Justin (2:53)

One of the ideas that you talked about when we first sat down last year was this idea of exploiting structural inefficiencies sort of in the market and in your career. And you had given the example of GARP stocks having like no, you know, natural owners. They don't sit in value, they don't sit in growth. But can you just explain the process that you think through when you're trying to identify those types of structural inefficiencies?

David (3:21)

I think there's a lot of different ways that we would attack that question. Of these structural inefficiencies, there's usually some kind of cause for that inefficiency to exist, not only exists but persists in the future. When we've talked about GARP in the past, one of the structural inefficiencies is the value manager who has all these banks and insurance companies and secondary challenge companies in their index. They'll look at a GARP stock at 18 or 19 times earnings and they'll say that's too expensive so that they won't be interested in buying that. A growth manager on the other side of the table might say I'm only going to buy companies that have double digit top line growth. Analyze GARP stocks don't have that. So there's not retail investors don't know about these companies. They don't know about a A.J. gallagher or a Revit. They don't still know those companies well. So there's just. And then it's not a hedge fund name because the stocks don't move a lot on quarters, so there's no natural buyer. So what you're able to, what you've been able to buy historically within GARP stocks, you've been able to buy companies that grow earnings, let's say three, four points faster than the market over time with much lower earnings volatility, much lower downside risk for a premium to the market that is very, very small, in some cases almost nothing today. So I think that's kind of the inefficiencies we're looking for in high yield and leverage below loans. The most attractive part of the high yield universe, double Bs. Why is that? Because there's very, very low default rate. But you're earning 100 basis points higher than what you would get in investment grade by buying there. And part of the issue is if you're a high yield manager, you can't be overweight double Bs because they have a yield lower their index. But since we're not focused on the high yield index, we're going to buy a whole bunch of double Bs on that 100bps of higher yield, not taking any really default risk and exploit that inefficiency. So we're going every. There's always usually a reason, something substantive, something that is persistent, that exists, that allows us to exploit these inefficiencies.

Justin (5:26)

I'm just curious, do you find that when like a value stock migrates, is kind of starting to migrate into that Garpy sort of environment in that area, you know, a value manager might look at it and say, wow, this is getting expensive, I don't want it anymore. But I, I would think some of the great performance from that value migration into GARP could actually happen, which is what you would be getting sort of exposure to there.

David (5:50)

No, I think it's a great point. I mean I think if you, if you take a step back, you go back to, let's call it 2010, 2011, I think you would have said a Thermo Fisher, which was growing about 3% of the time. You would have said a Pfizer, which was growing 2% of the time. I think most people would have said those were kind of more value stocks, right? And then over a period of time, as their top line growth inflected from, you know, low single digits to mid single digits, or even some cases high single digits, the multiple on those stocks went from a low teens multiple to in some cases a mid to high teens multiple, in some cases a low to mid 20s multiples. And those were stocks that kind of compounded wealth over a decade in the mid to high teens and were huge value creators. So I think you're absolutely right. There is a possibility of a transition from, with a good management team that does good things with capital allocation can also the composition of the portfolio to go from that value bucket to a GARP bucket and get not only faster earnings growth but also expansion. And that's where you can kind of get that double winner of again multiple expansion, faster earnings growth, where you can get these kind of mid teens to high teens kind of total shareholder return over a decade or more. And they can really massively draw it out forms of any kind of strategy.

Justin (7:12)

You're not known as this know person that is making like, you know, huge market timing calls. You're a long term investor, you've managed a capital appreciation fund for a very long time with an excellent track record. But when we had you on Last year, you know, you did explain to us that after the sell off for the tariffs, you know, you were strategically adding equity exposure and that was actually ended up being a good, I think outcome for, for you guys. And I'm just wondering if you could just explain the thought process and sort of the framework that you go through when you are sort of moving the equity exposure and the fixed income exposure up and down.

David (7:52)

I think this is just based on our view of history. I think what you. If we look at history and we say in the past when the market falls 15% or the market falls 20% or 30%, the risk of loss over the next 12 months actually are lower. Not higher, actually lower. The expected return goes from let's call it 10% per year to a 15 or 20% return when volume spikes. While it drives the stock market down in the short term, it's usually a very good positive indicator for 12 month forward returns or 24 month forward returns. So what you found over time is that what we've done, I think we've done a very good job at it. We did it in April, we bought $4 billion of equities in a three day period of time in the April swoon, we bought $7 billion of equities back in the great financial, in the COVID downturn, in the last couple days of that downturn. So I think we actually have done a pretty good job. When the market goes down, when everybody else has fear, when everybody else is calling for recessions, when everybody else is de risking, everybody else is adding to cash, we add risk not because we're just naturally contradicted, but because we know based on history, when bull spikes, insider buying accelerates, markets are down. The risk reward of buying stocks at that moment, even if it doesn't feel good at that moment, are incredible. And I think in the course of my 19 years running the cap appreciation strategy, almost 20 years now, we've probably done that 10 times with a head rate of basically 10%. And you know, again, next time we have a downturn of 10, 15, 20, 30%, we'll do the same thing.

Justin (9:33)

Yeah, it's so, but that's so you know, as, as a professional, you're disciplined, you do it. But you know, individual investors, it's so hard, you know, when the market's falling, the negative headlines are out there and that's, you know, what's being paraded around is, you know, we're going into the next bear market, it's going to be deeper, whatever it is, to get the Fear levels high. And so I, I think the point here is, you know, seeing through that is I think very important for long term success.

David (9:57)

I think try to focus on for individual investor the next 12 months of return. Not trying to optimize what makes you feel good in the moment, what's going to work for tomorrow, next week, next month? No, there's a lot of uncertainty but I think it's a great point that there's a reason why this happens every time. There's a reason why the market fell 19% in April. There's just a lot of fear, a lot of concern. Markets are going, stocks going down. But stocks going down is actually a good thing. It means forward returns are greater, the risk of loss is lower. So again, I think that's a, again we talked about, you asked a really good question earlier in the discussion around market inefficiencies. This is one of the greatest market inefficiencies that when the market is high, investors feel like yeah, things are great, valuations are expensive, things feel great. But actually your risk adjust returns from that point, next 12 months, next 24 months are great. But almost counterintuitively when the market's down 20%, 30%, 35%, 15%, your actually forward return expectations at that point are much higher. So what you will see over time is when markets are frothy, expensive, you will see us pull back directly exposure. And when markets are cheap, when there's fear in the marketplace, you will see us add to risk assets and that over a full cycle, probably neutral risk assets, but that over the course of my career, that 19, almost 20 year career, that's created a lot of value for our clients doing zigging when the market's zagging and vice versa.

Justin (11:36)

And how do you view, I mean there's argument right now that, that Even though the Mag 7, you know, not all of them have produced great returns or trading at the valuations, maybe they.

David (11:46)

Were at their peak.

Justin (11:47)

But you know, generally people would say the market looks kind of expensive here when you look at something like the Shiller PE or it's maybe its current PE ratio. So what is your current take on the market's valuation today? And is there anything about like the headline PE that you would sort of push back on?

David (12:06)

Sure. Actually I would just correct you on one thing, Justin. I refuse to say the Mag 7, we'll talk about the Mag 6, but let's just be honest. Tesla is losing market share in every region. Their profit expectations over the last three years are down 75%. If we're going to put Tesla in the Mag 7, we should put GM or Comcast or Ford in the Mag 7. Or because they don't deserve to be in the Mag 7, they are very overvalued. So I'll just maybe make that one point. So I always refer to the mag6. But to get to the heart of your question, in all honesty, one of the things I think the market, a lot of people are very, very lazy when they look at the market. They're lazy in that the market is a living, breathing entity. The S&P 500 of today is vastly different from the S&P 5002006 and very, very different from the market in 2011. In 2006, 45 of the earnings from the market were coming from financials, materials and oil. And those are all low multiple sectors, right? Today we have actually 53% of the S&P 500. Today from a market cap perspective are businesses that are actually growing organically in the single digits, basically twice nominal GDP. The S&P 500 is a combination of 500 different companies, all with different growth rates, all different fundamentals, all very different multiples. One of the things we do as a team, once a year we go through every company in the market, we look at their growth rate, look at where they traded historically. We project out five, six years forward, we come up with a multiple, what those should trade, then we aggregate it all up. We do some really, we basically do a Micro analysis of 500 companies in the market and say what is the fair value on the market? By doing all this aggregation analysis at the, at the micro level, right? Surprising to me. Very, very few people do that. I think a lot of people are just honestly very, very lazy when they approach this, this question. Just look at history. But again, it's a very, very different market today than it was 10, 15, 20 years ago. So when we do that analysis we say what is the right multiple of the market at the end of 2031? And the bottoms of analysis we get is about 19 to 19 half times earnings. And again that is just mix. Tesla wasn't in the index five years ago. Palantir was in the index a couple years ago. Financials are a much bigger part of the index. Energy is a very small part of the index. Utilities are becoming much, much faster companies than they used to be. You have to adjust for all that. At the micro level it's a lot of work. It's literally about a couple of weeks, two month process we go through, but it yields Great insights on the market yields, great insights in trying to find really great opportunities in the marketplace by doing that 500 company micro analysis. So when people say the market's expensive at X, I think that may be true. And the market is expensive today relative to where it should trade, but it's not based on where you used to trade 10 years ago or 15 years ago, 20 years ago. That's not a very good comparison from my perspective.

Justin (15:17)

Can you share that report with me when you guys produce it? I'm just kidding. I'd love to see it, but I think that's proprietary.

David (15:24)

It is a little proprietary.

Co-host/Interviewer (15:27)

To your point about the changing composition of the market, one of the things you see people who are bearish on the market constantly talking about is the idea that profit margins are a mean reverting series and the profit margins have to come back down. I mean, do you think that's wrong? I mean, given the nature of the market, do you think we're just going to continue to see at a market wide level expanding profit margins?

David (15:46)

Yeah, I think most of the brazen profit margins are where they are today is just mix. Nvidia has 70% operating margins and again, maybe those margins won't always be 70% gross operating margins, but they're a very large part of the index. You know, Apple used to have very, very little services business. Today services is over basically about half of the profits of Apple. Their service margins are very, very high. You see there are these mixed elements that go into it, right. You would, you would normally think of energy kind of being kind of a low margin sector, materials being a low margin sector, parts of financials kind of being a low margin, they're just a smaller part of the index. So I think again I would argue that profit margins are not necessarily mean reverting at an index level. When you adjust for mix. Again, that would not be something that I would get concerned about from my. Now there are certain companies in the marketplace that again, maybe Nvidia is over earning. We'll maybe talk about AI a little bit later. I think one of the challenges Nvidia might have is Nvidia has been the only game in town for GPUs. And that is changing. That is changing with AMD has a really great product coming into Q4, Q3, Q4. On this year we see the TPU success at Google. There's going to be more competition and the economic rents that Nvidia is probably getting today may not be able to sustain 70% monopolistic operating margins in the future. But that is a firm specific comment that could influence that and as we do our analysis that will come across but I don't think that is a cause for concern when you adjust for mix. I think that again I would argue that is a little bit of a lazy analysis.

Co-host/Interviewer (17:40)

One of the interesting things I found when I was prepping for this and you mentioned before your bottom up work on all 500 companies is a lot of people talk about the Mag 7 as expensive but I think you see maybe below them in the large cap space maybe a lot more overvaluation in names people might not expect. So can you talk about that?

David (17:56)

I think what's really interesting to me today is that you look at if you think about I could come at Goldman Sachs and this will be a good year from ma it'll be good for trading, it'll be a good year for equity issuance, it'd be good for IPOs. But I think in the course of my career I probably bought Goldman Sachs five times. And you can you buy it at 1.1 times tangible book when people hate it and you sell it at 1.8 times tangible book when people love it and you rinse and repeat and there's probably hundreds of hundred companies we've done that multiple times over the course of my investment career. And today Goldman Sachs pays for three times tangible book value which implies a long term ROE of 30% which no one really believes. And I think what's interesting is you think about whether it be financials some parts of consumer discretionary. Walmart trading at these almost 40 times earnings. Costco trade for 45 times earnings for companies that are let's call it high single digit EPS growth companies, low double digit EPS growth companies. Again that doesn't really make a lot or even industrials. It was interesting the other day just spending time looking at Caterpillar. Caterpillar's average about 17 times multiple over time. Today it's trading for 29 times. It's actually trading for 22 times 2029 for a very very successful company with at best mid single digit kind of organic growth. So I think what's interesting to me is in the marketplace today again we can debate I think Tesla does not deserve to be the Mag 6 Mag 7. I don't put in the Mag 7. A lot of the other names in the Mag 6 are not that expensive. I think the most overvalued part of the market today is industrials which are trading at just ridiculous valuations versus history. And I don't think their growth rates are vastly different what they've been in the past in many cases because we have that massive inflationary environment which elevated their growth or eps. I think it's unlikely most industrials grow earnings at a double digit clip over the next five years. And yet they trade for big premiums to the market financials. Banks trade for very very high valuations. Parts of consumer discretionary, even parts of consumer staples trade for very high valuations. So when we do this 500 company analysis, we do this micro analysis of the whole market. What's really interesting to me is the market returns are only expected to be like 6% in the next five years. But there are companies non pharma, healthcare, we can talk software, utilities, where you would look at this and you would say you know what, I think I'm going to generate returns buying these stocks today, anywhere from low teens to low 20s IRRs next five years. And then you look at industrials or press, consumer discretionary or financials, you say, well you know what, those returns are likely to be kind of in the low single use or even negative in cases. I don't know if in my whole career I've ever seen such a dichotomy in the market in the expected returns where the market just really wants to own beta. Today the market just wants to own beta and doesn't really care about valuations. And again, I don't think we've ever really seen this dynamic ever before in my career. This dislocation between parts of the market and other parts of the market, expected returns being again in some cases deltas of 1500 basis points over a five year basis. Are you a player in the private equity industry? Troutman Pepper Lock is one of the leading national law firms focusing on middle market private equity. Our podcast PE Pathways brings on dealmakers to share their thoughts on trends and developments. We do a deep dive into the M and A industry with topics around tax, employment issues, regulatory developments and much more. Check out PE Pathways wherever you get your podcast. On December 12, Disney invites you to go behind the scenes with Taylor Swift in an exclusive, exclusive six episode docu series. I wanted to give something to the.

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David (22:04)

The book the End of an Era and don't miss Taylor Swift the Eras Tour, the final show featuring for the first time the tortured poets department. Streaming December 12th only on Disney Plus.

Co-host/Interviewer (22:22)

You mentioned AI before and I was, I was interested to talk to you because I love talking to people who are managing actual portfolios as we go through this technological revolution, like, I just want to start at a high level, like, how are you thinking about AI? I mean, do you think about it relative to railroads and relative to the Internet and other technological revolutions? Like, how are you thinking about AI in general?

David (22:40)

I would say it is a PBD a little bit. And I think anybody who tells you Jack that they know exactly how AI is going to play out is fooling themselves. I think we know certain things. We know a lot of things, right? We know that coding works, we know coding works, it has great roi, it helps write software, it just works. We know that consumers are using ChatGPT, using Claude, using Gemini and really having great results. We know it works for marketing, we know it works for targeting ads to show you or your family from a meta perspective. We know there's some great use cases, right? But the question really is, are they use cases for there's this $40 billion white collar worker, Tam. Do you start? Did we really start? Does the productivity, does the accuracy get to a point where we just start replacing a lot of white collar labor with AI with software? I think the evidence so far is to be determined, right? I think most people who use Copilot for Microsoft right now would say that is a very, very marginal benefit. So we will see if that changes over the next couple years. I think that is, I think there are certain applications. We are seeing a clear substitution of labor for software for AI. But really to justify the massive expenditures here, you need to show broad enterprise adoption and really good orders. And I think we're just early in that case to be made about how that's going to play out. So could this be as impactful as the railroads or Internet? Absolutely. Maybe even more, maybe even more powerful. But I think it's still to be determined in how powerful that is. Because I think there's, there are things that AI is really good at and there's things that AI will struggle with even within software, right? There are. One of the experts we've talked with made a very good point to me. He said if you are just trying to get a good answer, AI is usually going to be pretty good. If I ask you to draw a picture or create an ad with a man or a woman in that ad and you want to describe that person, there's multiple, right. There's not one right answer. Right. But if you want to determine what my earnings were for this quarter at your price, or you want to, you know, you want to figure out what Microsoft earned this quarter, you know you're not, you know, AI is never going to be 100% accurate. Just that's just not what AI is good at. You're never going to replace an ERP system, you're never going to replace a workday, you're never going to replace an SAP with, with an AI solution because it's just never going to be in those situations. You need to have to be 100% accurate. It's just not what AI is good. But could AI replace what Adobe does? Absolutely. Completely. Adobe could go away. Could it replace parts of what Salesforce does on the marketing side? Absolutely. Is it going to replace SAP? Absolutely not. Is it going to replace Microsoft? Absolutely not. Is it going to impact, is it going to impact workday? Absolutely not. Is it going to impact ERP systems? Absolutely not. Right. But there are a lot of other use cases where it could. And I think what we're trying to do in this environment where the market is selling everything that is tied to health, to software in particular, where are those deserved? Where is that a real risk and where is it not a real risk? And as the market kind of throws the baby out with the bathwater, are there some really great opportunities in software for us to take advantage of? And maybe the last thing I would just say on software, on AI, I think the most important thing probably for your viewers or people who are listening to this today is I think it's a really important point. Is that really what Anthropic, we're private investors. Anthropic. I think hopefully that'll be a very good investment for us over time. Maybe even, I think anthropic will end up being bigger than OpenAI over time is that they've basically proven that if you have enough engineering talent, if you have enough time, you have enough just really smart people. Nvidia moat is not that important. You can basically put an orchestration layer and find what applications work best with Nvidia, what works best with AMD, what works best with custom silicon works with Trainium TPUs. And I think what's interesting, as we talk with experts, as we talk with companies, we are at an inflection point where I think this moat that Nvidia has today, where they're going to have 93, 94% dollar share of all the GPUs, that's going lower. And again, going back to thriller comment about margins, in a world when you have no competitors to having multiple competitors, there's probably going to be some margin pressure, some share pressure, doesn't mean it can't be a fine stock because the valuations come in a lot. 26 is still going to be a very, very good year. But I think if you look at 27, 20, 29, I think more and more companies are going down the anthropic model. And again, what Anthropic's proven is we can produce basically the best outlet in the world without spending the majority of our cash flows on Nvidia devices. We are using some, but we don't have to use Nvidia exclusively. And actually I think in many cases today the anthropic, the minority of what they're doing today is on amd and we're hearing that more and more from other companies. So that benefits broadcom manufacturers and TPUs, that benefits AMD, the second kind of solution in the marketplace and probably, and probably over time benefits the cloud providers as well. They can earn more rent. There's going to be a rent redistribution that's going to plan next five years again. Maybe not next quarter, not next week, not next year or this year. But I think if you have a five year view, I think Nvidia's market share goes a lot lower and probably their margins come under some pressure in.

Co-host/Interviewer (29:03)

Terms of the less obvious tech place in your portfolio. Is this something where you're going through every position you have and saying, how does AI affect this? Is that how you think through this?

David (29:11)

Absolutely, absolutely. That is, where is disruption risk? Real, where is disruption risk? Where is there a disconnect between what the perception of disruption risk is? I mean, it was funny yesterday you saw again, Anthropic came out with some solutions that were more legal in nature that could potentially impact the legal market. And you saw a whole bunch of index companies, whether it be lse, the stock exchange. You saw S and P Global also under a lot of pressure. Now some of that pressure was probably tied to some changes the administration had made with regard to mortgage fees that impacted Equifax or some. Gartner had a really bad kind of non AI related quota. But there was a lot of pressure. And these are companies that really have proprietary data sets that should not be any way impacted by AI. Yet these stocks were all down 10% plus and trading it, not trading more reasonable value. I think that's just silly. Again, one of the things we do, and I think one of the things that makes me feel better sometimes whenever we go through a period of time we have these events where the market just throws the baby out with the bathwater is we do due diligence right. And you know, I'm not going to mention the software company that we had this. We talked, we talked to one of their largest customers of a large software investment we had and the customers, the Stock's probably down 20%, 30% because of AI concerns. And they looked at us and they said, you do know, because of AI, we're going to send more money with this company, not less. This company actually becomes more valuable to us in an AI world today than it did in a non AI world. And so you have this disconnect that just builds confidence. Like okay, markets thinks it's a concern. One of the largest customers telling us we can spend more money, let's push that bet, let's get more aggressive, let's not listen to what the market's doing to where the market's panicking. Let's make really good investments for that five year time horizon and distinguish between where this is a reality again Adobe, this is a reality. This could really impact Adobe's business HubSpot could really impact their business. Right? Some small cap software companies and Intuit, this could really impact their business but it's not going to impact PTC workday SAP. It's just not in many cases these are companies will be benefited by AI and so we have to use this period of uncertainty to take advantage of these opportunities by taking a little longer time horizon, by doing really good due diligence, talking to customers and making sure we're right on these things.

Co-host/Interviewer (32:09)

Do you have any thoughts on the changing nature of. I'll catch myself here and say mag6 instead of mag7 but do you have any thoughts on the changing nature of those businesses? I mean what made those businesses great in some ways was they were very asset like companies, they had high free cash flow and now they don't look like that anymore. And I think a lot of investors are trying to figure out how to make sense of that. Are these like permanently changed businesses where what made them great's not there anymore? Like do you have any thoughts in general about that?

David (32:32)

I think it's a very good question. And again, you know, actually it goes back to I think a point you raised earlier about the, about evaluations. I think if you want to make a bull case for the Mag 6 you would say that the valuations are actually very, very reasonable relative to the market, relative to the growth rates. If you want to make a bearish case on those, you would say, well to your point, good point. There's a lot of CapEx today, so they're free Cash conversions. So their multiple on free cash looks a little bit less attractive. I think again what I would tell you today is that there's a question mark about the forward returns about all this capex investment. Again, what we've seen so far in the first two years we have not seen profit margins for Azure, for aws, even for Google Cloud come down, right? So we're spending a lot of money on capex and yet the returns they're getting on incremental investments are going higher right now. I would also say there is a little bit of a timing aspect of this, right? So the way you build data centers is you got to go and buy land first, right? Then you got to build a shell and you know that land doesn't really depreciate, right? You buy land, it doesn't depreciate. So you know the return you get on that investment initially is very, very low because you're buying land, then you got to put a shell on top of it and then you put on the short cycle GPUs, the, the network, all that other stuff where you are going to run a return. But there is, but return, you know, you would make an argument that the free cash flow right now is a little bit depressed because you've forward spent capex, that you're not earning a return on that you will earn return in the future. I think these companies have become more capital intensive. I think we are probably getting to a point now that that return on free cash flow equation as the mix of long cycle capital which has a low return initially but a good return over a longer term and the mix of kind of short cycle capital where you earn a return almost immediately. That mix which has normally been, let's call it 50, 50 last couple years has been like 75, 25, probably gets back to that 50, 50 over time or even kind of 40, 60 and you start getting higher returns on free cash flow going forward, you just get better utilization of that capex. So again, probably a little bit structurally lower free cash flow. Very, very point, fair point. But I also think there are other aspects of the cloud business. One of the interesting things about the cloud business, you think about the non AI cloud business. We are seeing that enterprises are accelerating their movement to the cloud because they know if I want to take advantage of AI, I have to have more of my data in the cloud. So we are seeing non AI workloads accelerate to the cloud today. Right? That was kind of going at, let's call it, you know, a 1 to 2 point increase in the percentage of workloads that are in the cloud to not in the every transition every year. And now that's kind of going by 3 to 4 points a year. So the non AI related workloads where you actually get very high returns on capital, very high roi, that part of the business is actually growing faster than it would have been otherwise. So that's also cushioning some of the headwinds we're seeing on slightly lower ROI on, on cloud today.

Co-host/Interviewer (36:00)

Do you think the biggest beneficiaries here will be downstream of the people that are doing the build out? Like if you look at the Internet, that obviously was the case. You know, the companies that built it out were not the biggest beneficiaries. But here I could argue, you know, this is intelligence, this is maybe a different thing. I mean do you think we're still going to see a situation where the biggest beneficiaries will sit downstream of the companies that are building this out?

David (36:18)

I think it's a, it's a great question. I think you're going to see benefits most likely everywhere. Again, this goes back to the point I raised earlier. We're just not, it's still very early. Even though we're two plus years into this AI cycle and we're spending hundreds of millions of dollars on GPUs, we're still not exactly sure how this is going to play out. We have yet to see a model that is trained on a Blackwell or MI450 kind of. All these models are still, have still been trained on older generation block. We still haven't seen what an LLM is capable of after it's been trained on a block or an Mi 450 kind of model. So we still don't know necessarily how big the benefits are. But I think to the extent that this drives increased productivity that you can actually reduce human labor and substitute lower cost software. You know, that is, that could benefit most companies that have a lot of white collar work in the labor force. You know, again, actually, again I'd go back to software. Software companies probably have the largest percentage of people who are doing coding. And if you can get rid of some of those coders, you know, your margin go a lot higher over time and you can add on, you know, additional AI work, add ons if you will, that could actually benefit software companies over time. Again, that's not, no one's really talked about it today, but I think over a multi year period of time that could be a benefit. You could get the margin benefit from less coders and also margin, you know top line benefit from more AI add ons there. So yeah, but it's still tpd. Again I would argue right now some of the biggest beneficiaries of AI will be probably a Broadcom, an Amphenol, a amd. The utility companies that are really helping facilitate a lot of this build out and especially the regulated utilities, I think they're very, very well positioned to benefit from this. And again it's too DB determinative. So when we do our 500 company models, we are not building in massive margin expansion based on AI over the next five years into any of those. That could be an upside. That could be an upside. To your point, do we wake up in five years and the unemployment rate has structurally gone from four to five and a half and the profit margins for the SB 500 are 150 pips higher than they would have otherwise done? That is an upside case that would accrue to everybody in the ecosystem or most companies in the ecosystem have a lot large white collar workforce.

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Co-host/Interviewer (39:55)

You seeing benefits from this as an investment manager? Like on one hand, I would think if you're doing 500 bottom up analysis this could help. But I would also think your analysts are probably still better than this. So like, are you seeing benefits in terms of that type of work?

David (40:07)

I think, I think it is. I think there is productivity, but it goes, you know, is it, you know, when we use a variety of different AI tools Again, I use Claude through Anthropic, I think, which is, I think is actually the best. And we use perplexity. And there's some, there's some alpha sense. And I think what it does, it does make us more productive. Right. When we would go back to April of last year when there was all the uncertainty around Paris, I had to do a deep dive on tariff law to figure out what is ieva. And that probably would have taken me three or four days to do. But in a world with quad, a world with perplexity, you know, to be able to say, this is what I'm looking for, give me all the rolling history of iepa, why was it in place? What have the court said? What are all the, you know, why will this be upheld? Not upheld. Yeah, I was able to do that a day and get a note out to the rest of the firm talking about how I thought IUPO would be overruled. And I had a high probability of that based on all that work. Now that would have taken me three days to me a day. If I want to find a email that one of my other CO PMs has sent me, I could find that almost instantaneously using these services. Right. If I want to read everything that had been written in the last couple of years in any different source on a certain drug, I can do that. So it does increase our productivity. On the margin. Does it make it easier for us to do that 500 company analysis? Yes, but I think, I don't think AI is fundamentally changing how we invest. I don't think it is fundamentally changing the number of people we need at tier price. I think on the margin it just makes it a little more productive. But I don't think it, you know, we're not ready to turn over the portfolio to AI just yet.

Co-host/Interviewer (42:03)

You mentioned lazy analysis before and I think one of the lazy analysis people do is they just look at the dot com bubble and they look at today, they say we've got a technological revolution, the market's up a lot, we're going to see the same exact thing again. And you've talked about how there's some big differences between that and now. So I'm wondering if you just talk about that, like, what are you seeing different now than you saw back then?

David (42:21)

Oh yeah, I think it's a great question. So what was interesting is if you go back to the dot com bubble, you know, that was a situation where those were. Yeah, those were, you know, if you look at the value, I think the, the Number is that I think Cisco may have peaked out at 500 times earnings. I think AOL peaked out at over 100 times earnings. I think EMC may have hit 1,000 times earnings. You just saw extremely high multiples based on really a lot of hope. And there was also, again there was a. So it was actually a very small part of the earnings for the market were coming from tech at the time. I think the tech sector peaked out at like $8 EPS. They go back to like that year, the peak year. I think the market was going to earn like $60. It was like 15% of the market. And then in the downturn it went from $8 to a dollar in the tech sector because, you know, a lot of those earnings just went away. And I think if you look at today, you know, you don't see the same kind of crazy valuation. I think I would feel a lot different if Nvidia was trading at 200 times earnings or if you, if you said but a lot of the tech earnings today really had very, very little to do with AI, right? Apple's earnings today, they really don't have anything related to AI, right? AI could go away tomorrow and Apple's earnings wouldn't be invented at all. Microsoft, again, there's a lot of growth built into Azure in the future, but I think there's also. That's still a very small minority of their revenue comes from AI. Today again, Nvidia is different. Clearly if the use cases for AI do not develop, if the LLMs commoditize more than we think they're going to commoditize, Nvidia's earnings could clearly collapse. That's absolutely true. But Nvidia is still a relatively small part of the SP 500. I think their earnings are like 5 or 6% of the S&P 500 today. So you don't have a situation where I think tech earnings would collapse in that situation. Again, software earnings aren't going to collapse. Most Apple earnings aren't going to collapse. Google has this very, very profitable search business wouldn't collapse. There's just a lot more reoccurring revenue today. I think it's very, very different valuation, not as high and it's not all being driven by the same factors, not all being driven by some kind of networking cycle or telecom cycle like it was back then. I think you would not see tech earnings fall 85% like you did last time because it's just so much of the earnings are more software reoccurring. Meta, meta again. Meta Again, almost Meta has negative earnings coming from AI today probably given all the spending they're doing today.

Co-host/Interviewer (45:13)

Yeah, you mentioned Apple and Meta and it's interesting to me, like contrast what they're both doing right now because it seems like Apple's idea is we're going to let other people build this out and we're going to take advantage of it. And Met is probably spending the most money on capex. Like, do you have any thought about the balance between those two things?

David (45:27)

I think it's actually, again, I think it's a very good observation in all honesty. What I would tell you is again I think Apple understands what they're good at and I think Apple understands that our probability of being successful in creating the greatest LLM is probably somewhat limited. Right. And why don't we just partner with Anthropic or partner with Chat, GPT or Gemini or whoever and build those applications and get a, get some kind of rent on that from the services perspective. Right. I think that, and I think we don't need to spend $100 billion in CapEx to do that. Right. So I think that's a very, very rational decision. And again Apple, you know, higher valuation some of the other mag 7 but on a free cash flow basis, you know, a little bit more, more attractive. I think Meta views this right or wrong, that they feel like it's, it's very, you know, first of all, some of that capex that they're spending today is internal use for ad targeting. And if you look at the organic growth rate of Meta, I mean it's been amazing. If you told me Meta would still be growing organically double digit, I mean not only double digit but 20% of this time. I would have told you three or four years ago you were crazy. But what Metis kind of figured out is we can use GPUs to better target you, me, Justin, and with better ads, if we have better ads, better hit rates, more, more ads that are more relevant, people are going to buy more and that's a great roi. So on that part of the business they're saying llama, they're actually getting a great return. I think the question is again, a year ago at this time we would have had a conversation about Lambda being one of the top three kind of LLMs in the marketplace. And Lambda fell behind, just fell way behind. And we have kind of this super team, the Avengers or whatever you want to call them at that marks put together and we'll see they're going to have something probably by mid year and we'll see if they can kind of get back in the, in the, with a, with a solution there. You know, they think that's really important to them. I'm not so sure that is as important to them as they think about. I think, you know, they're very, very far behind. Anthropic probably number one, Gemini number two open a number three today Grok like way, way, way, way, way, way low on that list. So we'll see. But I'm not so sure it's as critical as they think it is to get that right. So again, the way I would think about Meta is they're not idiots if they can't. They're not going to spend $50 billion a year on trying to create the best in class LLM every year if they're not having success. Right. I think if they wake up and they say, hey, let's just buy through Entropic, let's just buy through others, let's go down the Apple rack, I think that will be the back to plan. I think that would be probably a good option to stock if they're successful and they all of a sudden they have an LLM that can generate revenues from that and that's impactful. That's also possible. I think in many cases Meta is like a win win, right? Either they revert to the Apple solution and capex was way lower. That probably does well in that environment. If the LM is really, really good and it's in top three again, maybe that's a positive too. So I think Matt is almost from a risk reward perspective on that is kind of well positioned.

Justin (49:08)

When looking at the fund, it looks like the two sectors that are most overweight relative to the benchmark are one, healthcare and two, utilities. And you know, it'd be probably unfair to like paint either of those sectors with a broad brush and say this is the reason why, because it's more bottoms up. But if you were to try to summarize, capture the more positive thesis on those sectors, like how would you kind of bottle that up?

David (49:36)

You're happy to do that. So let me, let's talk about utilities first. So, you know, I think for 15, 17 years in this country, we basically had an environment where power demand in this country was flat. It was flat as a pancake. It didn't grow at all. But still utilities grew earnings 4 or 5% a year, fixing the grid, replacing coal with renewables. But I think what's interesting is both because of reshoring, maybe a little bit because of EVs. But more importantly, because AI, you've basically seen growth rates for utilities really accelerate. I mean, I have names in the portfolio that we think will grow earnings between 9 and 12% for utility. That's just kind of unheard of. I mean, we think NiSource will end up growing earnings, probably 11% with a 200% dividend yield at 20 times earnings. That's very, very low risk investment. That seems like a great idea for us. That will grow faster than the market, much faster market with half the volatility and trades for a discount of the market. Right. So what I think was interesting about utilities is again, this goes to the point of let's look at it at a micro level, not as a sector basis. Right. There are parts of the utility space that have wildfire risk. California's got wildfire risk. There are parts of the utility universe that are being impacted because of rising PJM pricing, because of the unregulated market. And that's kind of driving not reliability, but affordability issues. Right. So we're not investing there. But you know what, and NiSource, when they're putting a data center in Indiana, it's a billion dollars of savings for customers, $7 a month for customers, put Amazon's data center in there, they're going to probably put another data center in there in the next couple of years. That'll probably add another billion dollars of savings for customers. It's kind of the exact opposite of what's kind of happening in the PGM region, actually impacting my home state of Maryland. So where is all these data going to go? They're going to go to places like Indiana that want them, they're going to go to places like Missouri, they're going to go to Wisconsin, they're going to go to Iowa, they're going to go to Texas. And what are the companies that are best positioned to benefit from that and actually don't have affordability issues? Right. So again, we look at an iSource, we look at a CMP, we look at a, an Amarin, a PPO, we think those are pretty good investment opportunities here and that will grow earnings almost probably double digit or either high single digit earnings with a nice dividend kind of gets you a double digit kind of total returns very, very little. So we like that healthcare is different. Healthcare has been an area of consternation. We've had pressure because of administration kind of changes, but it feels like a lot of those headwinds are kind of getting into a little bit better place we've had more, a little bit better feeling around how IRA is going to play out, the pricing pressures, the tariffs impacts. I think we see a lot more uncertainty around that. We think there's going to be a lot of biotechs acquired over the next three to four years in the SMID biotech space as big Pharma is facing a 4 to $500 billion generic shortfall next 10 years. Yeah, they're going to just buy a lot of things. So we're buying a lot of companies that we think are great takeout candidates in that space. Biotech takeouts usually get happen at 50 to 90% premiums to where the stocks are trading. And we think there's a lot of names that have really de risk portfolios. So we're buying a lot there. We are buying things in life science tools because life science tools been kind of a tough space but again fundamentals seem to be inflecting there. We like the distributors and there's areas of healthcare that are really, really attractive. And again healthcare has been a sector that's been out of favor. Again we tend to go where the IRRs are the highest and healthcare and utilities and parts of software today are probably some of the highest IRS in the marketplace.

Justin (53:47)

It's just with healthcare, if you think of the aging demographics of this country and what people need for their health, it seems like, you know, at least, you know, if you want a job and probably if you want to do good, invest in investing over the next five to 10 years. It's like the demand is just going to be crazy.

David (54:05)

It's a very positive demographic backdrop. And again I think this, this biosimilar and generic pipe, you know that that's, that benefits the distributors, it benefits PBMs, it benefits all these small mid cap biotechs. If you think about the two real powerful themes that we want to play in healthcare over the next decade is GLP1s because I think that is GLP1s are going to be the new statins. I think there will come a time that when the price points come down and we have more biased signals, more options, I think half the population will be on GLP1s because we know reducing the risk of death, heart disease, sleep apnea, diabetes, all these things, it's really kind of a miracle drug in many respects. If the price points come down, I think the acceptance will go up. That benefits everybody in that whole ecosystem that benefits from GLP1s and then there's just giant generic cycle which again Benefits distributors, benefits PBMs benefits, managed care and benefits kind of submit biotechs which need to be acquired for a farmer to take, you know to, to basically alter their fix their, their, their pipeline issues.

Justin (55:16)

We've talked a lot about the stock side of the portfolio, but what about fixed income? Like where are the, and I think you might have mentioned this before, but where are the attractive areas right now and do you find is fixing, you know, are you finding it like rep. Like relative to stocks is fixed income giving you like a good opportunity?

David (55:40)

Unfortunately getting very good question there, there, there is less opportunity right now in fixing and because the reality of the world, the reality is that we are too. You know spreads are tight, Spreads are very, very tight and that's, and again when you get kind of a speculative equity market, you tend to get a situation where you know, spreads get tightened. Spreads are very, very tight today. Right. So there's not a lot of opportunity today as much as we've seen in the past in high yield leveraged loans as we've seen historically I'd say. And again I think with you know, when that 10 year got to 5% we were, we were buying a lot of Treasuries. I would even say any of the Treasuries today. You know, I think Treasuries from our first from a high level look kind of fairly valued. If you think about what's the way we think about, you know, just a back to the envelope way to think about Treasuries are what's the inflation rate? Solid 2 to 2.5%. Next five years add 100bps on top of that for what fed funds should be above inflation. That kind of gets you a fed funds of let's call it three to three and a half and then add on top of that maybe 100 basis points for the 10 year kind of gets you four to four and a half and then we're basically right in the middle of that. So I would actually argue Treasuries are kind of fairly valued today. So you know, but you know I think that, I think that. But I would say the one thing and we may have talked this last time is there's this negative skew to Treasuries and we believe that the most attractive part over time of the treasury curve is this, let's call it this four to seven year bucket, the belly of the curve. Because in that belly of the curve, if you had a recession, you're still going to get a lot of benefit of Reese drop. You're still going to get some appreciation of those bonds if you have a recession. But we do have an unsustainably bad fiscal situation in this country that will catch up to us someday. Do we catch up to that tomorrow? Next month? Next year, 10 years? I have no idea when the market starts to care about this stuff, but this idea of running 7% deficits to GDP is just unsustainable. It is an unsustainable situation that I don't know when is it death to GDP get to 150, 250? I don't know where that is. I just don't. No one knows what that is. There's no real historical precedent, but I think there are signs emerging. We saw what happened with Japan this year. We saw what happened to UK a year or two ago with Wraith. The incremental buyer of Treasuries at 10 years and 30 years today is a yield focused investor. And I'd also say the last two market downturns we've had, Treasuries have not performed as well as they have in the past. The 15 downturns before that, treasuries always rallied. In 2022 the market had a downturn, Treasuries underperformed and the April swoon yields came down, but then they actually went up. So if Treasuries are not as good as a diversifier as they've been historically, the relative attractiveness of Treasuries and portfolio goes down. So we believe the belly of the curve is more anchored to fed funds, whereas the 10 year and the 30 year part of the curve is more at risk over time from debt sustainability concern. So right, if you look at over time, the spread between the 5 and the 10 year has been about 40, 50 bips. That's kind of the long term average. We're kind of right there, but we're basically right there. We're like at 45 basis points. Yes. I don't know where we are exactly today, but about 45 basis points. Right. But if you ask me, are we going to go tighter, are we going to go wider over the next five years? Where's the skew? The skew is wider. It is more likely when we're having a conversation in five years. Unless this country's done something about its deficits, we are going to be in a situation where that 5 to 10 spread will be closer to 100bps or 125bps over time. So long term, historically the belly of the curve is most attractive space. But there's this added risk today this added skew that would kind of suggest also being in that kind of four to seven year part of the curve is the most attractive part of the curve.

Justin (60:15)

Well, and I think this might relate to partly to what you were saying about the level of our fiscal situation here in the US but, and I know you don't own gold in the fund but I'm sure at the investment committee level you guys have had discussions around it and just I guess my question is, is not necessarily like your outlook for gold but like this, you know, commodities tend to move like in multi year, historically at least like these multi year moves where commodities get really do really well and really strong and then you know, they fall off the cliff and like you know, white bear. But I'm just wondering have you guys at, at the firm level, what, what is, what is the, what is the house view, I guess on commodities in general?

David (61:03)

I, I would say again I, I would say we first we don't spend a lot of time on gold because it is not an asset class we can really invest in. I would say, you know, there's not a lot of market cap that's kind of tied directly or indirectly to gold. I mean I think going back to my last point, the reason why gold is there's some speculative excess. There's clearly some speculative excess in the marketplace around gold, silver. So I think that's one element. But there is another element that again that I think it is a way to express skepticism about the current financial debt unsustainably situation that is definitely a factor for where gold is. Now again I have not spent enough time to tell you is the fair value for gold 2000? Is it 3000? Is it 5? I don't know any more than I know is the right value for Bitcoin 120,000, is it 10,000? Is it a dollar? I don't have a perspective on that. You know, you are right. We, you know sometimes commodities go through, you know we had a giant bear market for 10 years and in energy, we had a bear market in energy from you know, in 86. You know we do have multi year periods of time. But I'm probably not the right person to ask about that because of that.

Justin (62:33)

David, this is the conversations with you are always excellent. Thank you so much. We just have one. You already answered our two standard closing question. So what we wanted to ask you today was when a newer portfolio manager comes into T row price, what are the biggest lessons that you and your you know, team try to teach sort of that new PM as they sort of get integrated into the firm.

David (62:58)

Say the most important thing, and again I've seen this time and time again is you have to think the best. Portfolio managers, my career think independently of the market. I mean that, that means it's not like you, you can be aware of what's going in the marketplace, but you have to trust your work portfolio. And I say portfolio managers who are always like chasing stocks that have gone up a lot and selling stocks have been down a lot. You're like the last car on a roller coaster, right? You're buying at the wrong times, you're de risking at the wrong times and you're chasing the market. And that is a recipe for value destruction. I think the other thing I tell people is you have to make bets. You just really need to make bets. I think I have found when we studied this that this is an industry that unfortunately, historically speaking you could make a lot of money being a portfolio manager in and be very mediocre because there were so many tailwinds in this industry. You can be very. Did I take many bets? You can be very mediocre. You can still. So I think there's still this like mindset of like let's not, let's make sure I don't underperform, right? Let's make, I think that if, but you, if you don't take any bets, you're not, your odds out for the index are very, very low. You're not going to create a lot of value for your clients on a long term basis, right? So I've always said your, your job is to find idiosyncratic, you know, great risk rewards in the marketplace, take advantage of market inefficiencies, identify those market efficiencies, think independently of the marketplace. And you can't just hug indexes anymore, right? That's just not, it's just not going to work anymore. I've seen portfolio managers and again we've done a lot of analysis around this at an industry level. The people who hug the benchmark the most, their probability of underperforming is very, very high. It's extremely high. Right. And again, I'm not built to hug the indexes again. I think over my career we've outperformed the equity market by 350bps a year for 19 years. We've outperformed the fixed income market by 300bps a year over 19 years. We've ended out form the 6040 index by 253 bits a year over that period of time. I'M very, very proud of that. But you can never deliver that track record to clients if you're always focused on what was working right now. If you're always de risking everything, the market went down and you were unwilling to make bets in the portfolio, I think that's really key. People who are willing to make really educated bets, people who are willing to think independently market and people who do good work, their odds of success are very, very high. And people who are unwilling to do really deep work, people who are kind of chasing what's working and selling what's not working and who are hugging indexes, their odds of success are very, very low and they're not really doing their clients a service. I think in many respects some of the challenges our industry has faced over the last 20 years is we still have too many portfolios at an industry level that are doing the latter, trying not to lose and not make bets, and actually not creating any value for clients and driving passive flows over time.

Justin (66:46)

Thank you very much, David. We really enjoyed this conversation.

David (66:50)

Great questions as always. I really enjoy this. I love the hour format. Great questions.

Co-host/Interviewer (66:56)

Thank you very much. We appreciate it.

Justin (66:57)

Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com. if you have any feedback or questions, you can contact us@excess returnspodmail.com no information.

Podcast Sponsor/Announcer (67:16)

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David (67:22)

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