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- [00:00]
Joseph Shaposhnik
Most headlines don't have meaningful long term impacts on companies because most headlines by their very definition are relatively short term in nature and they go away. It all comes back to the strength of the businesses, the durability of the franchises and their ability to keep compounding. For the longest time, software was thought to be one of the highest quality business models out there in the world. And I think that there's significant uncertainty about whether that will continue to be the case. I wouldn't want to make a significant investment today on predicting exactly who will be the number one player ten years from now. Which is why I think investing behind the suppliers who supply multiple LLMs today and multiple, multiple hyperscalers today is the better route.
- [01:02]
Matt Zigler
You're watching Excess Returns, the channel that makes complex investing ideas simple enough to actually use, where better questions lead to better decisions. I'm Matt Zigler talking billions owned. Bogomil Baranowski is with me as host today and now by way of Fidelity TCW and currently the Rainwater Equity ETF Portfolio manager Joseph Shaposhnik. Welcome back to Access Returns.
- [01:25]
Joseph Shaposhnik
Great to be with you guys.
- [01:27]
Bogomil Baranowski
Good to see you.
- [01:29]
Matt Zigler
Straight into the deep end with you, sir. Straight into the deep end. Events like the conflict that we're seeing right now in Iran, people want to start trying to predict immediately what's this mean for markets, what's this mean to my portfolio, what's this mean to my holdings? But you're a long term portfolio manager. That's why we like talking to you about these durable reoccurring revenue businesses. How do you think about something like when war breaks out over a weekend?
- [01:55]
Joseph Shaposhnik
Well, we've seen so many macro shocks since I started investing in the mid-90s or late-90s as a kid. Asian financial crisis, Russian crisis, 9 11, Iraq war, GFC and then all the things that have happened recently. And you know, we try to stay focused on the long term and what our businesses are going to do because generally speaking, great businesses can power through those, those dynamics. But I think that it is important to think about what is going on in the world as you manage a portfolio. And we certainly do. So we're not an investor that just says, well, we just focus on the long run and we don't think about how events could impact the portfolio and our businesses. We certainly consider it. But you know, as Buffett and other great investors have reminded us many times, it's very difficult to predict the future. And so it's one of the reasons we really like investing in recurring revenue businesses that, that don't really have a break point and, and have limited vulnerability to what can happen in the world and, and the macro environment and, and the geopolitical environment. But with that said, as I think about the, the current conflict, we look at the portfolio, we think about the businesses that may benefit from it and businesses that may not benefit from it or, or, or could be hurt by it. And we certainly think about how this conflict could impact the long term opportunity for businesses. And so one of the themes that we have been invested in is the growth in the aerospace and defense end market. And as I think about this conflict, I think that our thesis that defense is in a super cycle certainly is not weakened by the conflict and the Middle east, but I, I think it is strengthened. And so one of the long term growth opportunities that, that I see, that we see is, is the growth in spending by, by NATO countries in, in the area of defense. We think that over the next 10 years spending on defense could increase by a trillion dollars just from those companies, just from, just from those countries as they get up to, to the NATO targets that have been set. And so as I think about how that can impact the businesses, I certainly like to be invested in companies that have tailwinds that'll benefit from what I think will be very, very strong structural growth in that end market. And this conflict will certainly not be a negative to those, to those companies that will benefit and could certainly be a tailwind. And so it does give you some further confidence that growth will be solid in that end market. And then on the flip side of that, certainly companies that could see negative outcomes from this conflict. You have to think about how, how long will this conflict go on for and can those businesses sustain themselves as the conflict carries on and certainly build in a large buffer for how long it could go. You know, the conflict could be wrapped up in a week, or it could drag on for a couple more months or a longer period of time. So as I think about companies that will be negatively impacted, certainly you have to build that in. And as you think about position sizing, certainly hopefully you've sized investments in businesses that could be negatively impacted by conflicts in a way that gives you the ability to endure whatever short term impacts the business could receive. And certainly that'll translate into the stock price as well. So that's, that's the way we're thinking about this, this conflict. We certainly see beneficiaries from it or thesis, thesis or theses that are supported by what's going on. And obviously there'll be short Term impacts both ways for companies that are impacted by what's going on.
- [06:38]
Bogomil Baranowski
Joe, I want to ask you about the actual process. You know, something happens and lately we get kind of a shock, a headline that changes everything. Over the weekend or on Friday. I'm thinking of the Liberation Day. I actually was in the middle of a dental procedure. Not a fun week for me, very memorable for other reasons, but I was at the airport. I don't usually check my stock prices too often and clients will know after listening to this, but I think they know by now. Anyways, I opened my laptop and across the board all the stocks are down. It was Thursday, Liberation Day. I had no idea that it's happening. Anyways, I had other things on my mind that day and I boarded a plane, I flew to Miami. I'm landing. My plane couldn't land because the president had an emergency of the helicopter, one of the tires, and they couldn't remove the helicopter from the Runway. And eventually they removed it. I landed. So I couldn't actually land and do something about what was happening, which was maybe a good idea. Anyways, over the weekend I went through my list and I came up with stocks I was buying on Monday, Tuesday. I'm curious about your process. You know, a couple of headlines already this year. Probably many more in the coming months if we are keeping up the pace. What's your process like? You open your laptop, what do you do? Who do you call? How do you go about it?
- [07:55]
Joseph Shaposhnik
Well, look, I think that what we try to do is we try to know our businesses so well that when a piece of news comes across the wire, we already have a sense for who could be impacted by that particular news event. So as you think about the conflict in the Middle east, certainly we're thinking about the defense companies and how they'll be positively impacted. And maybe, you know, we own a little bit of. Of Hilton and we think a little bit about how Hilton could be negatively impacted. But we think about the headlines. We certainly dig into what's going on and then we dig into the companies and we just want to understand how will the long term free cash flow, compounding power of our businesses be impacted and whether it'll be impacted at all. Because it's very possible that the conflict that is currently going on really will have no meaningful long term impact on businesses that we own and in most businesses. So we're trying to understand as we look at the P. Ls, how much exposure do these companies have to whatever event is happening and will this event, if it drags on for a long period of time. Will that event have a meaningful impact on, on the future prospects for, for this particular company or a group of companies? In the case of the current conflict, I certainly think it makes the world and countries feel more compelled to, to become more defensive and to invest in, in their industrial base, to invest in their defense or defensive positions. And so that's the process. We really are bottoms up, very company focused. So if we see a headline we will go into our models and look at how our businesses are oriented and understand whether that'll have an impact on the companies that we own. But generally speaking, most headlines don't have meaningful long term impacts on companies because most headlines by their very definition are relatively short term in nature and they go away. It all comes back to the strength of the businesses, the durability of the franchises and their ability to keep compounding. In my experience, less activity during headline, during aggressive headlines or many, many headlines coming out, less activity generally has yielded better performance or good performance from my portfolio. So I'm always cognizant of that. Not overreacting to the headlines, just going back to the companies, going back to our investment theses on these businesses and trying to understand whether anything has meaningfully changed. That's our process.
- [11:04]
Matt Zigler
So away from a conflict scenario like Iran and back to what everybody was focused on up to Iran and sort of through it because we had the Citrini piece and everything else. Let's talk about AI. How do you assess companies in a space? How do you contextualize what we've seen in the promises of AI and this AI build out over the last few years? Like how are you contextualizing that part of a cycle and what kind of a cycle might it even be for the companies involved?
- [11:34]
Joseph Shaposhnik
Well, it's a very open ended question Matt. In general, you know, there are massive beneficiaries of AI. There are companies in the middle and there are companies that will be clearly negatively impacted by, by what is going on in, in the, in this, in this cycle. So as we think about it, we've certainly invested in semis which we believe will have long term legs and benefit, benefit significantly from the AI cycle. We've invested in the connector end market which will also have very, very significant growth as we continue to build out CapEx and AI infrastructure. And we've been invested in software businesses where the impacts are a lot more muddled. Some software businesses will benefit from the tools that, that have been introduced that'll help develop developers, develop much more quickly, much more Efficiently and in a much more dynamic fashion. And there will be companies that are, that will be very very negatively impacted. And so we think about that spectrum of who will benefit, who will have to work very hard to benefit and who will be negatively impacted by, by what has occurred in, in the end market. I think that certainly there are a great number of businesses that people believed were rock solid long term opportunities that are no longer rock solid long term investment opportunities. Businesses that may not be disrupted today, but you can see down the line are highly likely to be disrupted by what is by, by, by the introduction of AI and the phenomenal rate of change and rate of improvement that we're seeing from the LLMs that we experience on a day to day basis. It is not quite showing up in the P&Ls today, but we definitely believe that over the next couple of years many, many businesses will be negatively impacted. And it's important to get out of the way of what we think will be significant levels of disruption.
- [14:09]
Bogomil Baranowski
Joe, at some point last year you mentioned how 2026 could be the year of the 49, 3, 493 stocks remaining stocks of the S and P, not the seven that everybody's talking about. You talked about AI benefits across the board, maybe some rerating, just better quality of earnings. Can you talk about that? Maybe it's already happening.
- [14:32]
Joseph Shaposhnik
Yeah, of course. As I thought about the Magnificent seven coming into the year, I think that we've never seen this level of concentration in the history of the market. The rate of earnings growth and cash flow and rate of earnings growth I should say not cash flow growth as a percentage of The S&P 500 that has gone to the Magnificent 7 had been extraordinary. And valuations x Mag 7 on the Magnificent 493 as we call them had become relative to the Mag 7 very had experienced a very very large divergence. And so we believe that there'd be significant opportunities outside of the Mag 7 because of the percentage of market cap, because of the multiple differential and because we saw a lot of healthy businesses in the 493 that were just not, not seeing they continue to perform well, but they were not seeing the level of appreciation that was occurring in the Mag 7. And so I think we're seeing that businesses outside of the MAG seven have, have begun to perform well. Certainly we saw that over the last year or so or last six months or so. I'm not sure that that means the Mag 7 won't perform well, but I do feel as though there will continue to be a rotation toward regular businesses that have been good businesses that have been left behind by the market over the last couple of years. It reminds me to a certain extent of the rotation that we saw in the year 2000. After multiple years of very, very strong returns for the technology sector, the rest of the market was essentially left behind and the rest of the market benefited greatly from the year 2000 to 2002, 2001, 2002, where there was a significant rotation back to traditional businesses that were performing well. So that, that was the thesis and I think that thesis continues to hold. And at the same time, I think the Mag 7, certainly certain businesses of the Mag 7 will likely continue to do well. So it's not a bearish call on the Mag 7, but it's more of a broadening out of the market that we thought would occur and it seems to be occurring.
- [17:09]
Matt Zigler
There's this really interesting embedded point here. As some of these companies change their business models. We watch an asset light heavy asset light business become an asset heavy business. We watch these things move from just like pure high free cash flow generators to CapEx. CapEx heavy spending on infrastructure. Kaiwu likened it to tech companies becoming utility companies. I'm curious how you contextualize that. Is that a, is that a change in the quality of these businesses? Is that a loss of moat? How do you understand the transformation of some of these names?
- [17:43]
Joseph Shaposhnik
It's an interesting point. I met with Microsoft a couple months, Microsoft Management a couple of months ago and we were talking about their business and I talked about how when we invested in Microsoft in 2015, part of the investment thesis was this is a capital light highly recurring compounding cash flow compounding machine. And I asked them do you think that Microsoft can get back to being a capital light cash flow compounding machine? And their answer was interesting. They thought that at some point capex growth for their business would grow more slowly than the growth rate of the cloud business of, of, of, you know, a business that they're investing a significant amount, a massive amount of capex into today. And that to me says that it's unlikely that Microsoft will get back to being a capital light business for about as far as the eye can see. So these businesses which had been capital light are unlikely to become capital light in the near future. And so in some ways that makes them less attractive. They're just much more capital intensive businesses than they have been for most of their histories. And time will tell which of these businesses will be able to generate the returns necessary to justify hundreds of billions of dollars of capex investment that will need to be sustained for some period of time. And the other challenging part of the investment in some of these businesses is Microsoft as an example is heavily, is heavily tied to the success of a single LLM. So if that LLM doesn't prove out to be the winner of of the AI race, they will have a very hard time justifying the massive investment in capex that they've laid out to support a single customer. And so that's one of the challenges of making investments in the hyperscalers. There's a lot of concentration risk which is not something we particularly like to take on. And it's one of the reasons Microsoft, which had been a top five position for the funds that I've managed over the last 10 years or so, is no longer a top five position because the risk there is more significant than has been the case since we made the investment a long time ago. And so it still may work out well, but it's a riskier, more difficult investment than it has been for many, many years.
- [21:18]
Bogomil Baranowski
Joe, I'm very curious, is there something that we are getting wrong about this cycle? The high capex And I've been thinking about it a lot and Matt and I brought it up with Vitaly Katz and Nelson on the show too. And the more I think about it, I'm trying to see how can we be wrong about it because what is that Capex and is the number we're looking at now, especially the one that's expected in the coming years, is that an accurate number in other way to ask the question, the cost to build out the infrastructure, will it remain so high so that the capex has to be so elevated for so long?
- [21:52]
Joseph Shaposhnik
Well, I don't think it'll remain so high in perpetuity but that doesn't necessarily mean that the historical capital that has already been laid out will generate the level of return that is necessary to make these stocks attractive businesses. So in other words, if a company has laid out 200 or 300 or $500 billion of capex and has bet on one or two significant horses to generate the level of returns that are necessary and those two horses don't prove out to be the winners of the race, then despite the fact that CapEx will normalize at some point in the future, they will have made a very, very large investment that doesn't pay off. I think that where the opportunity to be to take on less risk and benefit from what is a very, very strong cycle and certainly a secular growth End market is on the semi side where you can invest in businesses that have a customer base that is far more diversified, a customer base that is generally healthier and has greater access to capital and has less concentrated sets of capital investors in it. And I think that's a much better opportunity. So if there's anything that I think people could be missing, it's that the suppliers of the picks and shovels are likely to continue to do very, very well because their customer bases are more diversified and they are not laying out massive amounts of capex to drive revenue growth. They're relying on TSMC to do that for them, which has allowed them to generate incredibly high free cash flow growth, incredibly high returns while reinvesting in technology development and being able to generate really, really strong growth and high returns at the same time. So if there's anything that I think is being missed, it's where would you want to allocate capital in a way that will generate high returns and do that in a way that'll be less risky? I think that's a preferred route and certainly we've taken that route.
- [24:27]
Matt Zigler
Take me to this point then. Because the companies make the spend, they bet on the future as they see it, the companies and then us as investors in the market. Are we more likely to be wrong on the magnitude of the ultimate impact of the payoff of these investments, of these projects, or are we more likely to get wrong about the timing of it? Where does this parse out over time? How do we think about it relative to those investments? How do I balance those two things in my mind and understand what's right and what's missing?
- [25:01]
Joseph Shaposhnik
Well, it's producing, it's producing a heck of a lot of growth for, for OpenAI and for some of the other LLMs that are, they're monetizing their IP, they're growing revenue very, very rapidly. They are gaining investments from their suppliers like Microsoft and Nvidia, and they are continuing to be able to generate very, very high rates of revenue growth. The question is, will they be able to generate significant amounts of free cash flow at some point in time? I think they will be. And will we have multiple LLMs at scale that are generating very, very, very, very high rates of free cash flow and returns. The history of the technology sector indicates that it's closer to a winner take all market than it is to a four or five horse race, which is why those that are investing, to your point, so much money into the future are making, making a bet on the duration of, of the cash Flow that's going to be generated by their customers and on specific customers who will win. And you know, it's difficult to know today exactly who will when we have our beliefs. But I wouldn't want to make a significant investment today on predicting exactly who will be the number one player ten years from now. Which is why I think investing behind the suppliers who supply multiple lms today and multiple, multiple hyperscalers today is the better route.
- [27:07]
Matt Zigler
Talk for a second through the software piece. You talked about it before. Some software companies would be able to muddle through or in the middle, but you also, I believe, took down a bunch of your software exposure in mid-2025. I feel like it's related to some
- [27:22]
Joseph Shaposhnik
of this, without a doubt. You know, I think that one of the, one of the, one of the quotes that I, that I really like from Buffett, which I wanted to share and I think is relevant, comes from, I think the 1987 letter where he says, experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or 10 years ago. That is no argument for managerial complacency. Businesses have opportunities to improve service product lines, manufacturing techniques and the like. And obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Therefore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress like business franchise. Such a franchise is usually the key to sustain high returns. What we saw in the middle of the year or the later part of last year was multiple fold. Number one, we had been long term investors in Constellation Software and our CEO had fallen ill and was no longer capable of being CEO of the company. And so because of our discipline, when a CEO leaves, particularly in a very abrupt fashion, that causes us to reevaluate the investment and step back and just take our time before we come back to it. And so, number one, we saw the disruption that AI was likely to bring to many software businesses. Number two, we lost, you know, just an incredible business leader and capital allocator in Mark Leonard. And so we decided to step away from most of those software investments for those two reasons. We continue to study Constellation, we continue to study many of the other software businesses. But it became clear that a large segment of data analytics and software was likely to be significantly disrupted by the lems, particularly as we saw the, the rapidity or the pace at which they, they had improved over just a couple of months. It caused us to question the, the durability of as an example, certainly there's a spectrum here of risk. You've got companies that provide very, very proprietary data and, or software that is very sticky and difficult to disintermediate. So that's on one end of the spectrum. The other end of the spectrum are companies that are providing or packaging up publicly available data and reselling them by putting a nice UI on top of what is publicly, really publicly available data. And so we had always believed that businesses on that end of the spectrum were likely to be disrupted. But what we began to believe were businesses that we thought had contributory data that were the only providers of contributory data. As an example, at some point those contributory services could become disrupted and for the longest time those were thought to be believed. AAA highly durable assets. And it's becoming possible, if not likely that some of those contributory models will be disrupted by AI and the AD the advances that we see among the LLMs. And so as we think about the opportunity, certainly all, certainly all software companies have derated massively over the last nine months. We continue to study the businesses because there will continue to be winners and obviously valuations are as low as they've been in, in a very, very long period of time. And so we're studying those businesses. We've maintained a very small position in, in software, but as, as I think about it, I think it's important to be invested to the extent that somebody chooses to be invested in software in, in businesses that have a learning culture.
- [32:19]
Bogomil Baranowski
Yeah.
- [32:19]
Joseph Shaposhnik
And so as we think about most software businesses, most businesses in general are very top heavy with management making decisions kind of at the top layer and then sending that down to the developers and the engineers. And so in an era of AI and AI disruption, I think there's no substitute for organizations that are decentralized, have appropriate incentives put in place for those decentralized businesses and are a learning culture that have a, a track record in the history of being learning cultures. And so as I think about Constellation Software, I do think about it as being a company that has a learning culture. And certainly they have been studying and deploying AI for a long period of time. And so that does give you some level of confidence and comfort. And I think that the additional piece of news is, or the other thought is who's taking advantage of this disruption today in the software space? And we've gone through now, I would call it half an earnings cycle, maybe an earnings cycle and a half of evaluating results from software businesses. It's so early. You know, we're in the first inning of what will be significant disruption in software from, from new technology. So it's very, very early to make decisions. But I do think it's positive that we see Constellation reorienting to some extent its capital allocation strategy by investing in publicly listed software businesses and taking advantage of far lower valuations than we've seen for a long period of time, particularly in the public market. I think they reported a couple of days ago and they said that valuations in the private market really haven't changed much, which is, you know, that's pretty surprising given the magnitude of the decline in valuations in the public market. But so what, what have they done? They're a learning organization, not just in sharing technology, learnings in the area of AI, which they've done in a very plentiful way, but they've changed in terms of allocating capital. So they've decided now to make permanent investments in public companies. And who is leading that effort? It's Mark Leonard. And so he continues to be involved in the business. And while we're uncertain about where the world is going to go, I certainly like to be aligned with managers and management teams that are evolving as the opportunity set evolves and are not just wedded to the way it's always been done. Because the way it's always been done may not be the right way, especially in a very, very dynamic, in a changing world. I'd also say, you know, for the longest time software was thought to be one of the highest quality business models out there in the world. And I think that there's significant uncertainty about whether that will continue to be the case. And so in the context of far greater future uncertainty, I think that we've prudently reduced our, our risk or we did that many months ago, which I think is proved to be reasonably, reasonably good thing to do given what's occurred in software. But I think that software will be a more competitive industry than it has been. It'll be a more dynamic industry than it has been. And the Buffett quote in terms of rapid change and radical change and that not being particularly good for future returns and the strength of franchises is something that we certainly bear in mind as we make these decisions.
- [36:47]
Bogomil Baranowski
Joe, I can't help but think about the employees of companies and you know, there are all kinds of pieces that have been circulating about the things you talked about about software being under attack in some way, but also about the people like some of the roles, especially entry level. And these times it's the white collar jobs will be gone. And I'm thinking of the K shaped economy that everybody's talking about that I vividly see when I look at earnings. You have companies that clearly are trying to target the lower income part of the society and they're struggling with weaker comps and margin compression and price sensitivity. And then you have companies that are benefiting from people still doing well at the higher income levels. But if the higher income levels group gets affected by companies hiring or firing, hiring fewer and firing more people, do you think it's going to catch up with us in a way that we're not expecting just yet?
- [37:40]
Joseph Shaposhnik
Well, it's a great question and another difficult question to know whether this will actually occur or not. I think one of the most interesting pieces that has come out in response to the Citrini piece is the, is the job opening or job search data coming out of. I think there was a presentation by Citadel, a piece of research that came out by Citadel which said that job openings for programmers and engineers have been growing very, very rapidly over the last six months. So it's possible that AI will make the need for software engineers, the need for developers, the need for those people. It's possible they'll become even more required than they had in the past. I was reading, reading some news out of Amazon yesterday which said that they've experienced a lot of disruption and bugs from the employment of AI in their development processes and they've had to throw a lot of people at fixing those bugs that were created by AI. So it's very possible that certain parts of the economy, the high end of the economy, perhaps they won't become less employable. Perhaps though, employment will be in greater need for, for engineers that really understand AI, it's possible that the high end will continue to, to, to thrive and that that outcome won't occur. With that being said, if the outcome that you describe occurs, I don't think that that's a likely outcome. And of course we have to stay cognizant and on the front foot if, if we're seeing that. But generally speaking, recurring revenue businesses are, they're wide in their exposure across the economy. We, we try to find businesses that are needed by everybody or everybody in a particular market. And if, if we're successful in doing that to the extent that the high
- [40:07]
Matt Zigler
end
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Joseph Shaposhnik
experience pressure, but the low end or the middle part of the economy picks up, hopefully that'll be a wash. But generally speaking, forecasting the economy is a very, very difficult exercise. We try not to do it and we try to be we try to invest in businesses that are agnostic to the outcomes of the economy or different subsegments of the economy. And that's the way we think about it. That's the way we try to deal with it.
- [40:41]
Bogomil Baranowski
It's.
- [40:41]
Joseph Shaposhnik
It's imperfect for sure.
- [40:44]
Matt Zigler
I want to take you a little bit on the philosophical level with this one, but related to that point, which is the fragile, anti. Fragile metaphor, how do we think about that in AI? What makes a company fragile, Fragile as it's pronounced in Italian, as we once were told, versus antifragile, as Nassim Taleb taught us to think about this.
- [41:09]
Joseph Shaposhnik
I like hearing the Italian on the podcast today. I think that you've got to have business processes that are addressed by software that are on one end of the spectrum, highly regulated, tied into multiple systems and processes at your business, non discretionary in nature. In order for your business to operate, this piece of software has to be operational and it has to be core to what you do. You've got to have an organization which is a learning organization. The organization itself should be highly decentralized and incentivized to be very close to the customer and aware of the competition. If you're far away from the customer, if you're centralized in your processes, you are less close to the action, less close to the competitive disruption capabilities of what is going on today. That's not where you want to be. You want to be in organizations that have been deploying AI and testing it and studying it as a part of what they do. And you want to understand that they are using it not just to become more efficient, but also to service the customer in a more efficient way. So that's one end of the spectrum. What do you have that is proprietary and that is highly sticky? The other end of the spectrum, as you said, fragile. I won't try to pronounce the Italian because I, I think I'll massacre it. But if you're just repackaging public data, if you're a financial, if you're a digital service that, that collects financial data and then puts it on a nice user interface and has a subscription business and some folks build models on top of that debt data, I'm pretty certain that your business is going to rapidly change and that your, your ability to price that product where, where it was two years ago is going to change significantly over the next couple of years. Because today the LLMs can do much of that work for you. And the cost of that LLM is a small fraction of, of the tens of thousands of dollars today that financial professionals spend on an annual basis for a subscription to receive that data nicely packaged up so they can use it efficiently. So that end of the spectrum I think is highly fragile. The other end of the spectrum has a reason for being. And then it's going to be about who can deploy the tools efficiently and effectively and compete for the customer in an efficient way. One other anecdote to my discussion with Microsoft that I think is relevant to this conversation, I asked them, a company that I think you can't get closer to, to AI than, than, than Microsoft and what they're working on. I asked them, what tools do your developers use to become more efficient in the development of products? What AI tools are they using? And it took a lot of follow up to get an answer to this question. But what was revealing to me is that Microsoft's engineers today are using the same off the shelf tools that are available to everybody else, that is, that is developing software. So today they have an agent that is working with them side by side. They're using the LLM side by side with the development by the human engineer to develop software. So today there isn't, there aren't proprietary tools that even the best and most well financed developers are using. It's going to be about which teams, which software teams, which companies can more competitively deploy these tools to generate value for their customers. And so as we evaluate companies, we've got to get down to the level of how are their developers using these tools to generate value for customers and hopefully generate value for the company and for investors as well.
- [45:57]
Bogomil Baranowski
Joe, we've been talking a lot about companies that will have to rethink their business models. Maybe they're under attack, under pressure. Do you see some obvious winners in the mix somewhere? And either specific companies, maybe some themes where you see that AI is actually making these businesses better, more powerful. And maybe these are surprising things. I'll mention to you how, you know, I was researching transportation brokers at some point and they pointed out to me that over the previous decade or two, the cost of the phone calls collapsed and then moving things online and having an interface, an app to manage all the, where things are going, where things are coming from as a broker has improved even more. So these are the things that I came across later on, but they were not in the headlines when the Internet bubble was going around. Right? So I'm thinking today what are the things that are happening where you have clear winners, maybe incremental, but still that we're not thinking about not talking about, but they're already gaining something out of it.
- [46:56]
Joseph Shaposhnik
A good question, Bogomil. I think that today the clearest winners, it's very difficult to forecast four or five years out the businesses that will benefit most significantly on the customer side of the deployment of AI. But from my perspective, the clearest winners are still the semiconductor providers of the enabling technologies to drive the LLMs to do what they do. But it's just, it's unclear on the service side who is going to win. I think that one of the end markets that can benefit certainly is industrial distribution. As I think about it, AI and robotics will significantly enhance their ability to be more efficient to deliver product from, from where they are to the customer. And so that's Grainger, Fastenal. Those businesses, I think they will become more efficient, particularly as they deploy robotics in the warehouse, particularly as they deploy autonomous delivery and autonomous driving from the warehouse to the customer. I think they will certainly have the opportunity to benefit. But it's also not so clear. It's very possible that those that benefit the most are open for disruption as well. Perhaps robots will build their own factories or manage their own factories and do the delivery on their own. It's a very much a changing world, so we'll have to see. But certainly businesses can become more efficient and they can thrive to the extent they're not replaced by robots in the future.
- [48:53]
Matt Zigler
Avoiding Skynet and the Battlestar scenario, this idea of expanding the markets, because we've seen this before, productivity enhancing technologies do expand markets over time. This is a thing we've experienced in history before. It's not a complete outlier. So what you were just saying, you could see AI following that pattern that's in here.
- [49:17]
Joseph Shaposhnik
I can certainly see it. I think that the bull case is that we'll become much more efficient across all major markets, across all businesses and that will generate significantly better returns across most businesses. It's early though. What we're seeing out of some of the software companies is that you have to invest ahead of that. And so to the extent companies are playing catch up to get where they need to get to, there is going to be upfront investment to get there. That means AI tools, that means capacity, that probably means more engineers. So it's company dependent and the payoffs maybe some years out before you see the returns. And so it's going to be about who has been investing behind this up to this point, who can balance the investment by becoming more efficient and who's just going to have to make the investment today and hope to reap the returns in the future. But I think that that question and that topic brings me back to management and the importance of investing with great, great managers. And you know, great managers have been investing behind AI for the last several years, not just starting and starting their investment today. I mean, I was talking with a company who is in the software industry, sells a very, very sticky product to the municipal market. And so sometimes companies that sell to the government are somewhat too relaxed. And they said they've only begun to start investing in AI last year. And so that's a company that you've got to be very, very concerned about. Others that have been investing for a long period of time, you get the sense that they have, they're at least on top of it and they're led by people that are thinking about the future and at a minimum, they're paranoid about the future.
- [51:37]
Matt Zigler
I, I think that's a really interesting point. I think a lot about this idea about it was very popular venture capital term of like you jump off the building and then you, you or the mountain and you build the plane on the way down. With the idea being you could go really far, but you also might not build the plane and you crash. And there's a totally different skill set at the manager, at the operator level, at the leadership level between people are trying to like build a bridge before it crashes or build a plane before it crashes and build a bridge where it's like you have some semblance of an idea of where you're going to and there's like a paced ordering of getting out there in front of it. It sort of feels like in this transition, you, you're, you're looking out at some of these bridge building companies and these bridge building CEOs of going don't get out too far but build that productivity into what you're doing. But you, you have to be building, you can't just be sitting still at this point. Is that a fair assessment or is that a useful analogy?
- [52:32]
Joseph Shaposhnik
It's a very fair assessment. And what, what you're trying to do is you're trying to invest with people that have a history of doing that. They have a history of having gone through the transition from on premise to SaaS. They've done that successfully. They've pivoted capital allocation in the past successfully when they ran into a roadblock or an end market where they were saturated. I mean, what comes to mind is, is Hock Tan at Broadcom, where he'd been acquiring businesses in the semiconductor industry for 15 years as CEO of what was called Avago, and then became Broadcom. And he tried to make his largest acquisition, which is Qualcomm, and it was blocked by the government. And he and his team made a decision at that point that pivoting the software and making software acquisitions was a better use of their capital and was an end market where they had done no acquisitions. And so there was opportunity and they made that pivot. And then some years after that, they pivoted to making XPUs. And now XPUs are incredibly important and the backbone of of significant number of hyperscalers. So investing with really, really smart management, that has proven their ability to see somewhat as you, as you said, building that bridge, you're not quite sure, but they're making the investments to be there. Investing with those types of people has proven to be a really good strategy. And I bring up the new concept that Constellation is, is putting forward, which is making these permanent investments, permanent minority investments in public companies. It's not clear that this is going to work. It's not clear that they'll be able to allocate a significant amount of capital to this end market. But what does give you some confidence is that this is a team that has made the pivots in the past and is attempting to make somewhat of a pivot or just an innovation to what they do in terms of capital allocation. They're not standing still, and that's what you need to be invested behind. I believe those types of leaders and managers in a, in an age of disruption.
- [55:13]
Bogomil Baranowski
You know, Joe, I'm thinking about the other technological evolutions and the companies that laid the foundations. The big investments were not necessarily the ones that would capture value. We had railroads, but it wasn't railroads that at the end of the day captured the value. It was the businesses, the cities, the companies that got connected with the railroads. I'm trying to find some parallels and what I'm thinking about with AI, we're thinking about a handful of companies that are providing it, a handful of companies that are providing equipment for it to run, a couple of incumbents that are trying to keep up with what's going on. And I'm thinking, are we missing a bigger phenomenon? I'll mention to you in a little anecdote. I try all kinds of research software, and only a few days ago, mat probably knows about it by now, but I was talking to a founder of a tiny little research provider that does a couple of tricks that I think are super helpful for stock analysts. But I'm talking to him and he's changing the app as we go based on the request that I have. And I was just blown away, a couple of guys out of probably their dorm room running this thing. And it made me think, are we going to see this wave of innovation that will be very different in the sense that it will be thousands of little software providers based on the infrastructure that somebody else paid for. But they might never scale to be multi billion dollar companies. They don't have to be. I'm thinking that something like that maybe happen in food and beverage. You know, we have Coca Cola, but then now when you go to the store you have all kinds of smaller brands that are very specialized. They will never be billion dollar brands. Is something happening here? I know it's, I'm asking you about telling us the future, but I'm just observing something that makes me stop, you know, pause and ponder.
- [56:51]
Joseph Shaposhnik
Well, it's a great question. I'm not so sure I think about it that way. I think about it, I think about speed and maybe that's related to what you're referring to. I just think the speed with which businesses and software will be developed has rapidly increased and is likely to rapidly increase into the future. And the ability to develop new products, the ability to debug existing products, the ability to service the customer, to receive the input and then know how to respond to the customer, I think will be the time to do that will dramatically drop. And I think that will make for a really wonderful world where service will be much better. As you said, the rate of iterating on new ideas will dramatically increase. And I think that that makes for a better world, a richer pie for companies to go after. I think it, it certainly reduces the barriers to entry in a lot of businesses. And I think you're implying that with your question. It certainly reduces the barriers to entry. It certainly increases the rate at which or the time to market that many companies can get to. And I think it makes for a very dynamic, very entrepreneurial environment where great teams will be able to scale, I think more quickly than they have in the past.
- [58:44]
Bogomil Baranowski
Just a quick thought. I think we sometimes get lost with the excitement of the innovation, both as consumers and investors. And I'm thinking that we kind of have to like shake and wake up for a second because at the end of the day we're trying to find cash flows, right? And if you can get sustainable cash flows with decent returns in a business that's almost absolutely not exposed to AI, which is hard to do these days, but if there is One this is as attractive, not attractive as a company that's trying to figure out how the product should be looking minute to minute, day to day because the consumer is willing to go to the competition. I want to emphasize that because we are so excited about this innovation. But then are there profits? Are they sustainable? And you might have those in businesses, the 493 that you mentioned. 493 companies much more than in the 7. I don't want to make any predictions, but it's just a hint I think
- [59:37]
Joseph Shaposhnik
that your, your view or, or your conclusion that there'll be a lot of, there'll be a lot of value generated from utilizing the innovations that the, the seven have developed over the next 10 to 15 years is right on. There's no, there's no doubt they, they have laid the, the railroads out there for all of the entrepreneurs out there to, to, to see and to use. And one can only imagine the new products, new businesses, innovations that'll be, that'll be developed. I mean I've give you a very simple innovation which has been a game changer for us is just the ability to interact with your CRM using natural language is the most basic of, of innovations. You know, before you, you had to go through and, and click through all kinds of menus to, to put somebody into your CRM or to, to edit your CRM or add somebody to your database. Now you can just go to Claude and instruct Claude to do X, Y and Z and it does it. And that's incredibly valuable. Just the most simple of APIs has been very, very helpful. One can only imagine five years from now how much better our lives will be and the kinds of businesses that will be created and the improvement to the existing businesses to the extent they can leverage AI, how much better those businesses can get to the extent that they can leverage it while protecting proprietary data, proprietary IP that of course they seek to monetize. I just couldn't be more excited about it. And I think the investment opportunities will also be really, really significant and it'll be on us to kind of sift through which one of these businesses can generate real cash flow for a sustainable period of time when and many won't. And so that'll be on us to figure out.
- [61:54]
Podcast Disclaimer/Advertiser
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- [62:23]
Matt Zigler
Inside of this theme of long term compounders, it seems like that next generation of long term compounders are the ones forward. It's the companies who make the best use of the best available tools. It sounds like that's something you're looking for because it doesn't matter how boring or non sexy your business is or how top of the world fascinating topical headline generating it is, it's just, are you making great use of great tools to actually drive capital allocation and drive profitability? Is that what I should take away from this?
- [62:53]
Joseph Shaposhnik
Yeah, I think that, I think that's right. Look, we don't want run a top down portfolio. We, we certainly run a bottoms up portfolio looking for recurring revenue businesses that are run by great leaders that can generate free cash flow for long periods of time. And so I don't want this conversation to lead people to believe that we're obsessively focused with investing in AI businesses. We're not. We're looking for businesses that, that, that meet that criteria and they happen to come from many different sectors. For sure. We talked about one of the themes which is aerospace and defense and you know, unclear exactly how that'll be impacted by AI today. Certainly I think there would be lots of opportunity for the incorporation of, of autonomous vehicles, autonomous navigation and, and many other incorporations of IT in defense. But you know, we're looking for businesses that are generating free cash flow today. And so that's one of the end markets that we think is really, really attractive. But as we think about businesses, one of those questions is how are you incorporating AI into what you do? What's your plan for becoming more efficient in serving your customer more effectively with the technology that is available today and will be available in the not too distant future. So it's certainly a topic of conversation. But we're not building a portfolio with a top down view of trying to find direct beneficiaries of the technology. We will certainly look forward to the extent we find it, we'll look at it, but it's a very broad world out there and so there are great opportunities and a lot of different end markets and certainly we're looking for that and thinking about how AI will impact and benefit businesses over the long term. For sure.
- [65:01]
Matt Zigler
Joe, if people want to bug you on the Internet, find more about your fund that you're writing all the things, where do you want to send them.
- [65:08]
Joseph Shaposhnik
Oh God, they should. They should. They should feel free to debug us anytime. They they should go to the website rainwater, etf.com LinkedIn, Twitter. God knows what other platforms we're on as well. But yeah, definitely you can find us on any of the platforms and certainly the website is probably a great place to start.
- [65:29]
Matt Zigler
You want to be following along with it, what him and the firm are doing. It's so cool Joe, and thanks again for the time on this. To see people who are taking these older disciplines the ways to think about recurring revenue and navigating between the Iran conflict, between AI, between the Trini piece into this work process. Infinitely useful. Thank you so much for coming back onto XS Returns. Like subscribe, comment, all the things below. See you guys real soon.
- [65:56]
Podcast Outro
Thank you for tuning in to 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 XS Returns network at XS Returns. If you have any feedback or questions, you can contact us at excess returnspod@gmail.com.
- [66:14]
Podcast Disclaimer/Advertiser
no information on this podcast should be
- [66:16]
Matt Zigler
construed as investment advice.
- [66:19]
Podcast Disclaimer/Advertiser
Securities discussed in the podcast may be
- [66:21]
Matt Zigler
holdings of the firms of the hosts or their clients.