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Happy Thanksgiving

| November 21, 2022
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I want to follow up last week’s blog with a broader look into the innovation space.  Before I do that, we want to wish you a Happy Thanksgiving. We all have so much to be thankful for, even though life may throw challenges in our direction, we should all feel blessed. Enjoy spending time with family and friends and, if you are traveling, bring your patience and get to the airport early.

Last week we discussed the FTX debacle and that hasn’t gotten any better as it looks like FTX owes creditors and counterparties over $3 billion. We have had many questions over the last week about exposure to this and if we have any. Of course, like many things in life, the answer is not so straightforward.  The easy answer is, no we don’t have exposure to those counterparties. That wasn’t so hard, was it?  Well…

Here's where things get a bit murky. While we don’t have exposure, that doesn’t mean that it doesn’t have an effect. Here’s what I mean by that.

One thing to remember is that most things are related to one degree or another. It’s kind of like the “six degrees of Kevin Bacon.” The companies that are owed $3 billion have customers and some of those customers likely either need some/all of their money, which they may not be able to get. So, they may sell something else that is liquid to meet their obligations. That is where we are most likely to be affected. They sell what they can, not what they want. So, they might sell stocks or bonds which would push the prices of those assets down. That is the proverbial rush for the exits. 

Is it a huge effect on portfolios? Again, probably not directly. Does it make people not want to invest in innovation? It would probably make them think twice about it. That might add some incremental downward pressure on innovation stocks. Which brings me to the real topic of this week’s blog.

Innovation: Is it investable, and is it cheap or expensive?

As you know, we have owned the ARK Innovation fund (ARKK). We first purchased shares in March of 2018 (before COVID) and before the huge gains in the fund. We went on to sell nearly all of our cost basis during the run up in 2020 with overall realized gains of about 135%. You could argue that we didn’t sell enough or that we should have seen that prices were going to come back down. Maybe there’s a case to be made, but only in hindsight. We still believe that innovation is highly investable, but it certainly depends on your time horizon. Like many things when the market pulls back, people’s time horizon also pulls back and gets much shorter. It’s still a free country and people are allowed to make any decisions they feel are right. Investing, as we’ve discussed before, depends so much on emotions and sentiment. Most times those emotions lead us astray and make us do things that are opposite our long-term goals.

Last week I was reading some research from Knowledge Leaders, one of our respected research partners. They were looking at valuations in the innovation space. Before we jump into that, it’s important to look at one of the fundamental building blocks of innovation. That is Moore’s Law. What is that you ask? Here’s the explanation from Investopedia.

Remember Intel? They were originally formed in 1965. Yes, so 20th century! Double the capacity and half the price…Sounds like my dream dinner at Golden Corral 😊. Alright, enough of that!

Let’s do some quick math (no test). Since we are close to 2023 and for math’s sake it is an even number, let’s look at the capacity increase since 1965.

That would be 58 years (2023 – 1965). If microchip capacity doubles every two years, that means 29 doubles during that time period. I’ll do the math, but let me tell you right now, the numbers will get big in a hurry. I wish markets doubled every two years!

1 to 2, 2 to 4, 4 to 8, 8 to 16, 16 to 32…  That’s only 5, we have 24 to go.

268,435,456 to 536,870,912…That’s 536 million times more computing power than in 1965. What can we do with that? Let’s think about it this way. Do you remember when the first human genome was mapped? Answer: 2003. Since that time, computing power has increased by 1000 times. It took 13 years to map the human genome the first time, now they can do it in an hour! It cost $2.7 billion dollars back then. Today you can get yours done for $200, maybe less on Black Friday! 

That’s the power of innovation. It all started with the computer chip. Today, the internet, artificial intelligence, robotics, self-driving cars, biotechnology, energy storage (battery technology), and Blockchain are all capable because of the computer chip and Moore’s Law.

So, let’s dig into the research from Knowledge Leaders. If you’re inclined, you can read their papers here and here.

Knowledge Leaders compares companies that do research and development and those that don’t. It’s quite stunning to realize that over half of the S&P 500 spends no money on R&D. None, zero, zip. Like the world is just going to keep buying their buggy whips forever, or their 35mm cameras…and the list goes one from there. Here’s the first chart.

  

The companies that do R&D make more money, are worth more, and are cheaper per dollar of earnings.

That’s just the S&P 500. It’s even more pronounced in the international space.

 

Double the value, double the cash flow, and selling for slightly less than their competitors that don’t do any R&D.

Maybe I’m the only one, but I find that incredible. Take a look at the headlines for an Inc. magazine story.

 

Aside from the horrible proofreading, the point is made. Business is moving faster, and if you don’t keep up, you will be bankrupt, absorbed, or otherwise deemed irrelevant. Any way you look at it, not the ideal outcomes for many of these businesses.

Let’s look at the sectors that are spenders of research and development.

It shouldn’t come as any surprise that health care and technology are two of the leading areas of R&D spending. I did find it interesting that the industrial and materials sectors represent a lot of companies spending on R&D.

Of course, the lines are becoming blurred, as companies cross over from one sector to another, or sometimes straddle multiple sectors. Let’s look at Tesla. Is it technology, industrial, energy, consumer discretionary? I think you could argue all those. Maybe even throw financials in there too, through traditional financing to special insurance for their drivers. If they have an autonomous taxi service, where would that fit into the traditional sectors? They are certainly taking part of the utility space with the Tesla power wall and Tesla solar roof.

Don’t get me wrong, should you have your whole portfolio in innovation companies? Probably not. It’s volatile, lots of winners and losers, and would likely cause your emotions to fluctuate too much to give you the returns necessary to withstand those ups and downs. Can I argue for some exposure? Yep. I think I just did?

Will there be more blow ups like FTX? Probably. Just like there were the internet companies in the early 2000s that no longer exist. Like I said last week, 90%+ of blockchain/cryptocurrency companies will not make it through this period. Does that mean it’s not investable? Nope, just means you need to stay diversified and maybe wait for the shakeout before allocating to that space. I know that’s basically how we’ve been approaching it.

I hope you enjoyed (or at least got something out of) this week’s piece. Thanks for reading. Let us know if you have any questions, and once again, have a blessed Thanksgiving.

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