Evaluating Opportunities in a Period of Disruption
The investment world changed dramatically in March. Stable, well run businesses seemingly became impaired in the blink of an eye. When the economy shut down, we immediately devoted a lot of time evaluating balance sheet and business risk, which says a lot as it’s where we spend most of our time under normal circumstances, but unprecedented times call for constant re-evaluation. We believe that if you can minimize the possibility of the permanent impairment of capital in a fund, your future results should be, at worst, middle of the road.
But our goal is not only to protect but also to grow capital and as such we have been spending the majority of our time digging into companies. In our recent commentary we talked about companies where we believe the intrinsic value has in effect increased during this tumultuous period. Searching for these companies, we are focused primarily on industries that will have secular tail winds as a result of the impactful changes brought forward by COVID-19 and our global response to it, and then analyzing the companies within these industries that have data points indicative of capturing the opportunity presented. We have previously discussed our evaluation process and risk assessment but here I’d like to highlight some of the areas that we believe have the potential for growth over the next five years.
Who will the winners be? Only the experts at “Hindsight Capital” know for sure. There is a lot of discussion about the potential trends and opportunities emerging from the global health crisis. But from our venture capital experience, we know how hard that game is. First you need to get the trend right. Second you need to get the company right. This underpins the investment strategy of the Pender Technology Inflection Fund, where we focus on expansion-stage companies, and analyse technology risk, market adoption risk and product risk, before investing to support or accelerate an existing trajectory. Taking that approach to the public markets, we are not so much looking to hit it out of the park by identifying new trends, but are focusing on existing trends that will hit an inflection point or be accelerated as a result of pandemic. And in our view there is a lot of acceleration of trends and adoption out there today.
Stable Customer Base
While it’s exciting to think about how the world has changed, as suggested by Jeff Bezos, sometimes it’s better to focus on “…what’s not going to change in the next 10 years”. Looking at companies today and understanding who their customers are, their need to use the product and their ability to buy consistently come to the forefront of our analysis. Companies that sell products or services that are mission critical or very small line items that can withstand the slowdown better than most. Fortunately for us, when Mr. Market really gets going, these companies get sold off as well and we look to find a discount to intrinsic value that signals a buying opportunity for us in these companies.
We think one of the major trends will be an increase in infrastructure projects. North American infrastructure is woefully outdated, and we have a lot of catching up to do. The global crisis has resulted in a catastrophic reduction in employment as whole sectors, like retail and travel, have shut down. A key priority for politicians emerging from this, in order to increase their probability of getting re-elected, is to see the electorate re-employed. We believe the ability to fund projects is in place, and the motivation to build is very high and we should see a tailwind.
Digital infrastructure (remote working)
Work from home, remote learning, online shopping, etc. People are changing their habits to conform to government isolation requirements and so are finding new ways to work, buy groceries and other essentials, communicate with friends around the world, give and take lessons. Many companies and organizations are now understanding the positive aspects of having people work from home. There’s a massive strain on fiber networks right across North America and many of these bandwidth-intensive habits may become the norm for many.
We spend a lot of time looking at technology companies. It’s an area we know well and we find many businesses in the sector have attractive economics (high ROIC, large markets) for potential capital appreciation. Over the past couple of years, we have decreased our weighting in technology. This was a valuation call. Tech stocks were in favour so prices were high. We have now begun to return to technology as valuations were, in our view, once again becoming attractive when March broke loose (see our recent commentary).
Our research is taking us into areas where technology companies are already developing and providing products or services in support of remote working. We’ve all seen the adoption of Zoom, Slack and Microsoft Teams over the past three months, but we are finding attractive opportunities in less high profile companies that deliver and support the fundamental infrastructure and software necessary for remote working. Similarly on the online shopping side, we are not looking for the upstarts, but for companies that were already leading in the space and that we believe are well positioned to capitalize. There’s no doubt Amazon will sell more as a result. But what is changing dramatically is the competitive landscape. In particular some well funded incumbents who are moving online as fast as possible, iterating, improving and optimizing, because their future now depends on it. Stronger competition eventually hits profit margins, so even though the pie is getting bigger, the crumbs may be getting smaller. We are also finding opportunities in companies that provide various tools that help other companies market and deliver their products or services online.
Healthcare has been disrupted by COVID-19. We hear daily of the medical staff on the front lines tirelessly testing, treating and caring for virus patients, but hospitals have been forced to adapt quickly and adopt crucial digital infrastructure to manage the logistics of the pandemic. Of course there is going to be a massive, multi-billion dollar push in drug development, for both the treatment and a vaccine for COVID-19, but there will be a lot of biotech spin-outs with so much capital and energy going into R&D right now. One area that had been lagging was personal medicine. Telemedicine was not widely adopted across North America prior to this. There was a lot of hesitation, from doctors, clinic owners, as well as patients, and also regulatory bodies. Well, we’ve now entered a period of time when telemedicine is not just necessary, it has become the primary option and adoption has happened all but overnight. Virtual appointments are now widely accepted. I recently sat down with Hamed Shahbazi, CEO of WELL Health Technologies on the Pender podcast and he touched on some of these issues.
Lastly we see increased demand for cyber security. When you’re in your office downtown, you are behind a corporate firewall. You’re fairly safe. The riskiest part for any company’s network are the devices and laptops that are outside the firewall, but being used for work. How do we protect corporate networks that are no longer in one place, but in multiple low security locations? Technology companies are moving existing solutions forward and developing new solutions in response to the increase in nefarious activity.
What will “Hindsight Capital” say?
How this plays out over the next 10 years is far from certain but understanding as many moving parts as possible is critical to a disciplined investment process; to try and stack the investment probabilities in our favour to both protect and grow capital over the long term and position the portfolios for long-term success.
David Barr, CFA
June 20, 2020