June 1, 2023 In the portfolios, I have decided to sell what we call our innovation basket of companies. We first identified this theme in July of 2021. Some of these names are very popular currently: NVDA, SNPS, CDNS, ANET. Some of the characteristics of these companies, and why we included them in the portfolio are:
Strong and growing free cash-flow.
Earnings depressed because of the expensing of intangible investment.
High barrier to entry into their field (could be described as mini monopolies in their respective markets).
Structural macro backdrop of industry growth.
Reasonable valuations.
High returns on total capital
If you are interested in more detail, you can read the commentary from July 2021:
The reasons for risk reduction in this theme:
The market has clearly started to recognize the value in these names based on their recent price appreciation.
Although I believe Artificial Intelligence is changing many aspects of our lives and economy, this is not new information. It has been going on for many years.
Companies used to be able to deduct Research and Development in the year incurred. This depressed current year earnings, which increased Price / Earnings ratios. In my view, this made many of the companies described above appear more expensive, and this likely kept some investors away. Tax law changes starting in 2022 (provision of the 2017 Tax Cut and Jobs Act) now require spreading the deduction over longer time frames. Hence, this accounting illusion of depressed earnings should be less pronounced.
In summary, although everyone seems to be clamoring to invest in the “picks and shovels” of the artificial intelligence gold rush, I find investing in names like this quite a bit more difficult than it was 12-24 months ago. Even though these companies are likely to produce abundant earnings well into the future, I am far less certain about their return on investment at current prices. Additionally, many of these companies now have a greater weight in the long-term diversified index funds which remain in the portfolio.
As I described in my recent commentary this month, I believe many small and medium sized businesses will increasingly benefit from Artificial Intelligence in the coming years. In the short run, the market seems to only recognize the companies that supply the tools to meet the increasing demand for AI applications. I try to demonstrate this in the two charts below:
The first chart shows the YTD performance of the Nasdaq as measured by QQQ (orange line) vs. the YTD performance of the Russell 2000 measured by IWM (purple line).
The second chart shows a longer-term version of the same.
The backbone of the US Economy is in these small and medium-sized companies, and I believe at some point, the market will recognize the benefits that many of these companies will harness from AI. It is difficult to know the timing, and it is also difficult to identify which companies might be the next big thing. As always, I will take a long-term view, respect what I do not know by:
Diversifying across asset classes, within asset classes, and across time.
Determine the appropriate level of market risk.
Selecting quality companies for our baskets.
As always, if you have any questions, do not hesitate to send me an email.
Joe
Joseph Cardello, Principal
August Wealth Advisors, LLC
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Westport, CT 06880
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