Interview

«The One Thing That Matters Is Inflation»

Gavin Baker, founder of Atreides Management, sees inflation setting the tone for financial markets. The influential tech investor says what rising prices would mean for the sector, what's next for the super-cycle in the semiconductor industry, and why the record number of new stock issues is creating attractive opportunities.

Christoph Gisiger
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Financial markets are heading into a pivotal phase. After a rapid rise in inflation, the coming months will reveal whether this trend is transitory or permanent after all. At the same time, the Federal Reserve is signaling that it wants to start winding down its gigantic stimulus program.

Gavin Baker thinks that inflation will become the key factor determining the direction in financial markets. The founder and CIO of Boston-based investment boutique Atreides Management is one of the most esteemed investors in the tech sector. Although he doesn't rule out the possibility that the surge in inflation will level off next year, he is preparing for any kind of scenario.

«I’m not smart enough to know what’s going to happen, so I want to be open-minded to any scenario»: Gavin Baker.

«I’m not smart enough to know what’s going to happen, so I want to be open-minded to any scenario»: Gavin Baker.

«We have been in a secular bull market with receding interest rates for decades,» Mr. Baker says. High-growth tech stocks, in particular, have benefited from this environment. «That's why it's so important to keep an eye on inflation,» he argues.

In this in-depth interview with The Market/NZZ, the investment veteran shares his take on the outlook for the stock market and the unprecedented shortages in the semiconductor industry. He also explains how investors can take advantage of the boom in IPOs, SPACs and direct listings.

Mr. Baker, once again, financial markets are laser-focused on the next move of the Federal Reserve. How do you approach this environment as a tech investor?

I don’t tend to focus very much on stimulus and the macro environment in general. I think things like that are lost in the sands of time. The Fed is going to do what it’s going to do, maybe it will be a good decision, maybe it will be a bad one. But the one thing that does matter is inflation, and here’s a reminder of how humbling our job as investors is: We saw these consecutive, massive CPI prints, and you know what happened? Counterintuitively, the yield on the long bond went straight down. This is why investing is the greatest game ever invented, and we’re all lucky to be involved in it.

What’s your investment strategy with respect to inflation?

I believe it's in the Bruce Kovner chapter of «Market Wizards», one of the best books written about investing. He says that he likes to picture himself as the boulder at the top of a mountain. Based upon certain things, he visualizes the path he’s going to take down the mountain: If X happens, he’s going to go down this way, and if Y happens, he’s going down a different path. So he’s keeping an open mind and tries to imagine all the different scenarios, depending on initial conditions and whichever way the boulder starts to go.

Do you think there’s a real risk that inflation is here to stay?

Something I profoundly believe is that nobody repeats the mistake of their parents. We all have nuanced opinions on what our parents did wrong; in life, as parents or in business. Whatever it is, nobody repeats those mistakes. But all of our parents had parents, and that means that a lot of times we’re repeating the mistakes of our grandparents.

What does this mean when it comes to the current environment?

If you go back to 2010-11, the last time there was significant quantitative easing, there were two remarkable open letters to Fed Chairman Ben Bernanke in the «Wall Street Journal», signed by the world’s greatest macro investors and economists. Both said basically the same thing: QE is a terrible risk, you’re going to unleash hyper-inflation, and you have to stop. These op-eds were written with a lot of conviction, and they were dead wrong. I think because of that, almost no one is really pushing back on what the Fed is doing today. At the same time, unlike in 2010-11, very few people in the United States Congress are pushing back against stimulus programs, and today the stimulus is a lot bigger. To me, that lack of real pushback is concerning, just because inflation and deflation are the two things that financial markets cannot abide.

Which way do you think this journey will go?

On balance, I think that a lot of this inflation will prove to be transitory. It’s reasonably likely that you will have negative CPI prints next year. Almost certainly, there is going to be a massive supply response coming. But if it starts to go wrong, it makes life very difficult for financial markets. We have been in a secular bull market with receding interest rates for decades. Obviously, we had huge drawdowns along the way, financial crises and crashes, but the market kept tugging, particularly over the last ten or twelve years. So inflation is the one thing that’s important to monitor. I’m not smart enough to know what’s going to happen, so I want to be open-minded to any scenario. Like Bruce Kovner said: If I’m that boulder on top of the mountain, I want to know which way I’m going to go in different scenarios.

How would tech stocks react if the current surge in inflation isn’t transitory?

Everyone has looked at the 1970s and seen that technology stocks did poorly. But back then, tech companies were low return on capital, low return on equity companies. They had many physical plants. Unsurprisingly, the best thinking on inflation’s impact on the equity market comes from Warren Buffett. He basically points out that the way inflation crushes you is that it compresses RoE over time by inflating your asset base. Hence, according to Buffett, you want to own high ROIC, asset light companies with a lot of revenue and profit per employee, particularly when they have pricing power. And that describes a lot of the technology industry today. That’s why tech might do better in an inflationary scenario than many people believe. If you are a company like Google or Facebook that sells digital advertising and if you’re selling it at an auction, by definition, you’re not really exposed to inflation. Your prices will inflate with the economy by the magic of these auctions.

Then again, the sector is rather richly valued. It’s also a fact that investors use large-cap tech stocks as long-duration assets instead of bonds. Aren’t these stocks at risk in an environment with rising inflation and rising interest rates?

«It’s actually pretty tough to argue that these mega-cap tech stocks are expensive. A lot of the big tech companies are pretty cheap.»

«It’s actually pretty tough to argue that these mega-cap tech stocks are expensive. A lot of the big tech companies are pretty cheap.»

It’s actually pretty tough to argue that these mega-cap tech stocks are expensive. A lot of the big tech companies are pretty cheap. Here’s something I like to do with these mega-cap tech companies: Let’s divide every number by ten; the market cap, the shares outstanding, the revenue, everything. And then, let’s pretend that stock is in another sector like industrials and try to figure out where it would trade. I can tell you the multiples would be way higher.

So far, investors remain quite optimistic. The S&P 500 and the Nasdaq 100 are up close to 20% year-to-date, hovering around their all-time highs.

Averages can be quite misleading. If a river is on average three feet deep, that sounds easy to cross, but not if at the deepest point it’s a hundred feet deep. While the averages and the indices have been very placid, there is crazy turbulence underneath with violent rotations. It’s not uncommon that on a day when the market is up or down 1%, one group of stocks is up 3 to 5%, and another group is down 3 to 5%. Sometimes it’s sectors, sometimes it’s subsectors, or thematic like work from home or re-opening, or cyclical versus defensive. I think that is the market sorting through all these crosscurrents: The stimulus fading, another infrastructure bill on the horizon, and the fact that the Fed at some point is going to taper.

Among the best performers this year are again some semiconductor stocks. What’s your take on the recent developments in the chip industry?

First of all, there is a difference in the semiconductor industry between a capacity cycle and an inventory cycle. In the 1980s and 1990s, we saw capacity cycles, and the reason for that was that most semiconductor companies had their own fabs. So when you had upgraded every line in that fab and there wasn’t a new process technology available, the only way you could expand capacity was to bring on a new fab. What’s more, most semiconductor companies back then would all bring on new fabs at the exact same time. So even though semiconductor demand was growing very consistently, you had these crazy boom-bust cycles where you would go from crazy undersupply to crazy oversupply. That’s why it was such a cyclical industry in the past.

How about today?

Mostly because of TSMC and the shift to outsourcing semiconductor fabrication, those capacity cycles have gone away. TSMC supplying such a huge increment of the world’s semiconductors means that at any point in time, it has loads of fabs and production lines it can bring on so that supply very smoothly matches demand. That’s why it’s been twenty plus years since we’ve seen a true capacity cycle in the semiconductor industry, outside of the memory sector. However, over the last twenty years there have been lots of inventory cycles.

How is an inventory cycle different from a capacity cycle?

It’s similar to all these equations in macroeconomics, like savings must equal investment, investment must equal savings etc. The equation that explains the modern semiconductor industry is the fact that customer buffer inventories equal semiconductor lead times. So if you’re a purchasing manager at a company like Ford, you generally have a pretty quiet job; you just have to buy stuff and make sure it’s there to run the factories. But what you really don’t want to happen is what actually happened: Ford’s plants got shut down because they couldn’t get semiconductors. That’s a disaster, and that’s how you lose your job as a purchasing manager.

What does this mean for the present state of the semiconductor industry?

Purchasing managers all around the world want to avoid that problem by holding buffer inventory equal to lead time. That means, if a semiconductor company is quoting you a lead time of two weeks to get a part, you want to have two weeks of inventory. Thus, when the lead time grows to three weeks, you build inventory for three weeks. Critically, as long as customers are building inventories, what the semiconductor companies are seeing is not true end demand. They’re seeing stronger demand because the customers are ordering to meet their demand plus to build inventories. That’s what you have seen in the semiconductor industry over the last year.

You’ve started your career in the investment industry as a semiconductor analyst in the late 1990s and you know the sector very well. What do you think is going to happen next?

«Everybody thinks this time it’s different, but it’s never different.»

«Everybody thinks this time it’s different, but it’s never different.»

Everybody thinks this time it’s different, but it’s never different. As lead times are increasing, I promise customer buffer inventories are increasing. If you’re a giant internet company, to provide services you need a lot of CPUs, GPUs and memory. You don’t want to run out of those processors and have the company’s growth curtailed. So you’re building inventory everywhere. If you’re a big handset company, you’re building inventory. Everybody is building inventory, and there is also something called double ordering. That means if you’re a handset company, you’re placing an order with more than one semiconductor company for what you need because you’re not sure you are going to get it. The semiconductor companies are always thinking it’s not happening. But it’s happening.

So how is this going to play out?

Semiconductor companies are straining to meet this demand that’s actually growing stronger and faster than true end demand. And then something happens. Who knows what it is? Maybe it’s the crypto currency market rolling over. Maybe it’s a big smartphone company coming out with a device that’s not as cool as it usually is. Maybe it’s the Delta variant slowing down economic growth. But all of a sudden, lead times go down one tick, say from twenty weeks to nineteen weeks. So of course, customers reduce their inventories. All of a sudden, demand flips from above natural to below natural, and then it spirals the same way down as it went up. That’s why you have these wild inventory cycle driven swings in end demand. It’s pretty clear that if we have not already seen the peak of this inventory cycle, we’re very close. But once we’ve gone through that, the open question is if we’re in a true capacity cycle.

What do you think?

That’s what we talked about in our last interview: Semiconductors are cyclical and economically sensitive, but long-term they grow faster than GDP. Now, artificial intelligence is going to raise the semiconductor intensity of global GDP. In other words, if in the past the semiconductor industry grew at 1.5x global GDP, now it’s going to grow 2x to 3x because AI, by its very nature, consumes so much more semiconductor content than software written by humans. Therefore, it may be possible that the world is structurally short of capacity, and we’re in a capacity cycle, driven by the confluence of AI and all these other trends: the electrification of cars, autonomous vehicles, crypto mining. All these mega trends will be driving semiconductor demand, but they’re all dwarfed by AI. Yet, we’re only going to be able to make that judgement once we’re on the other side of the current inventory cycle.

Semiconductors have become a hot topic in geopolitics, and leading manufacturers like TSMC, Samsung and Intel have announced massive investments to build new fabs, betting on government subsidies. Is this a smart move?

For their sake, I better be right about AI driving semiconductor demand. Because if I’m not right and all these fabs come online, it’s going to be a train wreck. Also, better be careful what you wish for. There is too much of a good thing, and government subsidies tend to distort supply and demand. I’m a huge believer that we should have fabs in the United States and Europe. We need leading edge semiconductors, it’s a geopolitical imperative. The same is true for pharmaceuticals and batteries: Every tank, every armored personnel carrier, every Humvee, every airplane needs batteries, too. You need a domestic supply chain for those three things. They're the oil of the 21st century. But if we have all these subsidies, and demand isn’t structurally higher, it’s going to be very painful for the semiconductor industry.

Which companies are attractively positioned against this backdrop?

Companies in the semiconductor capital equipment area: These are the arms dealers, and they have massively consolidated. What’s interesting about a lot of these companies is that they become structurally better businesses and thus evolve into really great stocks. They have almost done what the aircraft engine companies did in the past. The big inside in GE twenty years ago was: «Who cares making money on the engine? We’re going to make a lot of money on servicing that engine.» Semiconductor equipment machinery, whether it’s lithography or edge deposition, is really complicated. It’s like aircraft engines. So they realized: «Wow, we can do the same thing! We can have recurring revenue!» Consequently, they have become more stable businesses.

Where else do you think there could be opportunities?

Going back to my earlier point that AI requires a lot more processing and memory than software by humans, processor and memory companies are interesting areas over the next three to five years. But don’t get confused, they are probably all going to go down in an inventory cycle.

What are the areas in the tech sector where you would advise caution?

EV SPACs are the most ludicrous group of stocks I have ever seen. They are not the way to go for investors. These are absurd companies, and they’re going to get – for the most part – crushed between the dominant electrical vehicle incumbent and the OEMs, whether it’s BMW, Daimler, GM or Ford.

In general, the market for new issues is booming. What’s your approach in this space?

«There are a lot of inefficiencies in the market for new issues, and it’s a great area for anyone who is an investor to go do work in.»

«There are a lot of inefficiencies in the market for new issues, and it’s a great area for anyone who is an investor to go do work in.»

Here’s my recommendation where to research and spend time: Between all the new IPOs, direct listings and SPACs, the system has been overwhelmed. The world’s largest asset managers don’t have enough analysts to keep up with all of the new companies that are going public. Neither do hedge funds, ECM teams at investment banks and the research teams on the sell side. Hence, there are going to be a lot of exciting investment opportunities on the long side and on the short side in that cohort of companies. Some of them are going to go to zero, and some are going to be incredible stocks. There are a lot of inefficiencies in the market for new issues, and it’s a great area for anyone who is an investor to go do work in.

But aren't many of these companies already richly priced when they go public?

Two observations: One, Amazon went public at $1 billion, Facebook at $40 billion. But they both created a lot of value. If you go public at twenty, thirty or forty billion, it doesn’t mean you can’t create a lot of equity value, particularly in these «winner takes it all» tech markets with increasing returns to scale.

And what’s your second observation with respect to new issues?

Ignore them until they have been in the market for six months. Everybody pays all this attention to these announcements of IPOs, direct listings and SPACs, but it’s just sound and fury. You only get your first real market price when the lockup expires. So if a company goes public via an IPO and you’re interested, do some work, but recognize you’re generally not going to get a true market price until six to nine months after it’s gone public. Just put it on your calendar for six months after the date of the IPO, and then begin considering it.

Tech is probably the most disruptive industry in the world. How do you stay on top of your game as an investor when it comes to new market trends and the emergence of new technologies?

There’s a saying: If you don’t know who the patsy is at the poker table, it’s you. So I try to only invest in companies where I believe I’m in the top 1% of investor knowledge. The reason for that is actually not that I think being in the top 1% of investor knowledge will help me get stocks right. I’m just here to tell you it doesn’t. There are stocks where I’m way up into the top 1% of investor knowledge, and I still lose vast amounts of money. I’m still wrong half the time. Investing is really hard, it’s humbling, and the game within the game is always changing.

So what’s your advantage when you’re better informed about a company than most investors?

Good investing is all about finding a philosophy that fits your temperament and emotional make-up such that you can make high-quality rational decisions when you are wrong. Put differently, if I own a stock and wake up and it’s down 25% because of a risk I hadn’t considered, the odds that I make a low-quality decision are pretty high. That’s why I try to avoid these situations. Generally, if the stock is down a lot and I’m losing money, it’s because of a risk I considered. I know how to react to it and I’m going to make a high-quality decision. Sometimes that decision is to buy more, sometimes it’s selling everything, and sometimes it’s selling a little. It’s different every time, but I’m much more likely to make a high-quality decision. And, I’ve concluded that to remain in the top 1% of investor knowledge in the stocks and sectors that are important to me, I need to be in at least the top 20% of crypto currency knowledge. That’s because cryptocurrencies and blockchain are going to have a big impact on software, on the internet, on payments and on the back offices of so many companies.

Gavin Baker

Gavin Baker is one of the most profound investors in the tech sector. He started his career at Fidelity Investments in the late 1990s as a semiconductor analyst. In the course of his career, he rose to become one of the stars of the Boston based money manager. In total, Mr. Baker worked at Fidelity Investments for eighteen years, most recently as the portfolio manager for the $17-billion Fidelity OTC Fund. During his eight-year tenure, the fund outperformed 100% of its Morningstar peers, compounded at roughly 19.3% annually net of fees and won six Lipper Awards. He helped spearhead Fidelity’s venture capital investing and was a board observer at Nutanix, 23andME, Jet.com, AppNexus, Dataminr and Roku, among others. In January 2019, Mr. Baker founded Atreides Management. The firm brings the long-term perspective of a private equity investor to high growth technology and consumer companies and invests across public and private markets. At the end of June 2021, it managed assets of approximately $3.7 billion. Gavin Baker earned an AB in economics and history from Dartmouth College. He regularly shares his insights into technology on his personal blog and on Twitter. He’s an ardent fan of video games and science-fiction. It’s no coincidence that he named his firm after the house of Atreides, the powerful dynasty in the science-fiction saga «Dune».
Gavin Baker is one of the most profound investors in the tech sector. He started his career at Fidelity Investments in the late 1990s as a semiconductor analyst. In the course of his career, he rose to become one of the stars of the Boston based money manager. In total, Mr. Baker worked at Fidelity Investments for eighteen years, most recently as the portfolio manager for the $17-billion Fidelity OTC Fund. During his eight-year tenure, the fund outperformed 100% of its Morningstar peers, compounded at roughly 19.3% annually net of fees and won six Lipper Awards. He helped spearhead Fidelity’s venture capital investing and was a board observer at Nutanix, 23andME, Jet.com, AppNexus, Dataminr and Roku, among others. In January 2019, Mr. Baker founded Atreides Management. The firm brings the long-term perspective of a private equity investor to high growth technology and consumer companies and invests across public and private markets. At the end of June 2021, it managed assets of approximately $3.7 billion. Gavin Baker earned an AB in economics and history from Dartmouth College. He regularly shares his insights into technology on his personal blog and on Twitter. He’s an ardent fan of video games and science-fiction. It’s no coincidence that he named his firm after the house of Atreides, the powerful dynasty in the science-fiction saga «Dune».

All opinions expressed by Gavin Baker in this article are solely his own opinions and do not necessarily reflect the opinion of Atreides Management. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.