DKosig
When the world changes, opportunities to find value may present themselves.
Something, whether it’s a geopolitical event or a new technology, creates a question about a company’s future, and that question can impact valuations – so as value investors, we often are looking at companies going through a transition.
Here are some recent examples of technology sector segments that are being affected by transitions.
Key Questions From the Artificial Intelligence (AI) Hype Cycle
The investment landscape is currently experiencing the exuberance of the generative AI hype cycle.
But during a recent conference, some of our U.S. value equity team members attended, it was evident that AI’s true complexities are understood by a relatively small group of engineers worldwide, highlighting the nascent nature of AI-related business models. This uncertainty raises fundamental questions.
Will companies truly entrust significant business decisions to AI models? The answer is likely yes, but in our experience observing data-driven models in the past, from Fair Isaac scorecards for banks to the more recent data analytics craze, companies crave an advantage and technology brings that. However, when technology so powerful exists, with very few who understand it, evaluation takes time. Banks, for example, have spent years analyzing data before making a change to their credit models.
Another pivotal question is ownership of the data that fuels AI models. The separation of data from the model is possible, but the process is not without challenges. As data flows into the model, some of that data will be allowed to improve the broader model, but data that companies own or view as proprietary will likely be excluded. Data being included in some cases and excluded in others creates another level of complexity for companies to evaluate. We start with one model, but do we fragment these models over time based on what data is included? How do we maintain multiple models and who pays for that is less certain?
Another question: how will AI displace labor? One company we cover operates a call center generating approximately $500 million in revenue. The prevailing assumption in the market is that AI will devastate this sector, but the management team believes AI has the potential to transform the call center’s performance for the better. The aim is not to replace human agents but to empower them by swiftly providing information, thereby enabling the weakest representative to match the performance of the best.
Another company in this space that sells call center software has started to introduce AI bots into its software stack. What’s even more interesting is that this company is doing this on a consumption basis versus a license basis, allowing for accelerating growth as usage ramps up.
AI Can Distort Valuations – In Both Directions
While these and other questions are being answered, AI-affected stocks may experience significant price fluctuations, driven by both overenthusiasm and apprehensions about AI’s impact on businesses. Companies perceived as AI beneficiaries could see their stock prices soar, while those potentially exposed to AI-driven disruption may see their stock prices plummet.
These distortions in valuations, both on the upside and the downside, present unique opportunities. Quality companies caught in the crosshairs of AI-related uncertainty might experience a temporary dip in stock prices, providing astute investors with an attractive entry point. As value investors – who focus on identifying quality companies trading at discounted prices – we seek to leverage this market dislocation.
Geopolitical Conflict Can Drive Valuation Changes
A few years ago, our team noticed a Massachusetts-based company specializing in disruptive laser technology. The company’s innovative technology revolutionized metal cutting, which was previously dominated by blade, plasma, and CO2 methods with inefficient emissions and power consumption.
We were interested in the company’s robust balance sheet, which boasted more than $1 billion in cash, and its resilient business model. However, the company’s stock remained prohibitively expensive for value investors – until a significant geopolitical event (Russia’s invasion of Ukraine) came to pass.
Approximately 35% of the company’s workforce was based in Russia and Belarus, creating a precarious situation for the company when the conflict erupted. Its stock price plummeted by as much as 70%, presenting a unique opportunity for value investors to acquire the stock.
As we expected, the drop in the company’s stock price was temporary. The company’s leadership quickly unveiled a comprehensive plan to mitigate the consequences of the geopolitical conflict by relocating a significant portion of its employee base, restructuring production facilities, and exploring merchant options (a notable shift from its previously vertically integrated approach).
Over the course of several quarters, the company executed this strategic pivot effectively, stabilizing its operations and instilling confidence among investors. During this time, it continued to implement new products to disrupt other end-markets. The stock rebounded.
Trade disputes, economic sanctions, or geopolitical tensions often cause investors to flee stocks they see as negatively impacted. Those same investors typically move into stocks they deem to be safer or better-positioned post-conflict. This transition may create a temporary mispricing within the stock that we, as value investors, try to capitalize on. The example above illustrates how geopolitical events, although taking place abroad, can affect quality companies within our primarily domestic universe and how we would evaluate an attractive entry point into said company.
Rolling Recession Risk Makes Semiconductors a Waiting Game
There’s been a lot of talk about rolling recessions, in which some industries shrink while the overall economy remains above water. The semiconductor market is an example of this. The recession started in 2022 when the Philadelphia Semiconductor Index (SOX) [1] was at around 4000 and bottomed in the fall of 2022 when the SIX was at around 2100.
The primary concern was that as supply chains normalized, there would be a reduction in orders. We have seen some impact, as some lead times have started to contract. To give an example, lead times were extended dramatically – from 8 to 12 weeks to north of 52 weeks. In one extreme example, we heard of some products having a two-year lead time. But we have seen lead times start to normalize, and in some cases 52-week lead times have come in six months or less.
The process of working through these constraints is called inventory normalization and is usually very painful.
Take analog semiconductors as an example. Analog used to experience price declines of about 8% to 10% a year, but through a concerted effort by companies to manage capacity, by 2020 pricing was relatively flat year-over-year. Then the pandemic – with all its associated supply-chain disruptions – struck. Now pricing is up 20% to 30% across multiple product segments.
As a result, most semiconductor companies are at peak margins. Some of them have doubled their operating margins. And not surprisingly, their stock returns have been off the charts. In fact, the SOX has returned to levels above 3500 as investors seem to have looked right through the inventory normalization that still needs to occur.
Is that pricing sticky? Can companies maintain peak margins? Management teams believe so, but we are less sanguine. We expect some level of volume and pricing decline as the level of inventory is substantial. However, there are some strong secular drivers that we believe should impact semiconductor demand over the next decade.
With a reset in earnings still expected, at least for a portion of the semiconductor market, we are being patient. We believe there likely will be a reset to earnings and the market will apply a reasonable price-to-earnings (P/E) multiple to those lowered numbers. Thus, we continue to be patient and look for companies within 10% of our downside scenario. As the market starts to reprice quality companies, we will be ready to opportunistically add exposure.
Seeking Transitions in Value
Value investors can potentially capitalize on shifting markets in transition by focusing on quality companies that are temporarily undervalued. These opportunities exist in more than the technology sector.
[1] The PHLX Semiconductor Sector is a Philadelphia Stock Exchange capitalization-weighted index composed of the 30 largest U.S. companies primarily involved in the design, distribution, manufacture, and sale of semiconductors.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
