As the COVID-19 pandemic continues to affect the global markets, is there a common set of attributes that can help companies be resilient and even succeed? We address this question with our guest Ozo Jaculewicz, Associate Portfolio Manager and Senior Portfolio Specialist for the Fundamental Growth Equity Team at Wells Fargo Asset Management.

 

John Natale: I’m John Natale, and you are listening to the podcast On the Trading Desk®. As the COVID-19 pandemic continues to affect the global markets, is there a common set of attributes that can help companies be resilient and even succeed?

Today’s guest says the answer may lie in how well a company has prepared itself to operate in times of slow growth and rapid digital transformation. Joining us today is Ozo Jaculewicz, Associate Portfolio Manager and Senior Portfolio Specialist for the Fundamental Growth Equity Team at Wells Fargo Asset Management. Ozo, welcome to On the Trading Desk. How are you doing?

Ozo Jaculewicz: Thank you very much. John. I’m doing well. Like all of us, adjusting to a bit of cabin fever and restless, but just very thankful to be healthy and thankful for all the first responders, as we know across so many industries, that are helping us.

John: Couldn’t have said it better. Thanks, Ozo. Glad to hear it. So even before the pandemic began, we had been witnessing a stark contrast in the stories of companies that either have or have not been preparing themselves for a light speed shift to an economy that’s digital and yet slowing growth. And about a year ago, your team introduced this concept to the world and called it “the right side of change.” Can you illustrate this concept for our listeners?

Ozo: Happy to, John. Yeah, it really sort of struck from a conversation with my investment team led by Mike Smith and Chris Warner, our portfolio managers. There was a roaring debate in the last couple of years involving kind of growth versus value and a lot of labels and acronyms and buzzwords, and it just felt incomplete to us. It felt like there was something bigger going on, and we are a team of stock pickers. We’re not macro forecasters, but we kept hearing the same thread from all of our companies.

And so we stepped back and we came up with this simple framework called investing on the right side of change. And really all it means is the pace of economic growth is slowing, and at the same time, the pace of technological change is accelerating. And in the history of our country, we’ve had times of innovation and times of slow growth, but never to the same magnitude happening simultaneously.

So what that did is it created a growth-starved world where a scarcity premium was awarded to those companies that were the disruptors, that had digital advantages, that were innovative, and that ultimately would have durable fundamentals.

Because of this data revolution that you mentioned that’s causing structural changes throughout the economy, we felt it was broadening out and this framework helped us capture that.

One of the CEOs of one of our portfolio companies said to us there’s only three types of companies: Companies that are technology companies, companies that are becoming technology companies, and companies that are being disrupted by technology companies. And it just struck us that the importance of this digital transformation would make this environment sort of feel more secular than cyclical, John.

John: That’s really interesting, looking at it from a big picture standpoint, and I would imagine it’s only become more relevant now.

So Ozo, can we talk about investing on the right side of change in the current environment, the COVID-19 era. On so many levels, we’ve seen a dramatic shift in how we live, work, learn, and interact with one another, not to mention in how we take care of ourselves and the people we care about. Everything is changing. And the effects of social distancing, shelters in place, and any other variable that’s keeping folks at home, they were abrupt. It really felt like there was no gradual element to how we adapted to that shift. So what does that mean for a company that’s operating on the right side of change and operating in the current market environment?

Ozo: It’s a great question, John. And obviously, this is a global health crisis and it came at unimaginable speed, as you mentioned. There are so many of us sort of dealing with the disease that in some way some of these investment discussions sort of pale in comparison.

But the truth is for our investing style, we saw meaningful outperformance during the market volatility from these businesses on the right side of change. And essentially what we’re seeing now, John, is that this COVID crisis is actually accelerating demand and accelerating growth for a lot of the companies that we already owned in our portfolio. These management teams, we call them digitally native companies. Many of our companies were already transformed to have a digital product or service. They’re fast-moving and adaptive companies.

So let’s talk about a couple of examples. The first one is really obvious and that’s Zoom Video as a beneficiary in this environment. The way I want to think about Zoom is, let’s put it in context for a minute. We’ve talked in the past about a shrinking window of mass adoption. And what we mean by that is that past innovations like the telephone or the television took decades to reach mass adoption. The Internet reached mass adoption in seven years. The iPhone reached mass adoption in just over two years, so massive acceleration. Well, Zoom Video, which has now essentially become a verb like Xerox and Google, is an obvious winner in this environment and we’ve seen that window shrink even faster. John, between 2014 and 2015, the number of annual meeting participants using Zoom tripled from 30 million to 100 million in 2015. In March 2020, during the COVID crisis, Zoom reported more than 200 million meeting participants every single day. Essentially, we saw years of growth pulled forward, and this window of mass adoption shrink even faster to literally a few months.

Another fairly obvious example is in streaming entertainment. As beneficiaries, we’re all home. We’re all watching content, many of it streaming, and Netflix is obviously on the right side of change. Theaters are becoming on the wrong side of change, and this was happening even before COVID. One of the biggest films last year was called The Irishman by Martin Scorsese. It was a big-budget tent-pole movie with a massive cast, but Netflix bought the rights to that film, and it was barely in theaters. Almost 100% of the viewership of that film happened at home. Netflix was already winning.

The COVID environment is only accelerating that trend of streaming entertainment. What we’ve seen with the growth of some of the streaming options on movies like Frozen II from Disney+ or Trolls World Tour online, which racked up $100 million in digital rentals in just three weeks during coronavirus, which was more than the previous Trolls movie did in box office receipts in five months, is showing that there is this acceleration of content.

Now more specifically to Netflix, this massive library of original content is such a huge advantage. The network studios are closed, and their subscriber growth has taken off. Last quarter, there was an expectation for about 7 million of new subscribers in North America. They did 16 million of new subscribers last quarter. It’s accelerating the trends of cord-cutting. They launched huge hits of new content, whether it’s Cheer or Tiger King or Ozark. And what people don’t understand is there’s this magic number. As a global subscribers for Netflix approaches 200 million, the profitability of each incremental subscriber takes off. It explodes, and there’s really a lot of leverage in that business model that we’re excited about, John.

John: Fascinating. And the growth stories you’re talking about, their impact seems to go beyond these important performance metrics, be it the number of subscribers or paid users. The use cases for their products and services are also growing. Think about it. Presume it’s not just about the enterprise client. The user base includes online learners from K to 12 through higher education. And for Netflix, well, the use case isn’t just entertainment for entertainment’s sake. In fact, it’s incredibly helpful for parents—you’ve already done the day’s e-curriculum with their kids and perhaps they just need 20 minutes for a quick Zoom meeting.

So Ozo, thinking about other facets of our everyday operations, in life or in commerce, are there other examples of right side of change companies who have shown resilience and even growth during these tough times?

Ozo: John, I agree with all of those observations. Those are great points. And the change is so pervasive throughout enterprises and consumers, we could talk for an hour about the amount of investing that’s going to need to happen in IT spending for cloud conversion, cloud infrastructure, and there’s going to be trillions of dollars in cloud software across the supply chain.

But let’s talk about healthcare for a minute. I think that’s a really interesting area that’s going to see this COVID environment accelerate the change, and I want to profile a company in our portfolios called Dexcom. Dexcom makes wearable sensors, and they build software to help diabetes patients manage and treat their diabetes. They have a wireless app that runs on a smartphone, which allows for continuous glucose monitoring in a really efficient and innovative way.

And this is a massive market. There’s over 400 million worldwide diabetics, and right now, Dexcom is only serving a small fraction of this market that happens to be growing quite fast. It’s a company with very innovative, leading products with a lot of cash on their balance sheet. And differing treatment for diabetes is not an option, so people are not going to stop treating this in a COVID environment.

And what’s happening is the replacement cycle from the old standard of care of finger pricks to Dexcom’s digital sensors is accelerating. It’s part of this move towards virtual medicine, remote medicine, telemedicine, using digital tools in a COVID world. We think those kinds of businesses are resilient, durable, and, frankly, pretty scarce. And that’s why Dexcom is a really good example of a right side of change company, treating a major healthcare category that we continue to think will have exciting growth.

And then let’s shift to another area that’s a little bit more fun to talk about, John, and that’s video games. I think this is a fascinating area of right side of change investing and one definitely being impacted also by the COVID environment.

Video games used to be sort of a lumpy, hit-driven business, almost like the movie theaters that we talked about. They sold cartridges that were analog. A few years ago, the video game industry went through a massive shift to digital downloads, and when this happened, John, it made for a digital connection between the publishers—the software companies—and their consumers that was 24/7, 365 days a year.

As a result, video gaming became a category that was winning the battle for consumer time, even before COVID. And what was happening is that video game usage has really taken off, especially in this environment.

And right now, with everyone sheltered in place and at home, what we’re seeing happening with video games is they’re becoming truly a platform for people to communicate. People are connecting with their friends, even more so than texting or social media. Among a certain generation, now video games are becoming social networks, and these companies remember they have digital payments embedded into these platforms, which allow for constant monetization for the companies that develop these games.

So instead of passive scrolling through videos or TikTok or YouTube, video games are, in many cases, more of a goal-oriented, socializing communication tool and we’re seeing an environment where even concerts, and possibly sports, will be viewed on these video game platforms, because that’s where the growth is. That’s where the eyeballs are.

So now transitioning a little bit more to a specific investment we have related to this video game theme is Nintendo. Nintendo is one of the largest and most iconic legacy video game manufacturers in the industry. Nintendo owns 6 of the top 10 selling video game franchises in the history of the industry, Super Mario Bros., Zelda, Pokémon, and others. What’s happening right now is that Nintendo is taking this massive library of content, this intellectual property, and they were launching it in new platforms on mobile devices, on smartphones, and also on the Switch console system.

The Switch system has been a major success for Nintendo. It’s a hybrid system that can be used both as an at-home console and on-the-go tablet. What we’re saying for the Switch is, frankly, it’s been sold out since the COVID crisis happened. Hardware manufacturers can’t get enough supplies and the retailers are out of it. We’ve seen some data recently that hardware spending in March grew by 63% for consoles, and sales for the Nintendo Switch more than doubled compared to the year before. We’re seeing this explosion of video gaming in the consoles and they’re becoming platform companies. And we think companies like Nintendo are extremely well-positioned with their content, even after the COVID environment passes.

John: So Ozo, as you talk about these companies that reside on the right side of change, I’m mentally connecting the dots between their pre-pandemic actions and how they’re faring today, but that, of course, is with the benefit of hindsight. You and your colleagues on the Fundamental Growth Equity Team have been studying companies with these attributes for quite some time. So can you please tell a story for our listeners that shows how your team and the various skills that they bring to the table can pinpoint a company that shows that potential for being on the right side of change?

Ozo: Happy to, John. It really comes back to the legacy of the Fundamental Growth Equity Team that I’m a part of. It’s an investment process that’s been around for decades, and Mike Smith is our leader of the team and he’s been investing in this discipline for over 20 years. We have a team of 10 research analysts, 2 portfolio managers, and what we do, John, is we turn over a lot of stones. We study industries, and we look for change in a very deep way.

We believe that these businesses on the right side of change can compound earnings at a superior rate over time and what we’re doing is we’re looking for a mispricing of those companies.

Think about a microscope, John. If you were to take a microscope and put different lenses on it and apply it to different parts of a company, that’s how we do our research. We think about a business from the perspective of employees. What’s the management culture? What’s the competitive landscape? How do their suppliers interact with them? How do their competitors perceive them? Each one of those lenses allows us to find something misperceived or mispriced about a growth stock and, frankly, it comes, John, from doing many years of this type of research and it also involves a bit of creative freedom.

We are not an investment process, John, that has one quantitative screen that dictates what right side of change looks like. We have a non-formulaic approach. It’s more qualitative. We cast a wide net. We look for disruption. We look for innovation. We study the balance sheet. I’ll just end by saying the last thing we do is we build a portfolio striving for consistency. We want a balance of risk and reward.

So yes, we have these fast-growing innovative companies like the Nintendos and Netflix, but we also have some more idiosyncratic stocks in our portfolio. Stocks that are kind of more misunderstood that have their own drivers, that aren’t reliant on so much of the macro-economy, but are also on the right side of change.

And we put that portfolio together with the experience and the approach that I mentioned, we’re able to achieve investment objectives for our clients over the long-term.

John: Thank you for that added insight, Ozo. It’s always interesting for me to learn about how ideas are shared, supported, and then cultivated into something big. What you described speaks not only to capabilities and skill sets, but also culture, and that matters a lot right now. So on that note, I’d like to thank you for joining us on our podcast. We appreciate your time and insights, and I hope that you’ll join us again in the future.

Ozo: Thank you. It’s my pleasure, John. Hope to be on again in the future.

John: Well, that wraps up this episode of the On the Trading Desk podcast. To our listeners, thank you for taking the time to listen. Time is precious these days and we’re grateful that you choose to spend some of it with us. Until next time, I’m John Natale; be well.

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