FidelityConnects: Tomorrow’s disruptors: Investing in what’s next

[00:03:32] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Happy Friday, Happy Halloween if you're involved in that at all. We are going to be talking about innovation being absolutely constant. It is literally the new normal right now. Disruptive companies are creating new opportunities across five key areas, automation, communications, finance, medicine, and technology. How are our next guests investing in global disruption across all areas of the market? When it comes to their style and approach what sets them apart? Joining us here today to discuss their strategies for capturing opportunities, specifically in the communications and tech sectors and the factors therein we want to share a warm welcome to Fidelity Disruptors Class portfolio managers Michael Kim and Pri Bakshi. Great to have you both here today. Welcome, Mike and Pri.

[00:04:27] Priyanshu Bakshi: Thanks Pamela. Great to be here.

[00:04:29] Michael Kim: Thank you.

[00:04:29] Pamela Ritchie: Great to see you again, Mike, and introducing Pri to this particular platform. Delighted to have time with you both. We'll invite everyone to send questions in over the next little while. I'll begin with you, Pri, if you don't mind, because it seems like through this week, through the earnings releases, stories, discussions, forward guidance and so on, it appears that the CapEx for some of the massive AI communications companies that we're talking about, the disruptors, is absolutely full force ahead. There doesn't seem to be any wobbles in what they're saying.

[00:05:04] Priyanshu Bakshi: Absolutely. Pamela, if we look at the trajectory of the CapEx investment by the largest companies, the four largest companies, three years back their annual CapEx in aggregate was $100 billion. I expect it to rise by another 40 to 50% next year and it looks like it's going to keep going on for a while.

[00:05:32] Pamela Ritchie: Mike, for instance, when you're taking a look through what you do on top of everything that Pri will do on a more fundamental basis with some of the team members that do that, you take a quant approach, take a look at the risk management, take a look at certainly the volatility. From your perspective when you see promises, conjecture of the types of spending CapEx that will be sustainable, it appears, for the next year what does that do to the risk management story or volatility story? It smooths things out, no?

[00:06:03] Michael Kim: That's an interesting point. From a top-down perspective this year has all been about growth beating value. Momentum has been the top factor from an investment standpoint, from a quant style investing standpoint this year. I guess the question is, from your perspective, is is that sustainable. I think if you look at it from a growth-value perspective the valuations are actually pretty reasonable for companies like Google. When you think about what you'd rather own would you rather own something at a reasonable price with great growth prospects, or would you look to own something that's a lot cheaper but without the forward-looking growth in the earnings? I think the market is basically saying this year we believe in the growth story here, not just the next quarter but going out for the next couple of years. I think the market's kind of giving the answer for us.

[00:07:06] Pamela Ritchie: Really interesting. Pri, your team, when they got some of those numbers that you just shared with us I guess put it into context beyond just what was invested, for instance, I don't know, last year or over the last couple of years, in the AI story. Where does this put us in sort of the historical nature of investments in infrastructure? It's not road building but it's data centre infrastructure. We haven't done this before. How big is this, actually?

[00:07:33] Priyanshu Bakshi: That's a great point, Pamela. Actually, we should take a step back and see this in the context of the historical CapEx cycles that we've seen. The biggest one in the history of the United States was the late 1800s which was the railroads buildout. That peaked out at around 6% of GDP in the 1880s. The second largest one was the interstate highway buildout in the 1950s. That peaked out around 3% of GDP.  The dot-com bubble, call it, in the late '90s, that was just 1% of GDP. This AI CapEx cycle already this year is 2% of GDP, around $600 billion, and by all accounts it can reach 3% to 4% of GDP, so really up there with the biggest CapEx cycles ever.

[00:08:27] Pamela Ritchie: It's amazing. Mike, we're going to talk more about some of the themes within communications, tech. Some of them we know, some of them we want to know where the growth is. Tell us a little bit about the team, how it's set up for Disruptors Class, for investing. How do you guys all work together? You have quite different things that you're bringing to the table for this team.

[00:08:48] Michael Kim: Basically, as you noted at the top of the broadcast, the Disruptors Fund is looking at five broad themes, automation, communications, tech, financials, medicine. Within each of those groups we have teams of fundamental investors whose job it is, like Pri, to find the companies that we want to invest in in all those areas. Now, for each of those funds we also have different sub-themes that we're specifically looking at because of their disruptive nature. For instance, right now in automation we're looking at some new themes in aviation and space exploration, that sort of thing. Things are always evolving both at the company level and at the thematic level. My job as kind of the quant portfolio manager is to take everyone's ideas, kind of herd the cats and put it into an actual portfolio. It sounds easy but there's a lot of great ideas and there's a lot that goes into portfolio construction, of course. To your earlier point, risk management and just understanding how all the pieces fit together.

[00:09:58] Pamela Ritchie: It's been an extraordinary year. We'll ask more about sort of the time horizon and how you look out for that. Can we begin, Pri, to go through some of the themes? There's, actually, a lot I think that you want to talk about. The theme is innovation, the theme is disruption, what's disrupting the communications? It seems like the communications sector and tech sector are actually disrupting everything else, is there something within?

[00:10:21] Priyanshu Bakshi: Yeah, for sure. I think that the focus of this fund has been to find those mega trends which will really change industries over the next several years. It's clear that AI is the biggest theme right now. Of course, that takes different forms. First of all, we can see that the nature of entertainment itself is changing. People just used to spend a lot of time in front of their televisions and now less and less time is being spent on televisions watching long-form video and more and more time is being spent on social media platforms. We know that people spend almost two hours a day on their phones watching short videos, whether it's TikTok or Instagram reels, it's pretty incredible. That has an impact on the advertising environment. Advertising which used to be just brand-based and not tailored at all, you would see the same ad as your kids and your parents and whatever your profession is, whatever your interests are, it was all the same. Now, increasingly as you spend time on social media these companies are able to build a very detailed custom profile of each user using AI. Now increasingly you see ads which are tailored to what is of greatest interest to you. It's totally transforming the ad industry. The other thing...

[00:11:54] Pamela Ritchie: I mean, sorry, I was just going to push back on that because I feel like ads and if you buy something, remember the pandemic, you would buy something online and then immediately you'd have that for the rest of your life, that's been there for a while, what's new about it?

[00:12:10] Priyanshu Bakshi: It's true. The non-AI ads were actually very simple which means that if you look for something they'll just show you stuff which is very similar to that. What could be annoying for users is that you already bought it and still you keep seeing ads of the same product again and again and again.

[00:12:31] Pamela Ritchie: I just bought the running shoes, I don't need more running shoes!

[00:12:36] Priyanshu Bakshi: That's still true to a certain extent but it's getting better. Increasingly, companies are able to get over these humps. If you, for example, bought something they can now track it and maybe within a day or so you'll start seeing different ads. Secondly, it's not as simple as just what you've searched for. It's going to be based on very complex algorithms and people who've searched for similar things, what are they interested in, what's the next thing that you buy. I'll give an example. Let's say you've searched for airline tickets to Hawaii. In the past you just keep seeing ads for airplane tickets. Now once you've done that they'll show you hotels and they'll show you excursions and maybe beachwear. It's just going to follow that chronological path which used to not be possible before. We are somewhere in the middle. This is going to keep getting better for the next several years.

[00:13:37] Pamela Ritchie: Mike, when you take a look at the screens that you'll run over these what role does sort of the moats that companies would have around them, how does that show up from your perspective? Is that actually more on the fundamental research side of things or that must be quite fundamental to making sure longer term these companies will last.

[00:13:58] Michael Kim: Exactly. From a quant perspective I'm actually using large language models to help us score the companies in terms of do we think this company is possibly a good stock to include in our portfolio, should we give it a deeper review? The moats that you speak of and the actual fundamental investment case that you build are actually selected by the fundamental managers. I think that's appropriate. If you think about what a fundamental manager does they know these companies intimately. They've been meeting with the management teams of a lot of these companies even before they were publicly traded, or for more established companies they have deep relationships that go back decades with the management team. It's really up their alley to be able to figure out ... for each of the major themes we're only holding about 40 to 60 stocks per of the five major [indecipherable]. It's not a lot. Whereas when I'm running my screens, my AI screens, looking for disruptive companies and stocks that fit the themes that we're looking for it could be hundreds. It's really like a teamwork based thing where I'm kind of looking more broadly and using tools that way and the fundamental analysts are digging deep.

[00:15:25] Pamela Ritchie: Pri, you were going to mention something else. I know that gaming is a big piece of entertainment. It fits into the entertainment world as much as anything else. Is that right? It sort of fits with that side.

[00:15:37] Priyanshu Bakshi: That's exactly right. Absolutely, Pamela.

[00:15:40] Pamela Ritchie: Why does it fit so nicely there because it seems like they would be different, actually, if you're looking at some version of a story whether it's short form, longer term, whatever, and playing a game. One is much more active and one is more passive, basically.

[00:15:56] Priyanshu Bakshi: For sure. I think different people want different kinds of entertainment, people want different kinds of entertainment at different times of the day. If I'm relatively fresh on a Saturday afternoon I'd rather play a game and once I'm done with a long day of work on Thursday evening then I'd rather just scroll on social media. I think both can be possible. You made a good point on gaming. I think gaming is one industry which has benefited the most from technological advancement. If you look at movies, movies have been produced for decades, maybe almost a century now, if you think of the best movies ever, I think of Godfather, Shawshank Redemption, a couple of my favourite movies, it's difficult to think of modern movies that are going to match up to that.

[00:16:47] You look at games from 30 years back, it was like a pinball kind of thing, games from 20 years back, 10 years back, it's completely different. AI is actually supercharging that. Increasingly two things will happen to games. One is that the non-playing characters in games will get activated by AI so you can interact with your game the way you never thought was possible. Secondly, there will be a greater democratization of game development. In the past it used to take hundreds of developers and these large multi-billion dollar studios to develop games. Increasingly using AI tools casual developers will be able to make fun, interesting games, simple games and load them on platforms like Roblox for people to play. They're both very interesting trends for gaming.

[00:17:42] Pamela Ritchie: That's really, really interesting. Mike, coming back to sort of the idea of moats to an extent but sort of this network effect where there's just more and more engagement. How does that show up in the way that you're screening things? I mean, in terms of risk management you're going to be looking ultimately at the growth of earnings where you're seeing things having that kind of momentum probably across all of these different industries. Kind of coming back to the idea of this buildout and it's a contagion almost. How does that show up in the way that you look at companies?

[00:18:18] Michael Kim: I think you hit on it right on the nose with with your momentum comment. In fact, I think momentum has been the strongest factor this year. That's because when you look at AI and the way it's been playing out in the markets it's not just contained in the tech sector or the comm services sector. You're also seeing it come through in the utility sector because it turns out that we have to forecast the energy needs of all those chips running. You see it in the industrials as well because we need to build the data centres, all of the real estate development that has to go on in order to make the dreams come true. Whether it's across sectors and industries all that gets captured in that momentum factor and the stocks that have been working continue to work. Like I said, it's been the number one factor so far this year. I would expect that to continue. From the perspective of the valuation of that momentum basket actually still looks fairly reasonable when you're forecasting out two, three, four years from now.

[00:19:35] From a quant perspective, from a risk management perspective diversification is everything but for thematic funds like this there's a certain amount of ... we're trying to deliver to the client what we're promising. In this case, yeah, there's going to be some beta, there's going to be some volatility and there's going to be a lot of momentum. We hope that the momentum continues because that means that the themes are working and continue to work and the stock picks therein.

[00:20:06] Pamela Ritchie: I'll come back to you, actually, on that and just sort of the time horizon that you look at. Pri, first I wanted to just pick up on what Mike was saying, that it is across different sectors the AI breakthroughs come through, through power, utilities, all the things that Mike was mentioning there. Pri, at what stage to what you're looking at and where utilities jump off from where do you sit within there? The communication companies need the power, do you go as far to look at the power producers themselves or do you sort of hold back? How does that work?

[00:20:43] Priyanshu Bakshi: That's a good point. Actually, it's all very integrated right now. Let's look at AI data centre construction. It starts with the demand of a company which is building, a company like Google or Meta or OpenAI. These companies have the demand and they want the data centre. Then these data centres are provided by cloud service providers who build the shell, then they put in servers. Cloud service providers like Microsoft, Amazon and then Google Cloud products, they build the data centres. That building of data centres requires construction companies and power which is extremely short right now because we're talking about data centre demand requiring tens of gigawatts of power which can otherwise power tens of millions of homes all being directed towards that. Then nuclear names come into the picture and gas turbines.

[00:21:43] Pamela Ritchie: Do you invest in some of those other, we call them industries and sectors although there's a lot of connection right now, do you within the comms tech side of things within the disruptors go into the power generators, for instance?

[00:21:56] Priyanshu Bakshi: We tend to not do that within the comm services and technology sleeves because we can play it through the chip manufacturers like Nvidia. We can play it through the cloud service providers like Microsoft and Amazon and through the customers who are actually developing the end applications like Google and Meta. We don't need to do that for these sleeves. We get a lot of great exposure through the core sectors that we are in but we are very watchful of the impact that is happening on the other sectors because ultimately they are suppliers to this set of companies.

[00:22:32] Pamela Ritchie: That's really interesting. Mike, when you're looking across because, for instance, within medicine or within anything that's going to require power, a data centre to do what they already do but better, they're going to be dipping into probably the utility side and so on. Again, how does that change the game, you're looking out three to four years on risk, volatility, what if company A involved somewhere in the medical sphere trips up on data centres, how do you measure for that in sort of a risk management volatility perspective, what they need going forward to be successful.

[00:23:09] Michael Kim: I think part of the diversification issue comes down to diversification of revenues for each of the companies. Not all of the companies that we own are 100% levered to the AI play but you will get some of that exposure within, for instance, our automation kind of sub-sleeve. You'll see some construction companies and that's because part of what's driving their earnings growth is the data centre buildouts and things like that that we've been talking about. That's not 100% of their revenue. They also have exposure to old economy stuff. There are other companies that are more of what we call angle shots. They're not directly, necessarily, wired into the AI play right now but they're like the Levi's jeans during the great gold rush. They're kind of supplying the people who are supplying. It all comes down to kind of looking at companies not just from an exposure standpoint but also just, like I said, per cent of revenue, how much of their business is that ultimately touching the different kind of disruptive parts and maybe the older economy parts of their business.

[00:24:31] Pamela Ritchie: Such a fascinating time. It's really fascinating. Some great questions coming in here. I'll put this one to you, Pri, what impact does CapEx growth have on operating expenses for companies?

[00:24:44] Priyanshu Bakshi: For sure operating expenses are going up and we can see that even with the earnings season that just took place right this week. Here's the thing, expenses are going up for certain companies but they are benefiting on the top line as well. Google and Meta, at the scale of the advertising business that they have together around $500 billion, are growing their ad business in the mid-teens per cent. That is incredible. By our calculation almost half of that growth is because of use of AI. While their expenses are going up they are getting a significant top-line benefit using AI as well.

[00:25:46] Pamela Ritchie: Great question, Mike, put this one to you, could you touch on the safety net, ultimately, that's created within the fund for downside protection? That's exactly what you take a look at making sure is staying on the rails.

[00:26:04] Michael Kim: Like I mentioned, with a fund like this the type of companies that you're investing in, there's a lot of beta exposure in this. My job is ... basically, when I run it through an algorithm I am adjusting for the overall volatility. When I think about risk management, though, for this fund in particular, we tend to look at it on a few different levels. The first level actually starts with the fundamental analysts because they're the ones that know best. When they're making a forecast one, two, three years out what is the likelihood of this forecast being accurate or these earnings coming true. What is the quality of the management team, do we trust them or are they fraudy? Do they have a proven track record of solid capital allocation and execution or are they kind of just talking up big dreams? That's the very first layer of risk management.

[00:27:06] Whenever you're investing in volatile spaces like this you really need to… I'm a quant but I have the utmost respect for the fundamental team because it's their job to really kind of get to know the management teams, understand the companies. That's where you're going to find the most important layer of risk management. From my perspective when I'm putting the companies all together I am making adjustments for volatility, trying to keep the tilts of the companies that we like the most but at the same time kind of mitigating on a volatility level.

[00:27:43] We have a third layer, of course, with CIO oversight and board reviews so we have all the traditional mechanisms in place. Really, it's a team effort from the fundamental part to me to keep that stuff mitigated as much as possible but for a disruptive fund, you look at the companies that's what you're going to get.

[00:28:10] Pamela Ritchie: There's going to be some vol. That said, I'll put this to both of you but Pri first, are we in a bubble? Should we be concerned? Talking about the downside is this an interesting entry point? Has this gone too far? Tell us your thoughts from your perspective on the more fundamental side. Pri first and then I'll ask Mike.

[00:28:29] Priyanshu Bakshi: Increasingly we hear about comparisons to the dot-com bubble of the late '90s. I think that there are some similarities but there's some very important differences to keep in mind. First of all, remember that the companies which really were driving the 1990s boom, they were not very profitable. They were trading on odd metrics which really didn't have much to do with profitability because they didn't really have any earnings. The revenue multiple was also very, very elevated. Now we actually look at the Mag Seven, as we call it, yes, they're slightly more expensive than the market. An average, the Mag Seven trade at something like 26 or 27 times forward P/E versus the market at 22, 23 times forward P/E. If you take out the Mag Seven the 493 trade at something like 20 times P/E. But the earnings growth of the Mag Seven is actually something like 20% to 25% and the earnings growth of S&P 493 is something like 5%. For that extra P/E, maybe 20% higher P/E, you're getting five times more earnings growth.

[00:29:46] The other thing I would say is that the quality of the business, the technological complexity that the winners of the AI boom have, they're much, much deeper than what we saw in the '90s. I think that while there are some areas, especially on the private side, where there is euphoria and exuberance, and maybe some smaller companies on the public side, there is a lot of value to be had over the next several years in the big winners of this boom. That's our job. Our job is to separate companies which really deserve it and will keep going from the companies which have kind of just risen with the tide.

[00:30:31] Pamela Ritchie: Mike, is the risk mostly to the upside at this point? You've got to lean in?

[00:30:36] Michael Kim: I would just kind of emphasize what Pri just talked about, I agree wholeheartedly. I had the unfortunate ... I started my career right before the '99 bubble so I've been here, I've seen it.

[00:30:52] Pamela Ritchie: There's humility there.

[00:30:54] Michael Kim: We're always on the lookout, it's kind of a tough macro environment right now. There's a lot going on in the world, there's a lot going on with trade. When you think about the AI play right now, what's going on with the markets I'd just emphasize what Pri said. This isn't like '99 where the part of bubble, when we use the term bubble that's shorthand for speculative bubble and there was no doubt that there was a lot of speculation and just big dreaming without reality in the late '90s. But here the Mag Seven, these are established companies filled with the smartest people and they're well capitalized with management teams that have a proven track record of investing well. It feels a little different. May it get to that bubble point? Sure, but does it feel that way now? It doesn't feel to me like we're in the last few innings here, maybe middle innings of the game.

[00:31:55] Pamela Ritchie: Appropriate moment to be talking about innings, thank you.

[00:31:58] Michael Kim: Yeah, tonight, big game.

[00:32:01] Pamela Ritchie: Go Jays, absolutely. Sorry if you have your loyalties elsewhere for saying that here. Pri, great to have you join us. Mike, thank you for joining us as well. Perfect moment this week to have you weigh in on your thoughts of this particular area of the market. Thanks for your time.

[00:32:20] Priyanshu Bakshi: Thank you, Pamela. Happy Halloween.

[00:32:22] Pamela Ritchie: Happy Halloween, thank you. Coming up on Fidelity Connects over the next few days which begin next week, we're looking to Monday, Jurrien Timmer will be joining us, Director of Global Macro. He brings along his incredible charts and graphs to help discuss the macro themes on his radar that probably should be on your radar as well.

[00:32:40] Next Tuesday we'll be chatting with portfolio manager David Way to celebrate five years of the Fidelity Long/Short Alternative Fund. We'll look at how the fund has evolved with the market since its inception and we're David's looking next. This webcast will be presented with live French audio interpretation.

[00:32:57] On Wednesday next week you don't want to miss our special extended webcast. This is on AI and the possibilities it offers to add value to your practice. Portfolio managers Mark Schmehl and Darren Lekkerkerker will join us live in studio for a lively discussion on how they're playing AI. We'll also hear from tech analyst Ben Holton and Demand Spring Vice President Jonathan Milne on how you can leverage AI for your business. This webcast, of course, will be with live French audio interpretation, also Mandarin interpretation and Cantonese. Join us then. Have a good weekend. I'm Pamela Ritchie.