Counsel Views – Episode 4: Marcello Montanari and Robert Cavallo

Stu Morrow:

Welcome to Counsel Views. I'm your host Stu Morrow, vice president and head of investments at RBC PH&N Investment Counsel. Global technology stocks have been leading the charge in equity markets for some time now. And more recently during the post-COVID recovery period, most of the games and technology stocks have come from the well-known meg cap companies, such as Microsoft, Google, Apple, Visa, MasterCard, Facebook, and some technology related companies like Tesla and Amazon. Connectivity to the office colleagues, family, and friends has been a boon for most of these and other companies and for their investors. Technology has allowed most of the global economy to remain on a somewhat positive trajectory, despite the global pandemic.

Today, investors are well exposed to the technology companies that have led the way in the recovery. But as we look ahead, for some perspective, I'm wondering what could happen to these market-leading stocks once there is some resolution of COVID-19. Are there good long-term fundamental reasons to continue holding these stocks or perhaps even increase exposures today?

And what might happen to technology stocks if we start to see inflation rise, and interest rates begin to creep higher? To help us get a handle on these issues, I'm happy to welcome our guests for this session of Counsel Views, Rob Cavallo and Marcello Montanari. Rob and Marcello are portfolio managers with the North American equity team at RBC Global Asset Management. They co-manage the RBC Global Technology Fund and manage the suite of growth funds for the firm. Rob joined the firm in 2012 as a global equities analyst with a focus on analyzing companies within the healthcare and consumer sectors. He's had progressively senior roles at the firm and has over 13 years of industry experience.

Marcello began his career in the investment industry in 1992. Prior to joining the firm, he worked at the Canadian Bond Rating Service, which is now Standard & Poor's. Where he helped determine credit ratings for telecommunication in media companies. Marcello has been a portfolio manager and a member of the team since 1999.

Hey, Rob, Marcelo. Welcome at Counsel Views. Happy to have you with us today.

Marcello:

Thanks for having us.

Stu Morrow:

So maybe we can start with you guys spending a few moments discussing how you view the technology sector today, both in the US and in Canada. And when you're looking at your portfolio today, are you generally positive, kind of neutral or even cautious on technology stocks?

Marcello:

Thanks for the questions, Stu. When we think about the tech sector, we believe it's really important to kind of separate the short-term from the long-term view. We're big believers and we subscribe to the quote that's been attributed to Bill Gates that, "We tend to overestimate in the short-term, but underestimate in the long." And that's because people tend to be kind of linear thinkers and have trouble forecasting exponential growth. With that view, our most current view in the short-term is that we're kind of leaning more neutral, in the short-term. We had gotten a little cautious towards the end of August, given the blow off in the group and the mega tech names specifically during July and August, where we saw about a 20% rise, depending on the tech sub-index of your choice.

Most recently we've had a 10% pullback and we're feeling a little bit better and view it as a healthy pullback that you need. Over the long-term, we still feel very positive on the sector overall for a number of factors. We see the cash-flow returns of the group as highly sustainable with market-leading returns on invested capital. Also, the market is fueled by some pretty important themes across the space where we think we're still relatively in the early innings here. So digital transformation, cloud, 5G, e-commerce with the cash to card transition happening, automation, all of these things are... We still think there's a lot of room to move forward on these things. We'd like to stress that technology stocks tend to be long duration assets. So we tend to take a longer term view with the goal of allowing time and compounding to work for us, because circling back to the Gates quote I started with, we don't want to get too fixated on the short-term gyrations at the expense of long-term performance. Rob, anything to add? Or maybe the next question.

Rob:

Sorry. Thanks, Marcello. I have a couple of comments here I can add and thanks Stuart for setting up this call for us. I would say, in terms of thinking about sub-sectors over the longer term, we still remain most positive on the software and internet on one end of a barbell and semi-conductors on the other end of a barbell, thinking about how we approach our portfolio construction. These areas are still ripe for lots of growth going forward. We still believe software's leading the world on the one end and semi-conductors is powering the growth behind most of the major transformational themes that you'll see come up within the technology sector, such as digital transformation and 5G. Additionally, on the semi-conductor side, continued consolidation just makes us even more positive on the return profile remaining very healthy and the profile actually improving for the group going forward. From the other side, from a negative perspective, electronic manufacturing is always something that's challenging and we don't really see something that's going to change that anytime soon. So it's an area that we shy away from.

Additionally, hardware and communications equipment, which tend to be areas that commoditized pretty quickly, are areas that we are less positive on. We'd also mentioned that communication equipment customers tend to carry most of the power in the value chain. And it's another reason that makes us generally less positive on this group relative to areas like software and semi-conductors. Having said that, there are selectively some interesting names within the hardware and communications group. So it's not something that necessarily could be painted all with the same brush, but generally speaking, that's how we're thinking about sub-sector positioning over the longer term.

Stu Morrow:

That's great. Thanks guys. I really agree with the comments on not getting caught up in the short-term and focusing on the long-term. That's generally how we position portfolio construction and thinking about the investment world to our clients. So it really does tie in well with how we think about portfolio construction as well. When you think about the mega-cap names, so forget the short-term commentary, but the mega-cap names the Apple, the Google, the Facebook, the Visa, MasterCard are all really well owned in portfolios today. But how do you feel about them over the long-term? And if there's any of those household, large cap tech names that you don't own, can maybe tell us about one that you may not own and maybe why you don't own it?

Rob:

Yeah. Maybe I can start here and then turn it over to Marcello. What I would say is that, again, the same manner in which Marcello spoke about separating the short-term and the long-term, I think when we're talking about the mega cap names, we need to think about the businesses versus valuation as a sort of a separate argument. Looking at it first from a business perspective, we see very little right now that is going to disrupt most of the thesis around why you want to own most of these names. Be it Apple, Microsoft, Google, so forth, we're generally still pretty positive around the long-term sustainability of returns and ability to actually add more growth, add more S-curves to these businesses that make them attractive from a longer term perspective.

We get the argument on the short-term, where maybe in certain instances, valuations have, I wouldn't say overshot, but have maybe gotten a little bit towards the higher end of a range where we're comfortable. And using Apple as an example, it's a name that we're still positive on longer term, but we had become a little bit more cautious on near term and we'd made some tactical changes to adjust the weighting across our portfolios to reflect the very strong rise we've seen in this stock year to date.

When I look across names in that mega cap space we're generally maybe more negative. Really, a lot of these names will kind of fall into old legacy value tech. And this is where our weightings are either zero or big negative weight bets in the tech mandate. Some of these names would be, in Intel and IBM, Oracle, Cisco. These all tend to be names that we've historically not been very supportive of and have been reflected, again, either as a zero weight or as a big underweight in our mandates. One in particular that I would just very briefly touch on would be Intel, so it's a name that we've struggled with for some time. As you know, we see them having given up one of their key competitive, or if not, the competitive advantage of their business. And that's been on the manufacturing and production side.

They've had several missteps over the last several years. And despite other positive things going on in the business, in terms of keeping the earnings profile high and margins high to this point, we see some of these legacy issues on the manufacturing side. A reason why it's going to be a stock that's going to very much struggle over the next few years as they start to really cede market share to AMD and some other competitors in this space. That's just one example of some of the names in the mega cap space, or a name in the mega cap space that we'd be less positive on.

Just maybe coming back really quickly before I turn over to Marcello, we look at names, again, like Microsoft, Facebook, Google, where the pathway longer-term is still really very much intact. Where we have heightened focus is really on the regulatory side there. And maybe this is something that will come up later in our discussion, but that's really where we're focusing. And we really see that as being the key thing that could break a thesis to this group and maybe create more structural disadvantages within these names. But for right now, we feel very good with most of these mega cap tech names. Maybe from there, I can turn it over to Marcelo.

Marcello:

Yeah. Just to add onto that, when you look at some of the attributes of these companies and tech in general, most tech markets tend to be winner take all or winner take most, which supports the trend of the big getting bigger. They also have network effects, they're very real and very powerful. Again, that's another driver that favors the big getting bigger. A lot of the tech segments, especially software and internet, are characterized by increasing returns to scale. So the earnings leverage and the flow through of cash at the bottom line is unlike anything we've really ever seen in history. And then there's also an element of regulatory capture, especially in the United States, which helps to cement these companies and magnifies their power. Those are just a few things that add up to this.

And then when you look at their business models on top of it, the business models are increasingly subscription-based, which makes the companies more predictable in their operations. And at the same time, that enlarges the TAM by making the cost of entry for their customers lower than was historically the case in many tech markets in history. Finally, our approach to running the portfolio is to take a barbell approach where we mix a balance of what we call resilient names with buckets of optionality. And the resilience stocks tend to be these big mega cap ones, to a certain degree, the larger household names where we still expect to have a good solid growth profile. Typically, it's lower valuations in some of the others names. And then we complement that with a larger number of small bets spread across names we think have out sized prospects in return characteristics.

Stu Morrow:

That's great. I wanted to touch on one follow-up to that. You both have mentioned business models and Marcello you mentioned the subscription based business model for some technology companies today. Maybe perhaps on that and on the minds of our investors would be that these names have done really well over the last few years and they sort of led the charge. And what might be in the mind or the back of people's minds could be, are we set up for another big correction in technology? Similar to like, maybe we saw in the early 2000s. Is it sort of different for companies this time? Are we talking about a different universe of technology companies today versus then? And is that something we should be concerned about or not so concerned about?

Marcello:

Well, I mean, we've been getting this question a lot lately and it's justifiable, given the move we've seen, especially in some of the mega caps this year. So, that's obviously igniting some of the fears around history repeating itself. But, having lived for both episodes, I have to say the level of euphoria and froth in 2000 was orders of magnitude higher than what we're seeing today. I mean, it's frothy, there's elements of froth right now, but not like that. And we think that some of this froth we'll still need to shake out, but we think that there's some real fundamental differences this time around. From a macro perspective, we were in an entirely different interest rate environment, rates were meaningfully higher in 2000. And we were going through a tightening environment.

This time, the rates are near historic lows and what we've heard from the central banks around the world suggests to us that it's going to be lower for longer. And that's just the reality we're in. From a valuation perspective, the tech sector isn't priced nearly as egregiously as it was back in 2000. Sure there's some higher growth names that are trading a pretty lofty sales multiples, but broadly speaking, the group’s valuation is not elevated to the point it was back then. I mean, you have names like Apple, Microsoft, Facebook, Google that trade between 25 and 30 times P/E, which is a stark contrast to where the multiples for the big growers were back then. Fundamentally, in 2000 many of these businesses were, they were undergoing a hype cycle.

There was a lot of excitement. The internet was new. People were just imagining the unimaginable of what could happen, but the business models weren't solidified and the markets weren't really sustainable at that point, or we didn't really know what they would turn out to be. And it turns out a lot of them weren't really markets in the end. Many of these companies barely had any revenues and they were being priced off of high-balls, they were priced off of page views. There was some pretty egregious behavior going on. As you know, WorldCom and Enron became, although Enron wasn't a tech name, but they became the poster children of everything that was wrong with what was going on then. Some were simply bartering goods and services and recording it as revenue, like the big fiber players were swapping sheets of fiber with each other and they were recording the exchanged values of the swaps as revenues. So all sorts of stuff was going on.

Today, the tech stocks are, by a wide margin, leaders in cash-flow margins, leaders in return on invested capital. They're adding new S-curves to their business, they're flushed with cash. And even for the smaller names, the funding opportunities all are plentiful. So it's a completely different situation. That being said, it's clear that the market, again, coming back to the short-term versus long-term, it's clear that the market oscillates between kind of overbought and oversold. And the way we manage it from a portfolio perspective is, we'll run higher cash levels and we'll alter our mix between the resilient names versus the optionality names within the portfolio.

Stu Morrow:

That's some great perspective on the history, Marcello. Thanks for that. That does help. That's going to help our clients in thinking about the technology space. One of the things you mentioned, as well, was that the rate environment from the early part of the, in the 2000s to today. So a very different rate environment today, where rates are already quite low. How do you think about valuation for these tech stocks that are, one may say, they're called long duration assets so the value of the multiples will change quite a bit with changes in interest rates. So interest rates are low. If interest rates start to rise, call it inflation or growth, what happens to valuations in your process? How do you guys think about tech stocks in a potentially rising rate or inflationary environment?

Rob:

Well, yeah. I mean, that's a great question. And it's probably one of the key macro drivers that's going to sort of dictate what type of performance we see from the group, both in the short and longer term. We're not naive to the fact that to where rates are now is a favorable setup for technology. Just as you mentioned, given a longer duration aspect of how valuation works in the group. If we were to go through a period where we do see a rising rate environment, clearly this is going to have an impact to the discount rate that's applied to future cash flows. And we're going to see some pressure on valuations, especially for those stocks that are more reliant on pricing, much further out cashflow streams.

I think what you see is... How we would make an adjustment is, we would be a lot more stringent on how we think about valuing the cash flows within that optionality sleeve with the group. We could see a bit more pressure there than we do in other areas where there's more near term cash flow to support valuation. But clearly, rising rates could have some, at least short-term, impact to the group. But I think it's also important to step back and think about where are rates moving. Are we talking about rates moving up 50 basis points, or are we talking about rates moving back to early 2000 levels? And I think that's really going to be a big driver as to the proper way to think about what the impact of the group will be.

So we're very focused on what could change and what could drive a more structural rise in rates. To this point, we feel okay with the lower for longer thesis holding intact. And while we might see some short-term impacts that could have some pretty wicked rallies in rates and some hard sell offs on the short-term and the group, we still feel okay about how the longer term rate environment sets up for the technology sector. Again, we also, another important point is, we also think about this on a relative basis and I sort of touched upon this a little bit early in response to the question. There's going to be some names that are going to be more impacted than others that's probably going to be at the higher sales multiple type optionality names, as opposed to some of the more resilient, mega cap stock names.

So we would be looking to make adjustments along that spectrum. But one final point, I would just say, at the end of the day, the tech sector is comprised of many idiosyncratic opportunities that we believe are the bigger drivers of longer term performance. So our job is really to focus on those company-specific factors that are going to drive that idiosyncratic growth that is really difficult to find in most other areas of the market. We feel that tech is a very unique opportunity there and those companies are still going to work regardless of whether rates are going higher or lower. And our job is to really continue to try to identify those names that will add value regardless of the rate environment.

Stu Morrow:

That's great. Well said. Before we close it off, one thing I've always asked our guests was a book recommendation or their favorite podcast that they are listening to. To both of you, it can be technology related or market related or not, is there anything that you think would be interesting for our listeners to pay attention to?

Rob:

Yeah, I'll give you a few of my favorite podcasts and a few books that I would think would be helpful. So maybe first on the podcast side, I think my favorite one is probably Revisionist History by Malcolm Gladwell. I also like How I Built This, the podcast is focused on entrepreneurs, both in tech and without tech. It's just very fascinating theories. And then when you're thinking more on the tech side, Exponent by Ben Thompson is a very good one.

You'll also find a lot of good insight on the a16z series, by people from Andreessen Horowitz. And even ones like Invest Like The Best with Patrick O'Shaughnessy, you'll find there's a lot of really good tech investors that have been on there, that you can get really good insight from. From a book perspective, some textbooks that are pretty interesting how Google works, The Innovator's Dilemma, The Myth of Capitalism. Not really just tech, but pretty good lessons for big tech, The Upstarts and The Invincible, are a couple other ones as well, I think that would be interesting reads when you're thinking about some of the notable tech names in the space.

Marcello:

Yeah. On my end, I agree with a lot of those. I have a pile of unread books. I have this habit of buying, ordering five books at a time and then reading two or three of them and making a pile of the ones I dealt. So, I've been kind of going back to some of those, but I just more recently finished The Everything Store, a story of Jeff Bezos and Amazon, which is a great book. I love biography so I hope to get a... I've got a Walt Disney biography that's sitting on the shelf so that's kind of my next read I think. But as far as books about tech investing, foundational books that I found really helpful, I would add to what Rob mentioned, The Bristol Game and the Crossing The Chasm by Geoffrey Moore is kind of really foundational books.

And just from general investing perspective, anything that Michael Mauboussin writes, I would basically read. I've got his entire library of the pieces he's written, whether it was at Credit Suisse or Legg Mason, and now it's Morgan Stanley. So I pretty much have read everything and just love his work and his thought and his insight. And then just to add one last thing, Rob did mention that Ben Thompson, who runs, he has a newsletter that he calls Stratechery, which is probably the best $100 of value you will ever spend investing. So I find that that's all very helpful. I just want to add one point, investing in tech, this is the one sector where knowledge builds upon itself. So experience really... In our views, and I know we're kind of talking of books here, I get that, but we really feel that experience is really important in this sector because history doesn't necessarily repeat, but it does rhyme.

And so you start to see a lot of the same business models that failed in a prior period start to pop up again. Lots of trends and things that, like hype cycles, if you don't understand these things, it can lead to you into a lot of trouble. And understanding the history of semi-conductors, what was tried in the past, why it worked or didn't work, or why it might work in the future and not, these things are important. It's the one sector where, like I said, knowledge builds upon itself. So, we think that there's real value in getting a managed approach rather than an ETF approach that some people might be leaning towards

Stu Morrow:

I completely agree Marcello and that's a great last few points you've made about approaching the sector and having an experienced portfolio manager leading that, is quite important. I definitely agree with that. Gentlemen, a pleasure speaking to you both. Thank you for taking the time today to speak with us and share your thoughts on the tech sector, as well as your investment process. It's been great. I wish you both continued success and hope you both stay well.

Marcello:

You too. Wish you too.

Rob:

Thank you very much.

Marcello:

Yeah, thanks for having us.

Rob:

Take care guys.

Stu Morrow:

Thank you.