The Perpetual Global Innovation Share Fund is a hand-picked portfolio of companies that are benefiting from technological change and innovation. We asked portfolio manager Thomas Rice to take us through the sectors he currently likes, key trends ahead for innovation investment and a ‘truly transformational’ US disruptor.
What sectors are currently of most interest to you and the team?
Industrial automation is an area of focus for the team, and we think three significant trends will drive double-digit growth in this space. First, robots and other automated systems are becoming much more versatile due to advancements in machine learning and computer vision. This increased flexibility means that robots can replace a wider variety of tasks on the factory floor, increasing the size of the industrial automation market over time. At the same time, the working-age population in countries like China has peaked, which will drive further demand for greater automation. Finally, Covid has laid bare to many companies how tenuous their supply chains actually are. As a result, they are pursuing a combination of increasing manufacturing outside of China or reshoring many activities back to the US or Europe. Automation enables this. We’ve been buying companies that enable this investment, like Keyence, a Japanese company that’s a significant supplier of factory automation products, and Cognex, a US company that’s one of the leaders in the field of machine vision. We also own Siemens, one of the world’s largest providers of industrial software and automation equipment, and recently bought GXO Logistics, where automation in their logistics facilities is an integral part of the investment thesis on that stock.
Another area of interest is digital entertainment, which captures structural changes in consumer preferences and behaviour across video, music and games. We own Netflix, which recently had a Korean show, Squid Game, become its most popular show ever. I find this extraordinary and a testament to Netflix’s ability to surface compelling content from anywhere and serve it to a massive global audience. We think they have such a significant lead in subscribers and content now that it creates a positive flywheel effect that reinforces their market dominance. Another digital entertainment stock we like is Universal Music Group, one of the world’s largest music label and a key beneficiary of the ongoing rise of music streaming. Game streaming is another area I’d pay attention to. We’re invested in Pentanet in Australia, which recently launched NVIDIA’s GeForce Now game streaming service here. We were blown away by how well it ran playing Cyberpunk 2077 on my mobile phone as it was being streamed from a NEXTDC datacentre. On the games’ development side, we own CD Projekt in Poland, which will launch its first expansion for Cyberpunk 2077 in early 2022, and recently invested in Embracer Group in Sweden, which holds a large portfolio of games that are perfectly suited for game streaming.
You’ve identified a change in the spread of contributors to the Fund in the past financial year. Can you give us a sense for how concentrated or spread out this was compared to previous years?
In 2018, the total return of the fund saw almost 30% of it come from one stock (Axon), so it was reasonably concentrated. The contribution of stocks outside of the top 10 holdings was quite small. However, we are increasingly seeing that the long tail of stocks in the fund has added a lot. In 2021, we had a lot of different stocks contribute to the fund. So even if you took out Twist Bioscience, Boohoo Group and Vestas Wind Systems, which were the biggest contributors, the fund would have done very well. This trend has continued into the current financial year with Opendoor Technologies being the biggest contributor to date followed by another recent addition to the Fund in GXO Logistics.
I’ll talk about these two in greater depth but also worth pointing out another new addition, IQVIA Holdings, as the fourth-largest position. They run drug trials for pharmaceutical companies and the team has done a huge amount of work on drug development and the supply chain underpinning these medical advances. We have looked at a few drug companies directly and while we believe that drug productivity is improving, I think the best way to play this view is through a company like IQVIA. I think you are going to have more and more drugs through the pipeline and companies that host drug trials directly benefit from that without having to pick the winners. So that is why we have increased our position recently on this thematic.
Opendoor Technologies has been the biggest contributor this FY and you have taken a large position in the company. What is the attraction?
Opendoor is currently 14% of the Fund and I think it is a fascinating company. Possibly even a truly transformational company. Basically, it’s a US company that is the leading iBuyer or instant buyer in the world. Selling your house is normally a really complicated process that involves appointing an agent, cleaning up your house, making small repairs and then having people through your house to check it out. At the start of that process, you don’t know if the sale will take two weeks or three months. And you’re not sure what price you’re going to get, which may complicate your procurement of a new property. The concept with an iBuyer is that instead of dealing with all that hassle, you can go to their website, put in your address, answer some questions and they make you an offer within 24 hours. This provides a very good experience and has proved to be very popular.
The way the iBuyer makes their money is to charge a 5% service fee, which is comparable to US brokers charging a 6% fee. The idea is they can come in below the broker and the real value is offering certainty to the seller and an improved experience. This model is an extension of an old idea of using algorithms to value properties. Opendoor is focused on the use of AI and technology to analyse a lot of different data points. But it’s not entirely automated and data driven. As part of the valuation role, they combine local expert estimates with the automatic valuation, which helps to capture some of the local features that are relevant to the property. They have found that the longer they’re in a specific geographical market, the more data they accumulate, the more accurate their estimates tend to be, which is important for a business like this. If you’re the largest and you accumulate the most data, that drives better economics over time.
What is the potential upside for Opendoor and where do you see the risks?
We see this as clearly a superior process for selling your house. The data suggests sellers love it and the NPS scores are 70-plus, which means it could gain significant market share over time. The US market has about 6 million homes selling each year for a median price of about US$375,000. Even without overseas expansion, this is a massive market and they have recently started hiring staff in Canada. If they get 5% market share in the US over time, then with 5% margins it implies US$5.5 billion EBITDA versus US$12 billion market cap today. In certain markets, they are already above 5%, particularly the earlier ones. We feel this could be quite a disruptive company over time.
There are two major risks that we have identified. One is a major property downturn, but I would point out that property tends to move slower than other asset classes. Opendoor doesn’t tend to hold inventory for long. In a normal cycle, they will hold inventories for 90 days or so. At the moment, it’s quite a hot market in the US, so the turnaround time is even shorter than that. We think the risk in terms of the properties they’re holding at any given moment is mitigated by that short turnaround time. They also don’t have a huge amount of debt and they can survive a bad quarter. Over time, they should benefit from housing appreciation, with the occasional dip, but I think their model will be able to manage that. The other major risk is discipline: what is the risk if they overpay for houses? Here I am quite comfortable they have demonstrated an ability to reduce the risk when uncertainty arises. Last year, with the arrival of COVID-19, they actually dropped a lot of inventory and shrunk the business because they were less certain that their models might be right in this new environment. I thought that showed good discipline.
The Fund’s second biggest position is in GXO Logistics, which is a spin off of XPO Logistics. Why do you like this new version?
They are currently the second largest contract logistics outsourcing partner in the world. This is interesting because of the massive long-term trend towards ecommerce. Ecommerce typically means that the logistics intensity of retail is increasing by two to three times. What we’re seeing now is that rather than sending a big pallet to a warehouse and it then goes to a store, it’s going to the warehouse to be broken up into 100 boxes, going to 100 different people. And 20 to 30% of that will be returned so you have to now manage that. You also have technology enabling more efficient supply chains. This means the increased use of robotics in the warehouse and the level of complexity for someone to run their own warehouse is rapidly increasing. For retailers there’s an increased incentive to outsource the logistics of all this to a company like GXO.
Ultimately, it is these two trends – increased ecommerce and increased complexity – which is going to support the growth of these outsource businesses over the next decade. When we look at similar businesses around the world, whether they are running trials for drug development or semiconductor manufacturing, these tend to be businesses that started out being a little bit more commoditised and outsourced but, over time, a lot of expertise accrued within the outsourcing partner, which drove very high returns on capital over time. We think GXO is going to be the same story. In this case, we initially looked at XPO, which is the trucking business that owned GXO.