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Successful innovations make life better for customers, but that doesn’t necessarily make those companies good investments.
“In some cases, innovation just helps all of us have a higher quality of life, and that doesn’t mean that directly there’s an investment or a company that flows from that that tailwind,” Dennis Lynch, head of Counterpoint Global, Morgan Stanley Investment Management, said at the Morningstar Investment Conference on Thursday. His team runs several growth equity strategies for Morgan Stanley, including Morgan Stanley Institutional Inception Portfolio
MSSMX,
which had an average annual return of 49.71% through the end of August, compared to a 12.27% annual gain for the Russell 2000 Growth Index.
RUO,
Electric vehicles is one sector like that, and it’s why Lynch sold all his shares in Tesla
TSLA,
several years ago.
Lynch said he owned shares of the electric vehicle maker in a “small, speculative position” when the first Consumer Reports review of the car came out, about a half-dozen years ago. At the time, the company started to have “a real revenue stream in front of it,” he said.
The team sold the shares after about three years, missing most of the run-up in the car maker’s stock price.
In explaining his decision, Lynch said selling cars is a tough business, and electric cars means selling vehicles that are expensive for the average consumer and require financing.
It also comes down to one of his metrics he uses to value a disruptive company: focusing on unit economics.
Tesla has high capital intensity and constantly needs to get funding from the capital markets. That “isn’t necessarily bad, but it does put you in a position of potentially, during times of uncertainty, of relying on the kindness of strangers to continue that to continue the business model,” he said.
Lynch acknowledged that founder Elon Musk has done “really amazing things.” But he goes back to whether the company can be profitable.
“When you rely on capital markets, and you’re dreaming big, there’s a fine line between inspiring and making promises that maybe you can’t keep,” he said.
“We’ve been wrong in the sense that the [stock price] since we sold has done extraordinarily well,” he said. “But I think that’s one area that it’s really going to be hard to pick an ultimate winner, especially at today’s prices,” he said.
Lynch spoke at a panel on disruptive companies with Bill Nygren, a high-profile portfolio manager and chief investment officer of U.S. equities at Oakmark Funds, a value-fund manager. Nygren had his own take on disruptive companies, noting that investors often overlook the larger companies in the space that may be innovating themselves.
One example is Allison Transmission
ALSN,
which makes make transmissions for heavy-duty, off-road trucks, including fully integrated electric axles, he said. The Oakmark Select fund
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owns shares in the Indianapolis-based firm.
Oakmark Select is up an annualized 13.14% over three years through the end of August, lagging behind the S&P 500 index
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but has bested the index since its inception in November 1996 with an annualized return of 12.46%.
The move to electric vehicles will dramatically change that business, Nygren said, but he points out the entire valuation of newer companies in the space is similar to just what the market values Allison’s electric vehicle production, based on valuations being a multiple of the money spent on research and development. “You could argue that the market is valuing Allison’s EV business similarly to how the other pure EV companies are being valued,” he said.
As a value manager, Nygren’s team analyzes stocks with a forecast that goes out about seven years at most, and won’t invest in something they can justify at current prices, such as bitcoin
BTCUSD,
“We’re just we’re happy opting out. And I think people would be wise to not listen to me on topics where we’ve just decided we don’t know enough to make an investment,” he added.
Lynch, on the other hand, said he isn’t against taking a chance on a company that is unproven. His team is willing to make small bets on companies on hopes to win big, rather making a binary choice or owning or not owning a stock.
“Owing a little bit of something where things can go right, but also knowing that there’s some things that go can go wrong is not unreasonable when you have a world that has such disruption occurring, and where these upside scenarios wind up being so large,” he said.
Lynch has small positions in bitcoin and Square
SQ,
because of its exposure to cryptocurrencies. Bitcoin has persistence as a trend, one of the metrics he uses when looking at innovation. Discussion about cryptocurrencies rise and fall with prices, with some detractors saying it won’t last each time it falls, only to rebound. “I like to say that bitcoin is kind of like Kenny from South Park, you know, the guy dies every episode and he’s back again,” he says.
He called bitcoin “anti-fragile,” something that gains from disorder, which he also likes as a potential diversifier. One major risk is that governments could ban these alternative currencies, Lynch said, but overall, a small speculative position is worth having.
“It kind of sits in the portfolio in a small manner, that it possibly is something that can go right when the rest of our portfolios having something go wrong…. Ten years from now, given bitcoin’s persistence, is worth a small speculation,” he said.
