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The Promise of Tech Often Takes Longer Than Expected
In the 1970s and 1980s, more and more mothers began working full time, leaving kids as young as seven years old to fend for themselves for a couple of hours after school. Because these kids had their own house keys they were given the moniker, “latch-key kids.” This might be considered neglect by today’s standards, but no one called child services on behalf of any of our friends who enjoyed the great fortune of being unsupervised for a couple of hours before mom and dad returned home. Today, the majority of children grow up in a household where both parents work full-time and the children spend their non-school hours in a daycare or afterschool program. For many parents, childcare can be a burdensome expense, not to mention the other concerns that go along with childcare.
In 1999, one of us sat in on an analyst sales pitch for buying a wireless service provider. The pitch centered around the wonderous technological feats that would be possible within a year or two. The analyst confidently acted out a scenario in which a couple who were having a quiet dinner out, all by themselves, prepare to leave the restaurant and head to the movies. But first, they checked in with their two young boys who were at home alone. The mom dials a number and her oldest son appears on the screen. Shouting from the younger boy is heard in the background. Mom instructs the elder son to turn the phone around and scan the room which reveals that the younger son has been hog-tied with a jump rope. FaceTime wasn’t available until June of 2010 and was not widely used until several years after that.
Hurry Up and Wait
As with FaceTime, either technological challenges or the ability to profitably commercialize new technologies often leave potential customers waiting for a decade or more for promises to be fulfilled. Although we have witnessed a string of promising technologies eventually live up to or surpass their expected potential, the key word in the previous clause is eventually. For example, in 1968, the University of Utah introduced the first virtual reality headset, Sword of Damocles. Sony (NYSE: SONY) did not get around to introducing PlayStation VR, the first heavily marketed virtual reality headset, until 48 years later. By now, the majority of us were supposed to spend most of our waking hours exploring and interacting in the Metaverse. Blockchain is another example. Many blockchain experts expected that the stock market would be running on a blockchain by today and Bitcoin would be the strongest rival to the U.S. dollar for primary reserve currency status. We are not saying that the stock market will never run on a blockchain. We are also not claiming that Bitcoin could never become widely used as an alternative currency for completing transactions. We are simply pointing out that it appears to be a long way from achieving such acceptance. Often, the time between public awareness of a new technology and the point at which the technology achieves the level of usefulness and profitability that investors originally hoped for is much longer than first anticipated.
The Second Mouse Gets the Cheese
Another risk common to investing at the cutting edge of technology is the possibility that a competing technology leaps over a highly-touted technology. Sometimes a wholly different and better mouse trap supplants the original mouse trap. In the early 2000s, ethanol began to gain prominence as a solution to reducing CO2 emissions from transportation. At the time, Archer-Daniels-Midland (NYSE: ADM) was the largest U.S. ethanol producer. As the beneficiary of ethanol’s climate savior status, ADM’s stock price more than tripled from its July 30, 2004 low of $14.95 to its May 11, 2006 close of $46.71. Subsequently, the share price fell to $13.53 on October 10, 2008. Ethanol is still valuable, both as a fuel additive and as a fuel. However, for the time being, electric vehicles are assumed to be the solution to eliminating CO2 emissions from automobiles.
In other cases, a competitor makes improvements to the original mouse trap or gains a cost or marketing advantage. For example, Sony developed Betamax video cassette recorders (VCRs). Betamax’s market share was 100% in 1975. By the mid-1980s, a Betamax player was essentially a paper weight and the home VCR market was dominated by VHS. Then came a short-lived phenomenon known as LaserDiscs which was quickly replaced by DVDs. Today, many of us do not even own a DVD player due to the convenience of streaming. Another example, comes to mind. Once upon a time, Excite was the dominant internet search engine. We Googled whether or not Excite still exists (it does).
Speculating vs. Investing
“Quantity has a quality of its own” – Joseph Stalin
Stalin was referring to the fact that an overwhelming number of poorly trained and poorly equipped soldiers can defeat a much better trained and equipped, yet smaller, army. The same can be said of speculative dollars. The quality of decisions behind those dollars might be low, irrational even, but the special quality of quantity can allow speculative dollars to drive security prices to levels that defy rational analysis. But be warned. When the speculative horde changes direction, that quantity also has a special quality that can drive stock prices well below levels that sober analysis would indicate is a bargain.
While we know not all of our clients own Corning Incorporated (NYSE: GLW), last purchased for client portfolios in October of 2013, we use the stock as an example of speculative extremes. During the dot.com bubble, speculative dollars rushed into GLW shares launching them from $7.63 on September 3, 1998 to $113.33 on August 30, 2000. GLW was and still is the world’s leading manufacturer of fiber optic cable (“fiber”). Back during the dot.com bubble, GLW’s fiber sales grew from $1.4 billion in 1996 to $5.2 billion in 2000. In anticipation of infinitely exponential data growth, carriers overbuilt their fiber networks. During their frenzied network buildout, fiber manufacturers could hardly satisfy demand despite running factories at full capacity. Being clever, carriers placed double-orders with the expectation that the order would be cut in half when the fiber makers had to allocate their limited supply among customers. The telecom companies’ double-orders gave fiber manufacturers an exaggerated picture of demand, leading to an industry-wide overbuild in production capacity.
With additional capacity, fiber manufacturers were able to fill the double-orders just as access to credit was tightening for telecom carriers. Many customers canceled orders while some simply went bankrupt leaving the fiber companies with idle production lines, inventory write-downs and plunging sales. By 2002, GLW’s Telecom segment sales had fallen to $1.6 billion, and the company’s losses in 2001 and 2002 summed to $7.3 billion or 3.8 times the total profits for the years 1996 through 2000. As a result, GLW shares fell to a cyclical low of $1.10 on October 8, 2002. A large quantity of speculative dollars in search of something to buy in the technology sector helped GLW’s price reach highs reflecting what turned out to be irrational beliefs about future fiber demand. When the quantity of speculative dollars chasing technology stocks shrank, GLW’s stock price did as well.
Does NVIDIA rhyme with Corning?
For the last couple of years, it seems every speculative dollar conjured up by the latest round of Fed money printing is attempting to pile into anything related to Artificial Intelligence (AI). The frenzy is pumping up the valuations of AI-related companies in excitement over the boundless possibilities of AI. The number one beneficiary of this frenzy has been NVIDIA (NASDAQ: NVDA), the world’s largest company by market capitalization. NVDA is a high-quality company that is dominating the semiconductor market for servers used to train AI models. NVDA dominates the space with an estimated 80% to 90% market share. In our 2nd Quarter 2023 Quarterly Commentary, we wrote the following about NVDA:
The shares of NVDA currently trade at 220 times price to earnings (PE) per share for the last twelve months and 39 times price to revenue for the last twelve months. The consensus Wall Street analyst projection anticipates NVDA doubling revenue and quadrupling earnings by the fiscal year ending January of 2025, merely 1.5 years from now. To quadruple earnings on twice the revenues, NVDA will either need to double its overall profit margins or the new business will need to have 67% profit margins which is triple the already very healthy current margin of 20% on existing business. Even after that rapid and tremendous growth, NVDA’s $425 share price [price is prior to the June 2024 10-for-1 split] represents a valuation of 55 times price to extremely optimistic projected fiscal 2025 earnings per share and 20 times price to projected fiscal 2025 revenues. The earnings yield of under 2% is well below the 2-year US Treasury Bond yield of approximately 5%. A rich price indeed!!
As of the company’s fiscal quarter ended April 30, NVDA has surpassed analysts’ fiscal 2025 expectations set by last year’s company guidance. So, the market believes NVDA is worth triple of what it was worth last year. At quarter’s end, NVDA shares trade at 38.2 times trailing 12-month revenues and 45.4 times earnings expectations for the current fiscal year, not as expensive as 12 months ago but still among the most expensive stocks in the S&P500. Could it go higher? Sure! However, the semiconductor industry is highly cyclical and when expectations and valuations are set at levels as high as today’s, the slightest disappointment can be quite painful for investors. The table to the right shows that NVDA’s stock price has been subject to numerous downdrafts since its initial public offering. It is difficult for most investors to stomach such extreme volatility. Keep in mind that an 80% drop in price requires a 500% increase just to get back to even.
Alternatively, we were able to purchase GLW shares in 2013 when the challenges faced by the company were more than reflected in its stock price. At the time, the market did not expect much from their television and video display cover glass business. Additionally, many investors feared that GLW’s Gorilla Glass product would not stand up to potential competitors. However, at a PE of 10.1, we believed GLW was priced as an underdog leaving plenty of upside for those willing to kick the tires. Moving to the present, GLW has been gaining recognition from investors for its optical connectivity products that are capable of offering connection speeds suited for generative AI applications. Until now, GLW has had little AI potential baked into its valuation while NVDA’s valuation seems to have permanent market dominance baked in. If we feel the expectations for GLW’s optical connectivity products are causing its stock valuation to become too lofty, we will welcome that opportunity to realize further gains.
A further point of caution, in April, NVDA participated to the tune of $100 million in a second round of funding for the startup cloud computing company, CoreWeave, which rents use of Nvidia’s highest-powered chips. Since that time, CoreWeave secured a $2.3 billion debt facility collateralized by high-end chips that CoreWeave bought from NVDA. There is nothing unethical about this debt arrangement, but using semiconductors as collateral is highly unusual. Given the tendency for semiconductors to drop in price at a pace that most bankers would question their suitability as collateral, we believe it is at least a yellow flag, if not a red one. The intended use of the debt will be to buy even more high-end NVDA chips. This appears to be amplifying demand for NVDA chips possibly above and beyond actual demand, which could create a similar situation to the double ordering of GLW’s fiber during the dot-com bubble.
Very few investors have been able to repeatedly earn above average returns by investing in extremely high-growth companies trading at extreme valuations. Following a process that centers on valuations reduces the risk of excitedly buying into a bubble. We are not claiming that everything AI is definitely in a bubble. We can’t be certain about the future, which is the point. What we are saying is that the valuations of NVDA and some other AI darlings expose their share prices to significant downside risk if revenue and profit growth are simply good, rather than mind-bendingly exponential as current valuations imply. Our investment process leans on the stock market’s long history that supports a strategy of paying conservative prices which allows investors to earn attractive long-term returns even if the company does not quite live up to expectations.
We Are Not Sitting on the AI Sidelines
“If the shoe shine boys are giving stock tips, then it’s time to get out of the market.”
– Joe Kennedy
The quote above has been attributed to several investors of 1929, but the point remains: when the last possible buyer is pouring into an investment frenzy, it may be nearing an end. One of us enjoys listening to a country music themed radio show, and recently, the host of said show was raving about the return potential of NVDA. Coincidentally, or maybe not, this on-air personality also hosts a sports betting podcast. The Joe Kennedy quote above still rings true today, even more so, if we replace shoe shine boys with radio host and swap out the general term stocks for a narrower group of mega-cap stocks that includes most of the Magnificent 7 (Amazon, Apple, Netflix, NVIDIA, Meta, Microsoft and Tesla), Taiwan Semiconductor (NYSE: TSM) and Broadcom (NASDAQ: AVGO), along with a number of smaller companies.
When an investment theme goes viral, we prefer to find indirect opportunities rather than pay speculative valuations for headline-grabbing companies. We wrote about several AI beneficiaries in our 2nd Quarter 2023 Quarterly Commentary. In addition to those, Berkshire Hathaway (NYSE: BRK.A/BRK.B) and Fairfax Financial (TSX: FFH; OTCPK: FRFHF) are already incorporating AI into their underwriting despite the insurance industry’s traditional reputation for being late technology adopters. Berkshire’s subsidiary Geico announced a 2021 partnership with AI company Tractable to accelerate claim processing times. Fairfax’s Britt insurance arm made a 2020 investment into Ki Insurance, a company launching the very first fully digital Lloyd’s of London syndicate. We expect to see profitability improvement from the efficiency gains that result from these investments.
Another long-time holding in portfolios that stands to benefit from AI is HP Inc. (NYSE: HPQ). We last purchased a position in HPQ for all portfolios in the 1st Quarter of 2023. The company sells computers, printers, and adjacent products and supplies. The shares are trading at around 10x current year earnings estimates, which does not appear to reflect any potential benefits from AI. Recent financial results have experienced a post-pandemic lull due to demand for computer hardware being pulled forward in 2020 and 2021. However, it seems demand may be turning for the better with a new personal computer (PC) refresh cycle on the horizon as Microsoft (NASDAQ: MSFT) will no longer be supporting Windows 10. More exciting is the potential demand created by the adoption of AI-driven PCs pushing unit prices higher. Even if AI on your PC never takes off, HPQ has committed to return 100% of free cash flow to shareholders through buybacks and dividends. The shares currently have a dividend yield of 3.10%.
So far, investor attention and excitement surrounding AI has been focused on data centers and related equipment suppliers (i.e., Nvidia). Intel (NASDAQ: INTC), one of the AI beneficiaries in our portfolio that we wrote about in the 2nd Quarter 2023 Quarterly Commentary, has recently released the Core Ultra processor for PCs. This processor is designed to leverage AI capabilities across operating systems and applications, and integrates AI through a new neural processing unit (NPU). Microsoft has hinted that Windows 11 AI features will likely require a NPU to fully function. INTC trades at 2.6 times sales, a modest valuation in comparison to NVDA.
We can argue that AI will benefit every one of the companies we own from Teck Resources’ (NYSE: TECK) use of automated mining equipment to CNH Industrial’s (NYSE: CNH) sale of precision agriculture technology or Verizon’s (NYSE: VZ) growth in network traffic. However, the point we are trying to emphasize is that compared to the valuations of the Magnificent 7 et al, the valuations of the companies we have purchased do not reflect a fraction of the potential benefits they will reap from AI. We prefer to buy stocks at valuations in which the benefits of AI are a potential upside to current expectations, not a necessity for justifying a high valuation.
A Balm for Inflation Woes, Part 2
When gasoline price increases were the talk of the press back in the summer of 2022, we reminded our clients just how few shares of Exxon they had to own to fully hedge their personal increase in gas expenditures. Now that insurance premiums seem to be the front-of-mind inflation topic, we thought we might do the same for shares of Fairfax Financial, our largest portfolio position. There has been much media coverage about the fairly dramatic increases occurring across the range of insurance contracts. A recent Wall Street Journal story stated that Arkansas’s home-insurance rate increases approved since January 2023 have been in excess of 25%. The average cost of home insurance in the United States was $1,984 in 2021 and has increased to $2,377 per year by June 2024, up ~20% in 2.5 years. The average cost of auto insurance has increased even more, up ~51% over the same 2.5-year period. We wondered how many shares it would take to have hedged this increase in the cost of insurance for an average family, and even we were shocked by how few shares it would take. Just a reminder for our clients that their investment in insurance has likely appreciated far more than the cost of their annual insurance premiums.
Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.
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