,500 a share. And for us, you know, speaking to the company, understanding how reliant the lenders are on a FICO score. And there is a competing product called Vantage score, but it’s not, it’s not anywhere near used as much as FICO and a lot of the systems in terms of lenders, the mortgage, you know, the guys that securitize loans and sell it as MBS products to end investors, all of their systems are all set up on FICO score, so the incentive to switch is not really there. And then, when we spoke to the company, they still had views about, you know, creative ways in terms of they can increase pricing going forward. So for him, it wasn’t deterring them whatsoever. And so we took advantage of that. And then, you know, recently, within within the last couple of months, we’ve actually seen them come out with a unique way of changing their pricing and still getting, effectively, 100% year on year price increase, but just doing it in a way that is quite innovative, cutting out the middleman, so the end customer is still paying the same but they get twice, Christ twice. The revenues for themselves, and the FHFA came out and said, we’re actually supportive of it. So this is a business with pricing power. But again, a temporary dislocation. The shares were down sort of 30, 40% and you could sort of get in there, do the do the research, and walk away with a differentiated point of view and take advantage of that dislocation.
Wouter Klijn 20:18
Yeah, yeah, for sure. So you’re keeping a close eye on Trump’s tweets as well, then to see if it’s any opportunities there.
Maroun 20:25
His tweets are always creating opportunities. It’s basically creating opportunities on a daily basis.
Wouter Klijn 20:32
Either that or chaos. So if you look a little bit at your selling discipline. So I saw that last year there was a time that you you trimmed some of the stocks because you were looking at the PE ratios that were quite high. Can you tell me a little bit about how you how you stick to that selling discipline, even in markets like today, where it still seems to be going up all the time, but obviously you have to take profit at some stage, yeah.
Maroun 21:01
So we’ve got different reasons for sell, for selling, and one of them could be the thesis is broken, right? So we assumed something was going to play out with this company. It’s not looking like it. Our initial assessment is incorrect, and we need to get out, because it’s not what we thought it was. That’s a bit different to what you were alluding to, and you’re absolutely right. Another reason why we would sell is where the valuations are no longer representing a mispriced opportunity, and we are relatively sensitive to valuations. Even though we do like quality names, we’re not going to go out and pay crazy multiples for it. So if I go back to last year, the middle of last year were overweight the US, and towards the end of the year, we found a lot of names in the predominantly in the US had run, had run up so much and well ahead of their fundamentals that we were taking profits in some of these names, and when we were recycling them, we were just finding more relative value opportunities in places like Europe, for example. So we went from the middle of last year being overweight the US towards the end of the year being underweight the US. And that was really just because of risk management, right? We just wanted to make sure that the valuation of the portfolio level was manageable, because you don’t want to be susceptible to large drawdowns if you get a bear market, if you get rates moving up, if you get value sort of having a strong style rally, so we manage that as well at the portfolio risk level. So what we were doing last year was more around the valuation side, and ended up being predominantly moving away from the US in other areas, into other areas.
James 22:37
Yeah. Also, for last year, was particular the timing question you asked, because 23’ – 24’ Maroun and I four Maroun and I noticed a lot of the performance of the stocks was from PE expansion, so that’s fine if there’s earnings underneath that. So yeah, we haven’t had to chase stocks on 40 or 50 times PES, for example, to try to get alpha. A lot of the times they’re buying stocks on 20 to 30 times PES that are good quality businesses. But we’ve also held stocks that have, like, held on to stocks that have gone up four to 500% because the earnings are actually moving up in that quantum, that magnitude. So Apple oven, for example, we still own today, that is up four or five times from our original purchase. But the earn, the earnings numbers are actually a lot higher, 404 500% higher. But then also, if you look out one, two and three years, the earnings continue to grow at, you know, very high levels. So that also makes sense. But if it doesn’t make sense and why we did trim a lot, a lot of the stocks, like, for example, in US industrials, the stocks normally traded at 10 to 20 times. Multiples, no trading at 3530 or 30, a button above PES and the earnings growth was Five 6% so the analysts getting nervous. We’re like, this is getting a bit and so that’s when it’s a bit more dangerous, in our views, that the multiples have expanded, but the earnings are not there. And then, if you roll out year one, year two, year three, the multiples are still high relative to history, high for the growth and high in absolute terms relative to the market. So that’s why you got to Yeah, that context is what we constantly think about. And if Yeah, like Marin said that if the thesis is broken, that’s definitely a sale. But then also the valuations just start to make less sense to us, then the mispricing is not there, and then we will trim or exit.
Wouter Klijn 24:26
And how do you look at the individual companies placed in sort of the broader market environment? Because we are in sort of an unusual period where it just seems that equities just keep going up. I mean, we’ve seen a lot of super funds that basically said market is expensive. We’re taking risk off lower equities and then just continue for another three years. Yes, and might continue for another five years. How does that change your thinking in terms of portfolio construction?
Maroun 24:53
Yeah, I mean we our view is that we’re hired to solve the investment piece, so we’re not really trying to make a big call from. It is to cash. So we have a bit of flexibility in terms of cash, but realistically, cash for us, most of the time, is sort of five or 6% or below. We’re not going to sort of go out and say we’re really negative on the market. We’re making a big market core, and we’re going to go to 20% cash, for example. That’s just not what we do. Because ultimately, what our clients are hiring us for is we want you to solve the equity piece, and we assume that you know, if they’re getting nervous about valuations or equities, they can make a move themselves at their portfolio level, whether it’s an individual, whether it’s an institution, they can shift some money out of equities into cash, but that’s sort of not, not for us to make for them, having said that, we do keep an eye on the market levels. We’re looking at sentiment. We’re looking at euphoria. And so within equity, sometimes we can sort of move a little bit more defensively, out of higher beta names, out of names that are more exposed to the economic cycle. If we feel as though we are going more towards top of cycle, we might go into things like a bit more defensive health care, consumer staples, where we think they’re going to be relatively unaffected, even if you go through a recession or anything like that. So So we’re making those sorts of decisions, but we’re not going to be sort of moving the portfolio from 100% equities to 80% equities and the rest in cash.
Wouter Klijn 26:16
So how are you positioned at the moment in terms of those that balance between defensive sectors and more growth he wants.
Maroun 26:22
So right now we are, we do have a little bit more beta than the market. Our view is this, you know, the euphoria that we’re in continues. We don’t want to be super exposed to it, but we want to participate in it. So I think our beta at the portfolio level is probably about 1.05 Yeah, so slightly above market. We don’t have a huge amount of defensives in there right now, and cash is probably running at about 5% so relatively neutral ish for us. So we’re not looking to make a big market call, but we’re looking to participate in the continued sort of rally.
James 27:00
Sector positions are mainly technology, consumer, financials. They’re our main sort of positions that are like and industrials, industrials, that those four sectors make up probably 70% of the portfolio today. But also on your question, it’s also the market level. So that the market, I know it, is quite euphoric, and people say like the market, and we were aware of it, the market’s gone up nearly 20% has gone up nearly 20% for three years in a row, and it’s looking like the construct doesn’t look scary yet, like it looks quite good. It the breadth and depth of the market is still quite wide. The valuation parameters of the market is still quite attractive. It’s on like an 18 times per year, growing at double digit returns. The ROA is still about 15% ROE of the market in our mids and smalls universe, our portfolio is around 20 times, with over 20% ROA growing at double digit as well. So there’s nothing that’s like screaming red flags in terms of valuation parameters of the market or our position relative to the market, but we do track that every single quarter quite religiously, and try to make sure that the PE to G, pe to growth ratio, makes sense, the Pe to the roe also makes sense. That gives you an idea of where the market, you know, is extrapolating, and that’s where you can get extended. But yeah, there’s nothing that’s a massive red flag at the moment that’s yeah, concerning us.
Maroun 28:22
Yeah. I think it’s probably at this point worth highlighting the bifurcation between large caps and smaller mid caps. So everything James said is absolutely true. Our small and mid cap universe today’s is trading on valuation levels broadly consistent with its 20 year history on free cash flow. Yield, yeah, free cash flow, yield, PE A lot of those different valuation metrics where you’re seeing valuations looking very stretches in large cap land. So if you look the MSCI World, it’s trading at valuation levels that are in the top decile of its long term historical averages. So that valuation euphoria, you’re seeing it predominantly concentrated in large caps, in our segment of the universe, our valuation levels are broadly in line with the history, and so is the growth rate. So for us, relatively speaking, it’s quite attractive. And hence why we’re more invested in small and mid caps? If we were running a broad cap or a large cap mandate, then we probably might have a different answer for you in terms of valuations running too far ahead.
Wouter Klijn 29:21
So we talked a little bit about the sector balance. What about in terms of geography? I think in the recent webinar that you did, you talked a little bit about China, there’s some ideas around, I think, the tech ecosystem that might get a bit of a wake up call. What is your exposure there?
Maroun 29:38
We have a little bit of exposure to China, but not in the technology sector. Right now, we have exposure to China in the healthcare sector. Most tech, yeah, most of the technology names in China that are doing quite well are too large for us, so we’re not really participating in the Chinese tech space, per se, but we published another small cap. So. Unfortunately, not a smaller mid cap, yeah. So we are slightly overweight China. Our benchmark is developed markets, so any position in China is an overweight so we are slightly overweight China. We are overweight Europe, and then we’re a little bit underweight the
Wouter Klijn 30:16
US, yeah. So you just brought up benchmarks, and as I was preparing for this podcast, I asked some of the asset owners what I should ask a small and mid cap manager. And they said, What about performance comparison to ETF? Do you benchmark yourself to an ETF? Because there’s, these days, there’s an ETF for everything. So there is a quality value ETF. How do you look at that?
James 30:41
Yeah, qsml is definitely one that a lot of clients raise, and a lot of clients have that exposure in our universe, qsml has done quite well. We’ve done quite similarly to it. I guess the difference is that we are more balanced than the pure quality factor style, but mids and smalls has had a quite a good rally, like overall, especially small caps. So that’s, I guess, what you want to participate in longer term. But we definitely do look at it, qsml, Van Eyck product,
Maroun 31:14
Yeah, I think for us, a single style factor is not really who we’re looking necessarily at, because, remember, we’re a blend of four different styles in there, right? So what we’re ultimately trying to do is deliver a smoother return outcome for clients, and we’ve done that. So if you look back at calendar year 21 it was a very quality growth in momentum a year, same as 23 and 24 but 22 was was the exact opposite of that. You know, it was anti quality. Quality sold off quite aggressively. It was pro value. We outperformed in calendar year 21 we outformed the calendar year 22 we outformed the calendar year 23 very different markets, and we delivered consistent alpha in very different markets. So if we were tilted to one style or another, whether it be quality or value or anything else, we would have had some periods where we did incredibly well, and would have had some periods where we underperformed the broader market. And so you ride that volatility up and down if you’re excessively exposed to one style. What we’re trying to do is just sort of deliver consistent Alpha year on year, independent of what the broader market is doing, independent of what style is doing well, or what style is not doing well, independent of what rates are doing, what inflation is doing, what the Fed is doing, all those sorts of things. Our process is really more designed to give you that smoothness of return profile. Yeah.
Wouter Klijn 32:32
Fair enough. If we delve a little bit into your your process, one question that I always like to ask, because it gives a little bit of a sense of how you think about companies is, can you think of a company that you’ve done due diligence on? It looked initially attractive, but as you dug deeper, it actually turned out now we’re going to stay away from this talk.
Maroun 32:51
Yes, someone we looked at earlier, probably towards the end of last year into early this year, was was Decker’s outdoor. They own a bunch of different shoe brands, the two most prominent ones which account for over 90% of their sales, would be the Ugg boots, which we all know, and the other one is the Hoka shoes, which are those thick cushioned running shoes? Lightweight. Yeah, lightweight. Thick cushioned running shoes and Deckers has been on an incredible growth profile. The last four or five years, sales have been increasing double digits and accelerating. For a number of years, margins have been going up, returns have been going up. So everything kind of looked quite attractive, but when you sort of dug in a little bit below the surface, you realised it was the growth was predominantly driven by increasing penetration of Hoka there, you know, and they were first mover. Effectively, there was competition coming in, because you can’t really copyright shoe design, you know, there might be certain elements of it, like, you know, Air Max or something like that. But, you know, anyone can sort of come out with their own version of it. So competition was picking up. It wasn’t an area that you could have long term, sustainable competitive advantages in and and it was predominantly, you know, single product risk and trading on very high valuation levels, because the market had woken up to that growth profile.
James 34:14
So we kept looking at it, because it’s all people running out of the gym, running down the street, running through the park, everyone’s wearing Hoka you get into a lift, someone’s wearing Hoka, like Maroun. We got to look at this Hoka again. But we did it like, for like, a year, and we spoke to the analysts probably five times about it,
Maroun 34:30
And then, and then, you know, we decided to stay away from it. And then earlier this year, they guided to, you know, they they missed their numbers by a few percent and guided to a slightly weaker than expected quarter, still growing, but not 20% growth. It’s going to be more like 10, 11, 12% growth when you when you’re a stock on, you know, 50 times PE that’s a very sharp draw down, right? So the stock basically halved in the space of two months, even though. It’s still growing, but just not growing as quickly as what it was. And so for us, it was having the discipline to not get caught up in the euphoria and just just look at it objectively and ask yourself whether the fundamentals justified the valuation levels and our view they weren’t.
Wouter Klijn 35:18
So was that a buy moment when it halved?
Maroun 35:22
So we have looked at it again, but you know, at this point in time, we’re still sort of staying on the sidelines.
James 35:28
And symptomatic of our process too, like we meet with all the analysts around the world. So the shoe market is big, so Puma is listed, Nike’s listed, Adidas is listed. So we’ve got analysts in Japan, sorry, and that’s yeah, so Japan and Europe. And in this one, America, so Maroun, and I like saw what the Hoka brand was doing in our eyes, with people in the lift, in the gym, in the parks, and the valuation was at incredibly high levels. So, but the context of shoes was very competitive. So Nike was having a tough time. All of them having a quite a tough time. So yeah, it wasn’t an easy marketplace as well. So you had this Hoka brand that was doing something very different to the rest of the market. But then eventually the market weight, or the market anchor, basically brought it down. So yeah, it was a very interesting one for our process and conversations that we have between ourselves and the analysts. So it is quite an interesting example.
Wouter Klijn 36:28
Yeah, yeah, sounds a bit like I had a recent conversation where we’re talking about the nature of cyclicality. And the comment was there around well, some companies might not look cyclical, where their clients are, so maybe everybody that wanted that shoe bought that shoe?
Maroun 36:44
Well, it’s fashion risk, right? And fashion can be fickle. You know, what we used to wear 20 years ago and what we wear today? You know, very, very different, yeah.
Wouter Klijn 36:55
So just asked you about what would potentially be a dud investment. What is your most your favourite investment?
Maroun 37:01
Yes, well, certainly the most profitable, memorable one for us would be AppLovin, which is a very unique business that does ad tech. Basically, it’s historically surfaced ads for you in the video game world. So if you’re playing a mobile video game and you’re getting ads within the video game. They’re sort of the matchmaker that sit between the advertisers and the suppliers of ads, and historically, they’ve only surfaced you ads for other video games. So you’re playing a video game, and then you see an ad and how you might be interested in this video game. Do you want to download it? What they realised is they were that they had the technology and the information to be able to also serve you ads for different verticals. And a vertical they got into, they opened it up in beta form in q4 of last year, but it was e commerce. So now all of a sudden, you can be playing a video game, and you might see an ad for you. Might you might be interested in this shirt or this shoe or something like that, right? And and it was, they opened it up in beta form in q4 of last year, and all the feedback from the advertisers was that the return on advertising spend is very, very high. It’s second probably only to meta, ahead of ahead of tick tock, ahead of Snapchat, Pinterest, Google, even so, you’re opening up a new segment of the market all these e commerce advertisers who previously wouldn’t advertise with you. You’re delivering them very high return on advertising spend. It’s incremental new customers. It’s not sort of customers that that you’re getting in different parts of the funnel, and this year, they’ve gone from beta to now opening it out more broadly. And so we’re seeing rapid adoption in that and so the stock almost went up tenfold over the course of 18 months. So it has definitely been very profitable for our investors.
Wouter Klijn 39:00
So how would you classify stock like that? Is that traditional marketing is it like AI that uses the algorithm to predict what you want to buy?
Maroun 39:09
It’s got AI in it, so the engine that powers is AI. So say it learns they’re not obviously going to reveal their secrets in terms of what they do. But you know, if you’re on social media, it’s relatively easy to know what you’re interested in, right? Because you click on a bunch of different links you might be following you know certain people. So if you follow, for example, a lot of different food bloggers on Instagram, Instagram quickly works out that you’re interested in food, right? And if you click on different articles about celebrity chefs and all those sorts of things, it works out pretty quickly you’re interested in food, so it can service you ads related to food, whether it’s cookbooks, whether it’s a new new restaurant is opening up, you might be interested in going to it. It quickly works it out. When you’re playing a mobile video game, it’s a lot harder to figure out what you know or what you’re interested in, right? So they’ve got an AI system that sits underneath there. Yeah, and it has been able to sort of figure out quite effectively, things that you’re interested in, how they do it. It’s a bit of a black box, but that beauty of the AI model, so it’s very hard to replicate. They’re sitting on a huge amount of data. There’s no one effectively, with the exception of a very distant player called Unity, which is a very, very distant number two that has the data or the capabilities that they do. And like I said, they’ve just opened themselves up to a whole new customer base that can now, that can now sort of spend with them. So it’s it’s doing a lot of things. It’s leveraging AI, it’s giving customers who, over the last three or four years or five years have only really been able to spend money with Google, Facebook and Tiktok. In terms of advertising, now you’re getting a, you know, another avenue for you to place ad dollars in, and you’re getting incremental sales, you know. So it’s, it’s definitely doing a lot of good for its customers, yeah.
Wouter Klijn 40:54
So in terms of the process, is it a quality, value transition or momentum stock?
James 40:58
We call that an innovator. So basically, I’m from transition to momentum. But remembering now, like normally, quality we have as a multi year high roe business, this business, roe has gone from 10 to 60 but it’s held that 60% Roe, which is in the top one to 2% of the world’s ROA, or return on investor capitals for now two years. So, as I say, and I know, in my experience in the Australian market, if you find a stock that goes from like transition to momentum into quality, that’s up 10x so it’s happened with aristocrat, you know, going back many years in the Australian market. It’s happened with Apple oven in this marketplace. And it’s happened with other stocks that we’ve had that were, you think their momentum, they cyclicals, but then they managed to sustain that ROA for a very long period of time, and that’s when stocks can go up, you know, 510, x as these ones do so. They are innovators that go from your transition and momentum to quality, which is a very powerful structure. And even now, like you asked the question, now, the EPS growth of that business is more than 50% like this year, and then the year after, and they just did 300% return in the last two years. These stocks that have the earnings growth can go up a lot, but it’s because, like Maroun’s described, it is very innovative. What it is doing, he’s doing something very different, but it is solving a problem for its clients and the world. So when you do that, you create a lot of value, which is what we’re trying to find every day.
Wouter Klijn 42:24
Yeah, for sure. So to finish up with the if any research projects on the boil, I believe you recently published a white paper. What was that looking at?
James 42:34
Yeah, it’s a bit of detail. The white paper really looks at lessons learned that we’ve had over the years, the process, the asset class, and just takes, yeah, takes readers through, I guess, the journey of what we try to do in the Fund, and the data to support that, that process. Ultimately, that’s what I’ll be coming out soon. And then recently, Maroun and I led the AI webinar, which is, which is significant. AI revolution is a massive they call it the fourth industrial revolution of the world. So that was a really interesting thing that we’ve done just recently.
Wouter Klijn 43:06
Have you used AI in your own sort of research or your processes rather investing?
Maroun 43:12
I use it almost every day. I’ve got perplexity Google, Gemini, use a little bit of chat, GPT and grok as well, but perplexity is my favourite of all them. I’ve actually got a paid subscription with perplexity that I use, and it’s amazing. I mean, the amount of things you can leverage it for, it’s just amazing.
Wouter Klijn 43:32
Can you give one example of what you use it for?
Maroun 43:34
Yeah, so I’ve got, like, a prompt, for example. Let’s say it’s a stock. I want to get up to speed on it very, very quickly. We’ve obviously got internal analyst notes, so we can read a lot of that. But even for private companies that we might not have notes on internally, I type in what I want it to do, and it goes down. It searches information for me, market shares, how those things have trended over time. It does a huge amount. Basically, it can do a relatively decent report on a business that would get you from A zero working knowledge to at least a respectable level of working knowledge. And it can do that for you in minutes. And so you can get up to relative good speed in 10 minutes, 15 minutes on a company after you’ve read it. And then from there, you can go and say, right, these are the key areas I need to look into. These are the key areas I need to dive into a bit, you know, because these seem to be the key value drivers. And then you can spend the next two or three weeks diving into just those key areas and making sure you have comfort around that. But it basically saves you that upfront work of about a week, you know, a week’s worth of work, and does it for you in literally minutes.
Wouter Klijn 44:43
So there’s definitely some productivity gains.
Maroun 44:46
There huge amount. Yeah, a huge amount.
Wouter Klijn 44:49
Fair enough. Well, Maroun, James, thank you very much for coming to our offices and for doing this podcast.
Maroun and James
Thank you very much. My pleasure.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe. The [i3] podcast is available on Apple Podcast, Spotify, Amazon Music, YouTube Music, or your favourite podcast platform.