No. 35: B-grade Stocks, Populist Energy Policy in Germany, Gavin Baker Interview, Acquired NVIDIA podcast
B-Grade Stocks
It's a strange time. It's one where most companies would feel pain if we got into an inflationary recession. But it's also one where the stronger companies would extend their competitive advantage despite taking short-term margin hits.
A good example is CPG. The largest scale players with brand and distribution advantages can bargain with suppliers for scarce commodities. While suppliers may not even pick up the phone for smaller CPG customers. Retailers are so concerned with filling their own shelves that they may divert resources away from their own private label efforts, reducing competition to the top CPG brands. In order to increase market share, the best brands might not raise price as much as they could in that situation.
Short-term, top brands take a margin hit. Long-term, they secure supply and hence enhance market share and position on shelf.
In semiconductors, the big guns like Apple and NVIDIA fork out increasing gobs of cash to secure supply with TSMC, while smaller customers simply can't.
Short-term, pay the price for capacity. Long-term, extend distribution and production advantage.
In certain industry pockets I will definitely be wrong. Some of my examples are far too general. But what stays true is that I believe the B-grade players come out worse than the A players in an inflationary recession. Even though there'd be earnings compression across the board, the best in each industry would survive with their competitive advantage in tact.
Which is why I've cut all my B-grade player positions in the portfolio.
While B-grade players in each industry might be great during an upmarket, they feel disproportionate pain on the downside. There's no visible signs. The earnings reports and fancy slides from each company look the same. Every company extolls their "industry leadership" and "moat". But if this inflationary period turns recessionary, one by one, they get shaken out.
Securing raw materials or capacity in some form is only part of the equation.
In most other industries, if we magically get a Volcker-style inflation killer recession, interest rates could go higher, taking capital away from those who relied on stock options and VC funding to attract talent.
And so on.
There's also the market part of it. If stocks go down for a year, then magically bounce back, investors can understand that - and talented people with stock options might be willing to stick around and wait rather than jumping ship to a different employer. But if stocks just go down for 5 years, I don't know which investors would stay (1) hopeful and (2) still in business. Stock options would no longer be attractive to top talent - and maybe cash comp becomes more desirable. We would get Economist headlines like "Equities are Dead", and for all intents and purposes, they'd probably be short-term right.
However, we aren't in recession territory yet. If demand stays hot, some businesses can raise their prices higher than the cost inflation they face. In other words, margin expansion - rather than compression.
I wish I knew which companies these were - but if I was a long-term oriented manager in a great company I might keep prices low to grow the moat. ASML is a good example. They probably could raise prices as high as they wish. But if ASML piss off their large customers like TSMC and Samsung, they'd immediately start funding R&D to substitute ASML's EUV technology.
Therefore, though some companies can bolster their P&L during inflationary times, I don't expect them to show their hand when the alternative is to build long-term competitive strength.
Populist Energy Policy in Germany
It's very rarely that I opine on geopolitics. But this time I couldn't resist. And as with all things macro - please take this with a pinch of salt.
Some of my friends in Germany are ardently anti-nuclear energy - citing the waste, radiation, cost etc. These are the exact same people who thought buying Russian gas instead and filling Russian coffers with lots of cash was a great thing for Europe.
As a simple boy from New Zealand who didn't wear shoes to school until I was 10 years old, I scratched my head when I heard this.
Now these same friends are virtue-signalling by turning off their heaters - not only to save money from high gas prices but because they "don't want to support Putin's regime". The bad news is that they have supported his regime - by voting to take nuclear power out of the grid, hence increasing reliance upon a wildcard Russia - and shovelling them truckloads of dollars that could have been otherwise spared.
It's one of those risk-reward situations that looked OK at the time - but in hindsight was a mistake. Nuclear has known risks - and we have experienced the worst of them with Chernobyl. However, funding and becoming reliant upon Russia had unknown risks - those which could not be seen or quantified - which were therefore forgotten in the calculation. After all, how can you account for political wildcard decisions in scientific papers?
Am I saying that the Russian invasion of Ukraine could have been stopped by Germany keeping a few nuclear plants running? Of course not. There were many other factors at play.
But I am saying now that Germany stands to lose industrial competitiveness due to unstable energy supply sources, and has a huge dependency upon Russia which can't be immediately solved- thereby implicitly supporting their activities in Ukraine.
The nuclear topic is not an easy one. I'm not a scientist - nor do I know the facts. But all I would ask is that when we examine nuclear energy, we look at it as a decision of relative risks between two different types of base load energy, rather than zooming in on the absolute risks of nuclear energy without understanding the benefits it could also bring.
How we currently view nuclear energy would be like saying "it's safer to drive a car than fly a plane because there are plane crashes".
Gavin Baker
Gavin Baker always has interesting thoughts. Sometimes he challenges the various HODL/compounder bro orthodoxies espoused on Twitter.
This interview was no different:
Big Tech Investments
Companies like Google and Amazon will stick around and make attractive profits. However, Gavin says is that the competitive environment is changing, leading to a structurally lower ROIC going forward in each industry. Though I still believe these businesses have major advantages, I would side with Gavin in saying that the level of structural underpricing of these stocks is probably less than before.
"For investors, there was a playbook that worked very well for around ten years. For many of these mega tech companies there were essentially minimal competitive threats. They were basically levered royalties on global GDP with a very high ROIC, and they were perpetually underpriced. But that playbook is changing. As that stable coopetitive environment becomes more intensely competitive, there are going to be more opportunities for investors, more opportunities for stock picking and to differentiate.''
Semiconductor Market Cycle
Compounder bros talk about the structural super-cycle ahead for semiconductors. I happen to be sympathetic to this line of thinking, given industry consolidation and a supply/demand balance which has become more reasonable over time.
Gavin, however, is a seasoned semi analyst and that job title comes with a healthy dose of skepticism. He has good reason to be doubtful. After all, semi manufacturing is still a high-fixed-cost business with rapid changes in technology. Therefore there is plenty to be worried about in the short-term - with rapid swings in inventory and technology paradigms wiping out chunks of the industry every couple of years.
"There are beginning to be a lot of signs that PC demand is slowing - and PC, along with cloud, is still one of the biggest consumers of silicon. The way semiconductors work is when one area loosens up, it spreads to other areas. So when the PC chip manufacturers start asking for less wafers from a foundry, that foundry will have more wafers available for other sectors."
Acquired NVIDIA podcast
Amazing episode talking about the early history of NVIDIA and its founder Jensen Huang.
Here's a snapshot about Jensen got funded by Sequoia after screwing up a pitch to Don Valentine:
Jensen's walking out the door. He's totally dejected. Don stops him and says, well, that wasn't very good, but Wilf says to give you money. Against my best judgment, based on what you just told me, I'm going to give you money. **But if you lose my money, I'll kill you**. Classic Don line. It's so good.
Another interesting fact about Jensen's past is that his parents unknowingly sent him and his brother to a reform school in the US. So Jensen's early friends were juvenile offenders. This apparently led him to start lifting weights early in life! Gotta love Jensen.