The purpose of this weekly is to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision-making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece! Feedback is welcomed. 

This week: 

⮚ Dependencies: Their impact on companies 

⮚ AI Speculation Already Here 

⮚ Bent Over Backwards: Just Look at the Chart… 

Dependencies 

What needs to be true for a company to be a long-term value creator? Obviously, a large addressable market is a great starting point. Loyal customers and the brand are also great. To us, what is also great is a lack of significant dependencies. We define dependencies as what a company needs to have happen to pave the way to long-term growth. 

Every company has some dependencies, with the most common being dependent on a healthy economy. Some dependencies are much more difficult to analyze and predict the outcomes than others. Being dependent on a government agency for contracts, drug approvals, setting Medicaid reimbursement, etc are the types of dependencies that are hard to predict and are outside of the company’s control. We do not believe that we have any insight into those areas, and as such, we believe that those are dependencies that we are not willing to live with. 

Slower-growing companies that track their growth at GDP plus a little bit are dependent on the health of the economy. Many financial services companies are dependent on the level of interest rates to determine their level of business activity. These types of companies are dependent on the economic cycle for prosperity and therefore can encounter larger swings in business results as the cycle plays out. As I mentioned before, all companies are dependent on something to repeat their success to date.

Many of the best companies undertake a strategy to vertically integrate, where they insource parts of their business models to have more control and gain more of a moat. The easiest examples of this in recent history are the decisions by Amazon (AMZN) to build AWS as a business as well as the way that they built a transportation company within Amazon to reduce their dependence on UPS and FedEx. This typically begins once the company has achieved a nice level of scale, and they are in a solid cash position to make these investments. 

One thing that has become more prevalent in the last 8-10 years is the business model that constantly depends on outside funding for growth. This is necessary in some industries and even then, it is needed only for some time. The catch though is that in a model that has not been proven out, one that produces cash, the dependence on outside capital can have negative impacts. 

The worst outcomes are when companies tap into debt markets in good times because they can get favorable terms, then when conditions change, the debt obligation becomes a large problem. The impact of negative leverage can be close to fatal for some companies and after some period of retrenching, the company will never be the same. Yet, companies are managed by humans, so they are subject to human error or misjudgment. 

Another bad outcome from depending on outside capital for growth is the bad behavior that can creep in when there is little consequence for spending, especially on personnel. This is correctable for larger companies with great balance sheets, but not good for emerging companies that get too enthusiastic in good times and then must peel back when times get tough. 

We try to simplify by thinking about a company’s dependencies at the time of investment and avoid at all costs companies that have a lot of dependencies or ones that are hard to predict. So, as one would guess, we: 

• Avoid Biotechnology – too hard to predict. 
• Avoid cyclicals such as Materials and Energy – requires timing the economic cycle. 
• Avoid interest rate-sensitive Financials – hard to compound economic value when you are at the mercy of the Federal Reserve. 

These all have dependencies that are outside of the company’s control, and outside of our circle of competency.

Circling back on the avoidance of companies that depend on capital markets to provide growth capital, it is good to use an example. In terms of the use of leverage, we are generally fans of the strategic use of debt to help companies grow their business, but when large debt loads are added to the capital structure, this can backfire if any of your circumstances change. 

We wrote a few weeks ago about Hubspot and Wayfair and the differences over their time as public companies in their business models and returns for shareholders. 

Wayfair added a lot of debt in the last 5 years. When interest rates changed, and subsequently the economy changed, Wayfair was left with less revenue growth and negative free cash flow but the same amount of debt and interest payments. It is always important to remember that those are fixed… What you are left with is a business that must retrench, let people go, get leaner, and hope for a turn in revenue. This kind of dependency will cause the company to stall and force it to be resilient. No matter what, the former trajectory has changed, and as mentioned in the prior piece, the direct cause and effect is a lower valuation paid by the market while this gets sorted out. Observing this kind of outcome over a number of market cycles, one thing is clear: you do not want this dependency! 

AI Speculation Already Here 

We have written in prior posts that we had anticipated a period of high enthusiasm for AI due to actual results in revenue and earnings coming in higher and quicker than expected. We believe that there is a high likelihood that there will be pockets 

of speculation in public and private markets in AI-related beneficiaries (real or perceived) for some time until we sort through the first wave of applications for Gen AI. 

There is already speculation happening. We are surprised by how quickly it came upon us! We cannot recall a company of significant size having a greater than 50% increase in its stock price after reporting earnings like ARM Holdings (ARM) did this past week. In addition, we have never seen a company in the Russell 2000 Small Cap index increase its value by more than 800% in one year and trade at a $56 billion valuation like Super Micro Computer (SMCI). 

We understand that there are factors that drive short-term moves in prices, with the most important being supply and demand. There are not a lot of obvious pure plays in Gen AI that are public right now. This, combined with the spectacular

performance of Nvidia (NVDA) over the last year, has speculators looking for the next Nvidia.  

We like to say that the most opportunities and the most mistakes are made when there are extremes. The key is to be aware that there are extremes happening. It’s the denial that bites back hard! 

Bent Over Backwards 

When we pull up a stock chart of Super Micro, it looks like it is bent over backward. This generally is an extreme reaction of the market. For some time, we have been pondering what the impact of Gen AI will be on the economy and individual companies. We think that there will be an enormous impact, but we don’t yet know what it will look like in a year or longer. To us, that is alright, but we admit that it could cause many to feel discomfort. 

We believe that we can have periods of high enthusiasm for companies that are considered to be Gen AI beneficiaries and that there will continue to be shifts in the leaders as the technology evolves. Eventually, Gen AI will have a more broad-based impact, one that spans across industries that are not just technology, and the world will look different. 

This was true in the early days of the Internet. The hype was important to notice, going beyond the stock market volatility. The internet era produced what are now the most consequential companies of not only this era but in the history of our economy. 

Going back to the odd behavior. Just because there is speculation in a handful of AI-related stocks does not mean that we are in a market bubble. We believe the following to be true, or at least high probability: 

• A business with Gross Margins of 16% over the long-term, aka a commodity business, like Super Micro will trade at 0.5-2x revenue over the long-term (2x is very generous btw). Today it trades at around 3.5x. So, unless something else changes, they will need to produce at least $28 billion in annual revenue to justify the high end of the valuation range, up from $9 billion today. This seems unlikely.
• There will continue to be head scratching price moves in the AI-related companies for a while due to the low supply of investable options. We see this happening in public and private markets. 
• Valuations for the semiconductor companies have moved up, and in most cases are above long-term averages. This may stay like this for a while as demand should exceed supply for some time, especially for the next generation of chips. Ultimately, supply and demand will come into balance, and it is highly likely that valuations will settle back into long-term averages. 
• Other areas of the market are not flashing overvalued right now the way we track valuations. So, AI plays may be an area that has extra high enthusiasm built in, and it could also be true that this may be the new normal for some time until the first wave of Gen AI impact has made its way through the system. 

Note to readers: Arrowside Capital owns positions in Nvidia, ARM Holdings, and Hubspot.  

My story 

I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital (http://www.arrowside.com), based in Boston, MA. I have more than 30 years of experience in the investment business, investing in companies geared toward innovation and growth. The blog is named 

The Zen Innovation Investor because I believe it is so important to remain calm and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought-provoking. 

Disclosures 

  

“ArrowSide Capital, LLC is an Exempt Reporting Adviser. This report is not an offer to sell or the solicitation of an offer to buy any securities or instruments. Past performance is no guarantee of future performance. No part of this document or its subject matter may be reproduced, disseminated, or disclosed without the prior written approval of ArrowSide Capital, LLC. This material is furnished on a confidential basis only for the use of the intended recipient and only for discussion

purposes, may be amended and/or supplemented without notice, and may not be relied upon for the purposes of entering into any transaction. The information presented herein is based on data ArrowSide Capital, LLC believes to be true but ArrowSide Capital, LLC does not in any way guarantee the accuracy of the information. The views, opinions, and assumptions expressed in this document are subject to change without notice and may not come to pass. The document does not purport to contain all of the information that may be required to evaluate the matters discussed therein. Further, the document is not intended to provide recommendations, and should not be relied upon for tax, accounting, legal or business advice. The persons to whom this document has been delivered are encouraged to obtain any additional information they deem necessary concerning the matters described herein. The interests in any private Fund have not and will not be registered under the Securities Act of 1933 (the “U.S. Securities Act”) or any state securities laws or the laws of any foreign jurisdiction, and the Fund will not be registered as an “investment company” under the Investment Company Act of 1940 (the “1940 Act”). The interests may not be offered or sold except pursuant to an exemption from, or in a transaction not subject to, the U.S. Securities Act. Accordingly, each purchaser of the interests will be required to (a) represent that such purchaser is an “accredited investor” as defined by Regulation D under the U.S. Securities Act and (b) make such additional representations as may be required by the Fund to allow it to comply with one or more exemptions from registration under the 1940 Act. “