Latest / UBS Trending / Is software dead from a financial lens?

Transcript

Is software dead from a financial lens? · UBS Trending

• 0:00
  The headlines say AI is coming for software jobs and companies.
• 0:04
  But some people aren't buying it.
• 0:05
  Our small cap software firms at risk?
• 0:08
  Or are they driving the next wave of innovation?
• 0:10
  We're going to break that all down
• 0:12
  for you and a whole lot more right now.
• 0:13
  On UBS trending.
• 0:26
  Hi everybody, and welcome to UBS trending.
• 0:28
  I'm Anthony Pescatore.
• 0:29
  Thanks for joining me today.
• 0:30
  Randy Kurtzman who is from Baron Capital.
• 0:33
  He is here in the studio with me.
• 0:34
  And he runs a small cap growth equity strategy there.
• 0:37
  So first of all, Randy, thanks for coming in.
• 0:39
  Good to see you. It's good to see you too, Anthony.
• 0:40
  I do want to get into that whole AI part of the story,
• 0:43
  because it's really compelling
• 0:45
  and something we've been talking about
• 0:46
  since really the beginning of the year.
• 0:47
  But I wanted to get a sense from you.
• 0:49
  Let's kind of like lay out the small cap
• 0:53
  kind of landscape right now.
• 0:56
  How is it looking for you?
• 0:57
  And just so our audience knows,
• 0:58
  here in our chief investment office,
• 1:00
  we do have a neutral view, obviously
• 1:01
  being selected with some names and some strategies in there.
• 1:04
  What's your view on small cap right now?
• 1:06
  Yeah, sure.
• 1:06
  I you know, being
• 1:07
  that I'm a small cap growth investor,
• 1:09
  I have a pretty positive view.
• 1:11
  But there's,
• 1:12
  you know, good elements that lead up to that conclusion.
• 1:14
  First, valuations
• 1:16
  are really low compared to where the S&P 500 is.
• 1:20
  Typically you don't see that typically
• 1:22
  small caps traded a three times multiple premium.
• 1:25
  And now they're trading at a slight discount.
• 1:26
  And that's been going on for about four years.
• 1:29
  That almost never happens.
• 1:30
  In fact I don't think I've ever seen
• 1:32
  it happen in the last 25 years. Wow.
• 1:33
  So that's interesting.
• 1:35
  And another
• 1:35
  really interesting fact is that
• 1:37
  the category is very under allocated.
• 1:40
  So right now less than 1% of all growth
• 1:43
  equity assets are in small cap growth.
• 1:46
  Typically that's about 1.6% on average and as high as 2%.
• 1:50
  So there's potential that people could come in,
• 1:52
  you know, and really start to reallocate,
• 1:56
  when the economic environment looks a little better.
• 1:59
  And probably the last point
• 2:00
  that I'd make is, you know,
• 2:01
  the growth is pretty good in the companies that we own.
• 2:03
  We typically look for 15% compounded returns on our investments,
• 2:08
  meaning either 15% top line or a combination of top line and,
• 2:12
  margin expansion that leads to that.
• 2:14
  But a lot of our companies are growing
• 2:16
  25%, 50%, or even 100% a year.
• 2:18
  There are sectors in the economy that are very, very exciting.
• 2:21
  And those include obviously, AI, as we talked about,
• 2:24
  whether it's infrastructure or software related.
• 2:27
  But they could be defense, which clearly is very topical right
• 2:30
  now, and various sectors within health care,
• 2:33
  which is an area of our expertise as well. Right.
• 2:35
  You know, and before we get into the AI side of the story,
• 2:38
  something that obviously
• 2:39
  I know you're looking at all the time is,
• 2:41
  you know, small caps
• 2:41
  are definitely much more susceptible to cyclicality.
• 2:44
  Obviously, we've got,
• 2:45
  you know, this
• 2:46
  Iran conflicts
• 2:47
  of geopolitical tensions have certainly heightened,
• 2:50
  kind of outside of that,
• 2:51
  you've got all these fears over private credit.
• 2:52
  There's just been so much going on this year.
• 2:55
  How do you deal with
• 2:56
  all of the things that are going on around the world
• 2:59
  and in the markets, to feel the way you still feel about
• 3:01
  small caps?
• 3:02
  Yeah, it's a great question.
• 3:03
  I mean, the interest rate environment
• 3:05
  looked like it was getting very, you know,
• 3:08
  a positive for small cap and the economy in particular.
• 3:11
  You're starting to get lower inflation below 3%.
• 3:14
  Rates look to be coming down.
• 3:15
  And there was a fight over
• 3:16
  where the fed should be cutting rates as opposed to,
• 3:18
  you know, raising rates.
• 3:19
  We're at the tail end of the cycle.
• 3:21
  Typically.
• 3:21
  That's really good for small caps.
• 3:23
  Now obviously we've had a couple of events in between.
• 3:25
  You know we had tariffs which for the most part
• 3:28
  didn't take too much out of GDP, as we saw in hindsight.
• 3:32
  But clearly the Supreme Court case throws a wrench into that.
• 3:35
  The Iran war.
• 3:36
  And what's going on in
• 3:37
  AI are the two
• 3:39
  big factors that have really thrown things off track.
• 3:41
  And we're a little concerned about the consumer right now.
• 3:44
  And inflation perking up a little bit.
• 3:46
  So there's a there's a lot of ripples.
• 3:48
  What we're trying to do is stick to our long term
• 3:51
  investing thesis. Right.
• 3:52
  And look at companies
• 3:53
  that are
• 3:54
  really well protected from a competitive advantage standpoint.
• 3:57
  And in five years, will have amazing free cash flow.
• 4:00
  Right. So that's what we're looking at.
• 4:01
  Excellent. Thanks, Randy.
• 4:02
  And yeah us here too.
• 4:04
  And at UBS and CIO we do have obviously a long term view.
• 4:07
  We do think the fed is going to still cut rates.
• 4:09
  But maybe we're kind of thinking later
• 4:11
  the year now maybe September December possibly.
• 4:13
  Obviously everything is in flux since we don't have,
• 4:16
  knowledge about what might potentially happen with the Iran war.
• 4:19
  A lot of uncertainty.
• 4:20
  Yeah, I would I would add one more thing is.
• 4:22
  Yeah, please.
• 4:22
  Typically we invest in companies that don't need funding.
• 4:25
  So less than 5% of what we own is cash flow negative.
• 4:28
  But we think we're there funded through break even.
• 4:31
  The other companies don't need to raise capital.
• 4:33
  Right. So no real leverage issues there. Correct. Right.
• 4:35
  And typically that's why people shy away from small cap
• 4:38
  in particular because they're worried
• 4:40
  these are companies that need funding.
• 4:41
  And when rates go up that's that's a natural fit.
• 4:44
  Absolutely. Yeah.
• 4:44
  That's something that obviously we've talked about for
• 4:46
  you and I and sitting in,
• 4:48
  you know,
• 4:48
  our various conversations about how a lot of small cap
• 4:51
  names are over levered and are very susceptible to rate changes.
• 4:54
  So let's go into the
• 4:55
  AI story,
• 4:56
  because that's another really interesting part
• 4:57
  of what's going on in the small cap space.
• 4:59
  So just talk about, you know, the the headlines.
• 5:02
  Oh AI is going to replace software.
• 5:04
  It's going to replace software jobs.
• 5:05
  What are your thoughts on that.
• 5:07
  Yeah I mean it's it's terrifying because it's
• 5:10
  something brand new.
• 5:11
  And even the experts
• 5:13
  don't exactly know where AI is going to wind up going.
• 5:15
  So we started out with OMS, which are,
• 5:18
  you know, these large language models
• 5:19
  that take a lot of information, pull it together, create weights
• 5:23
  and then based their answers, to people's questions,
• 5:27
  based on those probabilistic weights, and deterministic data.
• 5:30
  So deterministic data is actual answers, with real information.
• 5:35
  And then probabilistic is when you don't have an actual answer,
• 5:39
  you use your model weights to interpolate
• 5:42
  a probabilistic answer to the question.
• 5:45
  Now that's a key differentiator to many of the software companies
• 5:48
  we invest in, which we believe have deterministic data
• 5:51
  that can't be gotten to by some of the OEMs,
• 5:55
  particularly cyber security type companies.
• 5:58
  Right.
• 5:59
  There's so much network data that's being produced,
• 6:02
  by all the endpoints,
• 6:03
  the things that are attached to your network,
• 6:04
  by your interconnections,
• 6:06
  and then by the usage of the next stage of AI,
• 6:08
  which is a genetic.
• 6:09
  So we genetic AI is companies
• 6:13
  create harnesses which, which control how the models work,
• 6:18
  and harness particular snippets of code
• 6:20
  that can then go into your network with privileges.
• 6:23
  Right.
• 6:23
  So they have their own passwords
• 6:24
  and everything, almost like people and automate tasks.
• 6:28
  It's amazing.
• 6:29
  But if you think about it, there's a lot of cyber implications
• 6:32
  to that. Yeah.
• 6:32
  And I,
• 6:33
  I love the idea that, you know,
• 6:34
  obviously you look very specifically at each company's
• 6:38
  business structure.
• 6:39
  You know, their bottom line, obviously their leverage.
• 6:42
  You know what how much they're borrowing.
• 6:44
  So there's a lot of opportunity
• 6:45
  to be very selective in the space.
• 6:47
  And I like how you talk about this deterministic sort of software
• 6:50
  like idea of like software.
• 6:52
  It's really it's really compelling
• 6:53
  and obviously
• 6:54
  something that, investors should be keeping a keen eye on
• 6:56
  as they're looking towards growth
• 6:58
  and adding some diversity to their portfolio.
• 7:00
  I was just going to say the babies are being thrown out
• 7:02
  with the bathwater, right?
• 7:03
  The entire industry has sold off and it's hurt us
• 7:05
  the last couple quarters. Right.
• 7:08
  Valuations in software right
• 7:09
  now are as low as they've been in ten, 15 years.
• 7:13
  And so if you can find the companies,
• 7:17
  that are competitively advantaged, even in an era where,
• 7:21
  rapid software development, by anybody
• 7:24
  is democratized,
• 7:25
  it's going to be a really interesting time to invest.
• 7:27
  And we think there's a lot of profit
• 7:28
  to be made in that, in that circumstance.
• 7:30
  There's a couple of other areas of software
• 7:32
  that I think are kind of interesting
• 7:34
  in terms of thinking about competitive advantage.
• 7:36
  One is regulated industries.
• 7:38
  So for example, we own a health care company
• 7:40
  that is an FDA approved AI algorithm,
• 7:44
  for analyzing CT scans
• 7:46
  to determine what's going on in your coronary artery
• 7:49
  plaque buildup. Right.
• 7:50
  Do you have, blood flow, issues?
• 7:53
  That is something that FDA approved.
• 7:55
  It's not going to be developed by,
• 7:56
  you know, some kid,
• 7:57
  you know, a 12 year old kid, right, with vibe coding,
• 8:00
  and then just thrown up into the ether.
• 8:02
  So that's that's really interesting.
• 8:05
  And then,
• 8:06
  you might have a network effect vertical software company,
• 8:09
  for example, we in a construction software company
• 8:12
  where the general contractor requires
• 8:14
  the subcontractors to be on the platform
• 8:16
  because all the changes that are made from the computer
• 8:19
  aided design
• 8:21
  all the way down to every component
• 8:23
  that goes into the construction,
• 8:24
  every piece of equipment, every material has to get changed
• 8:28
  on an ongoing basis,
• 8:30
  and the scheduling will change as well
• 8:31
  based on that, and the costing will change.
• 8:33
  So it goes back into the accounting systems.
• 8:35
  There's a community
• 8:36
  aspect to this that again, it's not going to be developed.
• 8:39
  And let's forget all the marketing, the sun and everything
• 8:42
  and the integration that has to get done in a complex
• 8:45
  corporate environment.
• 8:47
  There's a lot of different ways that existing software
• 8:49
  companies are truly competitive advantage
• 8:52
  even in this environment.
• 8:53
  And so, you know how markets get I mean, you get you
• 8:55
  get a theme, people get scared, they sell.
• 8:58
  And look, we have we've got, private equity out there,
• 9:02
  with there's there's a lot of private debt,
• 9:03
  I should say, out there that is funding some software companies
• 9:06
  people are very concerned about.
• 9:08
  So it's easy for the short sellers to kind of shut up for now,
• 9:10
  but I think it might have been overdone.
• 9:12
  Unfortunately, we're out of time or any.
• 9:13
  But I really appreciate you coming through.
• 9:16
  Love to have you back again.
• 9:17
  I think there's a lot of opportunity.
• 9:19
  Like, as you said, valuations right now are pretty, pretty low.
• 9:21
  So there's an opportunity
• 9:22
  depending on how selective you want to be in the space.
• 9:24
  But good to see you or anything.
• 9:26
  Thanks Anthony. Always good to talk to you. Great.
• 9:28
  And again
• 9:29
  Randy Grossman from Baron Capital, thanks again for joining us.
• 9:31
  And for more information on everything
• 9:33
  coming out of our Chief Investment office and our great partners
• 9:36
  like Baron, make sure to check out our website at ubs.com/views.
• 9:40
  Plus you can follow us on social media.
• 9:42
  We're on LinkedIn and Facebook.
• 9:43
  Plus we have a dedicated channel for the studio on Instagram.
• 9:46
  Follow us at UBS. Trending.
• 9:48
  And as always,
• 9:48
  if you have any questions
• 9:49
  about what Randy and I spoke about today,
• 9:51
  I encourage you to continue this conversation
• 9:53
  with your financial advisor.
• 9:54
  Until next time, I'm Anthony Pastore.
• 9:56
  We wish you a great rest of your day, and remember
• 9:59
  to keep your eyes on what's trending.
• 10:00
  We'll see you soon, everybody. Thanks.