Anna Macdonald and Mikhail Zverev: Investing in innovative new frontiers

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Transcript

Merryn Somerset Webb: Hello and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. We are talking on May 12th 2022. And I think I better set the scene slightly because it has been quite a rough week for markets. S&P was down another 1.6% last night. Now down 17% year to date. And Nasdaq is down nearly 30%. And even the FTSE 100, which has put up a brave fight this year, is down 2%.

Small-cap in the UK down about 12%. And of course bitcoin, which I'm sure not very many MoneyWeek readers hold in volume, has proved itself to be definitely not the new gold, down 37% this year, 23% in the last five days alone. Against that backdrop and hopefully to talk about some jollier stuff, I have with me, Anna Macdonald of Amati Global Investors. I think a lot of you will know Anna. She's been on the podcast before. She, I think, must have written in the magazine, mustn’t you, Anna?

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Anna Macdonald: I have done, yes.

Mikhail Zverev: And if you are up early in the morning, you will often hear Anna being clever on the radio. She runs Amati’s very successful small-cap fund. Also with us today is Mikhail Zverev, who is in the process of launching a new fund for Amati based on innovation. This will be a global fund. Mikhail, thank you very much for joining us today.

Mikhail: Thanks for having me.

Merryn: Let's start, Mikhail. Why don't you tell us about the new fund? Because I think we're all fascinated by the idea that there is someone out there who looks at the numbers that I've just given at the beginning and says, I know what I'll do. I’ll launch an innovation, growth-focused global fund into a tech selloff.

Mikhail: It sounds counterintuitive and in some ways, it's actually a, in our opinion, very interesting opportunity to start. First thing, just to set the scene, it's a specialist global portfolio. It's not a single sector or a single theme fund. For example, at the moment, the portfolio has six sectors represented. But we're looking for innovative businesses, launching new innovative products, services and deploying innovative business models that make a real difference to meaningful-size markets.

The address and where the implication of that innovation is not priced in by the consensus. That’s the headline objective, what we're looking to do. And of course, we're looking to outperform the markets through that strategy. But there are a couple of reasons why, both on the long-term view and if you like, in the moment, it could be quite an interesting point to start. And I'm happy to elaborate on any of those.

Merryn: Yes, please. I’ll tell you what, tell us the long term first and then we’d all be fascinated by the short term too.

Mikhail: There's a combination of personal experience and the team behind the fund have quite a few decades of investing in change, in technological change and innovation-oriented areas. And we've experienced that market is not very good at pricing in the implications of innovation. It brings about change. It brings about uncertainty. It's complex. It often impacts across different domains, across different sectors.

And markets are biased and not always particularly good at pricing those things in. Investors are averse to complexity. Investors are averse to uncertainty. And investors do not read across effectively between different sectors. All those things, in our experience, create inefficiency, which of course we’re looking to exploit for our clients and generate off of that way.

But it's interesting that there's a growing body of relatively young, but very thorough academic evidence that looks at different metrics of innovation on the corporate level and observes exactly what we said. That through the empirical quantitative studies, it's clear that market is inefficient in pricing in impact of innovation. And often, if you read those papers, which we of course had, they cite the same behavioural biases.

Complexity aversion, uncertainty aversion, anchoring, inability to read across different domains. The way academic finance puts it, attention span deficit.

Merryn: Can I stop you there, Mikhail, and ask you, how is it that you will be able to overcome these biases that other people cannot?

Mikhail: One is just the process design. If you actively apply yourself to innovation, if you say we are looking for areas of material innovation that's making a difference, this is the purpose of this process, then you, by design, bias yourself towards that. That's point one. The second one, you want to put yourself in the position of informational advantage. You want to build a network of knowledge around you that is better than the average investor in understanding that innovation.

And here, Amati makes a real difference. UK is a global centre of excellence in a number of innovative industries, life sciences, material sciences, areas of tech, industrial. It's actually quite a well-rounded innovator base. In some ways, leading the world, in some rankings, leading the world in that.

Having a very successful, very well-connected smaller companies and venture capital trust business in this market puts us in direct, constant contact with fund entrepreneurs, with technical talent, with senior execs in companies at the leading edge of that innovation. And we take that knowledge, we take that understanding and apply that to the global opportunity set.

Merryn: That's quite interesting. It’s not a popular view that the UK is a leading global centre of innovation and a world leader in quite a few of these metrics. Would you expect the final portfolio to have a bias towards the UK?

Mikhail: No, I don't think so. And you wouldn't expect us. We have a fantastic UK smaller companies and venture capital trust product that captures that already. But if I may disagree with you with the nuance, I think a lot of criticism of the UK on the innovation front is the country invents a lot of things, but not often good at commercialising them on an American level. It doesn't create Googles. I'll give you a few examples that will be instantly recognisable.

ARM Holdings designs processors that run a global smartphone ecosystem. The Illumina gene sequencing technology wasn't invented in the UK, albeit sold to Illumina, which was the US company, of course. DeepMind, which is one of the leading lights in artificial intelligence, was sold to Google. Again, case in point. At the early stage, there's an awful lot of really interesting insight and knowledge. It's scaling up to global giants where UK sometimes falls down, but not necessarily…

Merryn: Is there a quick and easy explanation for that?

Mikhail: Some of that is a depth of capital markets. Some of that is the magic positive feedback loop of, the more people invest in scaling it up to the global scale, the more money they have and they’re successful to invest in the next chapter. This is my hypothesis.

Anna: I think from looking at it from when companies, much smaller companies are looking for backing, it is available. Obviously, this is what our venture capital trust, the Amati AIM VCT tries to exploit. And for qualifying companies, that's all fine. But it's often when a company really does need to take that leap of faith and sometimes those funds are just not there because I think… I don't know. I think sometimes our investor base is much more directed towards more stable equities paying dividends.

And sometimes they're not quite so willing to take that leap of faith. Whereas you hear from the US that they will quite happily invest in a lot of different ventures, happily knowing that some will fail.

Merryn: … too cautious..?

Anna: Maybe. I don't know if Mikhail agrees. I just do think that sometimes it can be quite hard for companies to perhaps achieve some of the valuations they deserve. But maybe not. We often hear of companies trying to do a list so that they can get the Nasdaq valuation. But that doesn't always work for the best either and it's actually quite an expensive and difficult thing to do. It's just I think sometimes there isn't that enthusiasm in the UK, particularly for further rounds of fundraising that might be required.

Which wouldn't perhaps attract the same tax advantages as those initial raises can do.

Merryn: Even less enthusiastic now. Mikhail, I'm sorry I interrupted you. You were going to tell us about the short-term opportunity as well.

Mikhail: Yes. Thanks for that. Just to finish off that point, we don't depend on… Although we wish that UK companies proceed to the global scale while staying UK-listed. But we don't depend on that because the value of that connection to the grassroots understanding of innovation, it gives us stock ideas, specifically in the UK. It gives us insights that we can apply to the global opportunity set and then pick a European company or a US company, an Asian company that is best positioned to exploit that innovation.

But to address your other question, it's an interesting time. Obviously, you'd think other opportunities because of the selloff and we will be selective around that. But I think there's a bigger thing at play. I think for the last three, five years, investing in innovation focussed on a very particular camp of stocks exposed to innovation. We refer to them internally as pioneers. Leading edge, leading light, often concept, often pre-earnings, often pre-cash flows, very fast-growing immature business models that invented the thing.

Whatever the thing might be that were creating that innovation. And they were very high growth and, like I said, low profitability and low cash generation, which in the low interest rate environment thrived. And in some cases, consistently accessed capital markets to keep growing when they couldn't generate cash themselves. I think the next ten years will be quite different. The macroeconomic stability and political stability and the low interest rate environment we've come to rely on is no longer a given.

And I think investors will still want and we would still believe innovation is worth tapping as a source of value and source of alpha. But you have to be more quality-aware and more valuation-aware when you go about that. And that is how we designed this approach and this is how we address it.

Merryn: Can we move on then to talk a little about the sectors that you think you're going to be finding interesting?

Mikhail: The way we approach this, we start with innovation. We say, what is the, what we call it, innovation frontier that's exciting to us? That there's something that's being done that's very different, improves cost, improves functionality, addresses meaningful market and importantly, is already happening. We're not looking into ten-year out conjecture. We are interested in something that's already gaining traction and adoption, just not…

As we call it, the future is already here. It's not very equally distributed, which I think is a science-fiction author quote. We're looking for those things. And if I pick a couple of innovation frontiers we’re really interested in, one actually quite close to the business you guys are in, is the evolution of digital advertising on the open web for publishers, other than big platforms like Facebook or Meta and Alphabet. And what we mean by that is there's a lot of change in how the targeting and efficiency metrics, targetability metrics on the open web work.

Cookies are being phased out for all the right reasons. IDFA, which is equivalent to cookie on the mobile device, is being phased out. There's a lot of money that's invested in online advertising, looking for new mechanisms and new places to apply itself. And we're looking at first-party publishers like yourself, which are in a very good position in the space. We're looking at native advertising providers. We're looking at digital trade advertising. Lots of interesting niche business models which might benefit from that.

Merryn: Anna, you're investing in this space in the UK, aren't you?

Anna: Yes, we have an investment we took at IPO just over a year ago called Dianomi. And it's been really interesting talking to Mikhail about that stock and comparing it to the much bigger providers such as Outbrain and Taboola, which seem to sometimes… Whilst they do obviously increase advertising income for the publishers that they work with, we and Dianomi both think that some of the ads that they put onto various websites are a little bit spurious a little bit.

But they can seem quite click-baity. Whereas what Dianomi has done is built a really robust and scalable platform with some really premium publishers such as The Times and Bloomberg. And they've linked that together with really relevant advertisers such as wealth managers and investment platforms, companies such as St. James's Place and Invesco. And they have a direct relationship with them and can really channel some very premium readers.

In fact, I think they work with The Week and MoneyWeek readers as well. If you're all lined on your platforms, you will be able to see some advertising delivered through the Dianomi platform. And most of their exposure is in North America. And they are now doing some more programmatic advertising. But still, what they're going to be able to deliver is really premium-level… They're going to link premium content to the premium advertisers that want people to see relevant things.

And they've started working mostly in the financial segments, but they're also expanding into premium lifestyle, lovely holidays and things like that.

Merryn: They sound nice right now.

Anna: I know. I was just thinking that.

Merryn: Don’t mention any more luxury holidays. Mikhail, another area that we've talked about before, I know you're interested in, is the digitalisation of law enforcement. Tell us about the innovations that you're seeing there.

Mikhail: I mentioned earlier that a lot of investors focus on companies that invent things and those are high-growth, not very mature businesses. And they go through their growing pains and last 12 months really have not been very helpful for that. As I mentioned before, our approach looks a little bit broader. And one of the questions we ask is, who are the enablers of innovation, the picks-and-shovels suppliers? Which sidesteps some of that early-stage immaturity risk.

But also, who are the, what we call, adopters of innovation? If you have an incumbency, if you have a footprint of your business that is particularly valuable if this new innovation is going to be applied to something, if you've got client base and stall base network of dealers, whatever it might be, and you put that innovation through it, and it becomes really valuable. One such example of this adopter is a company called Motorola Solutions, which is a really fable-storied company.

But at the moment… If we had this conversation three, four years ago, their core business was running emergency communications for first responders. The walkie-talkies, the high-performance radios, both handsets and network equipment for firefighters, ambulance crews and police force, and that's a very big end market for them, is something that they enable. What they've done is through acquisitions, as well as some organic initiatives, they are building a portfolio of software and video technology that augments that.

If you buy everything from Motorola, and your police officer will not just carry a walkie-talkie. That walkie-talkie would also run a voice recognition software similar to Siri, instead in their case it's called ViQi, where you can speak to your radio as you pursue a vehicle on the motorway or as you point a gun in an armed confrontation. And you run a number plate, you ask for some background information and the system automatically recognises that.

Their video kit recognises number plates, faces and can even recognise concealed weapons. Their artificial intelligence algorithm running on those cameras can do that. And it's all networked. If you're a police officer and you draw your weapon from your holster, it automatically triggers an event that gets registered in the case file. It automatically alerts other units that this event is happening and reinforcement might be needed.

This networked dispatch, case management monitoring, video processing software adopted, implemented on top of their very loyal and established customer base, is something that we think will create value and we're not sure market recognises that. That’s the area that we're interested in. And Anna and her colleagues on the smaller companies in the VCT team have investments in this space as well.

Anna: We were talking earlier about attention span deficit and things requiring lots and lots of work. And one of those things is often when you're looking at these early-stage companies, you really need to do extensive due diligence. And a company that we have invested in earlier this year, we have invested £3 million at a pre-IPO stage. And we do expect an IPO over the next year to 18 months. And we have obviously got to do an awful lot more ground-up work when we're looking at companies such as this.

And this company is called Chorus Intelligence. It’s developed investigative software. And this involves connecting to any data source anywhere, analysing it, storing it, searching it and sharing all data related to an investigation in one really secure and encrypted workspace. This sounds like the things that we imagine police forces already do. Those dimly-lit offices where someone's working late at night and typing things into a computer and connecting up data, it doesn't really work quite as smoothly as you might think.

But the things that Chorus Intelligence offers helps police hugely in identifying criminals and be able to turn those leads into evidence that can actually be used in a court of law. And substantial successes today include lots of prosecutions by the British Transport Police because they've been able to identify the top criminal layer running county lines through phones of the children being used to transport the drugs.

They’ve got some concrete evidence that they managed to do very well. But the good thing about working with Mikhail and all this due diligence that we've been doing around that is that we've been able to include him in the conversations. And I've been on the calls when he's been talking about Motorola Solutions. It's quite collaborative. He can ask questions. I can ask questions. And we can talk about his…

I think Mikhail joined the call I had with the North Wales Constabulary, which is seen as one of the most forward-thinking and early-stage adopter of technology. And they've also been adopting these technologies in the US. And it's also all about understanding those enormous, addressable markets. We've got 43 police forces in the UK. They all need to start talking to each other better. And in the US, it might astonish you to know that there are nearly 18,000 different police agencies. You've got your state police, highway patrol.

You've got all those city police departments and county sheriffs. It's really helping us understand the full addressable market as well and what it offers.

Merryn: I'm only half-comfortable with all this technology, I think. Anna, let's talk a little bit about your portfolio. There's been some phenomenal falls in small-cap area over the last six months or so. Is there any real value emerging here, things that you look at and you think, this is ridiculously cheap now, or are we not quite there yet?

Anna: There's been some extraordinary selloffs. And I think you opened the podcast talking about how weak the market’s been. Nasdaq…

Merryn: I have to interrupt you right there. We're talking in the morning on Thursday, for anyone who's listening. And I got my screens open as we’re speaking. And Scottish Mortgage, which I know lots of our readers will hold, is down another 4.5% today already.

Anna: And the Nasdaq is off 29% from its all-time highs. And we've seen a lot of volatility. And there have been some really weak names in our portfolio and beyond the portfolio. We have started to look, though, for some growth names that are back at levels that we could only have dreamed about buying. We have been adding to some of our holdings that have derated quite far where we still see that they've got some really good growth ahead of them.

I would highlight perhaps Craneware and GB Group, these are companies that we've known. What gives us comfort in them is these are companies that we've known for a very long time. Because we've owned them since IPO in the VCT and we've bought and sold these companies from the smaller companies’ fund through certain times of when we think they are particularly attractive or not. And GB Group, we participated in a fund-raise last year, which they were doing to grow their presence in the US.

They help e-commerce and financial institutions and betting companies. All of these companies do… And ID verification. When you tap in an address when you're buying something online and it does the autofill and checks the location and so on, that's the thing that they can offer. And ID verification is a really fast-growing and important market. Whilst it’s seen as a tech company, it wasn't quite high-multiple, it's now looking pretty compelling and it's delivering growth.

Craneware we feel is quite insulated from what's happening in the economic environment because it works with US hospitals and it's done a really earnings-enhancing acquisition and should be able to deliver a strong growth. GB Group has a lot of revenues coming from the US and Craneware has all its revenues coming from the US. And we do see that whilst the US is battling inflation, they're responding to that by raising interest rates.

And we feel that that's been very beneficial to the dollar. On a purely transitional aspect, that's been this support to their earnings. But we also think that it is likely, whilst the US is of course experiencing pain like all of us, given their own security of energy supply and they are slightly more protected from what we will see as a continued cost of living crisis in Europe. Which will probably perhaps hurt European economies even more than the US.

Merryn: I was hoping you were going to end on an upbeat note so I could say, on that happy note, let's end, but you didn't. I think we’re…

Anna: There's still opportunity and the markets… And I don't know if you remember last year people would say, gosh, this market really needs to rebase, as if it would be a good thing. It never feels like a good thing, does it? But we just need to keep our heads and remind ourselves that we've been in the up-and-down cycles before and that it's very difficult to time markets. But we do think that the long-term opportunity is still there.

And equities do remain a very good way to protect oneself from inflation in a way that fixed income does not.

Mikhail: If I may offer a little follow-up on that?

Merryn: Please.

Mikhail: We're launching the fund in a few weeks’ time. We're really excited about some of the areas where companies that we think have multi-year growth opportunities are sold off. Lots of babies being thrown out with the bathwater. The model portfolio, as it still stands today, which is almost live, has a reasonable P/E, has a reasonable free cash flow yield, is growing meaningfully above the market in terms of the weighted average EPS growth.

It looks very good value to us. The team behind the fund will be investing a significant proportion of our personal assets into the strategy. But I think the one other point I would make in what might recovery from this stumble look like, I think people will remember that the lower for longer interest rate nirvana we've experienced might not repeat over the next ten years. And the macro and geopolitical environment has changed.

But there's not a lot of structural opportunities there. You just need to access them in a broader way. I think should I benefit from this innovation breakthrough by backing a single product concept stock and carry all the attendant risks or should I maybe consider a picks-and-shovels supplier that's already a profitable, cash-generative business will benefit from that growth as well? Maybe to a lesser degree, but will have a lot more diversified risk profile and will be a better risk-reward opportunity.

Or should I indeed look for an adopter who already has a very good business and this innovation, as an extra tool, extra magic dust on top of that, would enhance that value? That's the approach we're taking. And I think investors will be more attuned to that.

Anna: And I will give you, if I may, just another positive thing to think about. Is that I think that there are very, very few positives to come out of what we're seeing in this crisis in Ukraine. But one of them is that investors’ eyes are being opened to the idea that we do need to have a rethink around energy security and where we're sourcing our energy from. And hopefully, that we're able to also, by investing in oil and gas stocks and other natural resources’ stocks in the right jurisdictions, we can deliver some good returns for investors.

Whilst we're very signed up to the idea of energy transition, but we do need to think about energy security in the short term. That's definitely something that we're looking at and we're working together with… Paul, my boss, is also on the board of Clean Trade. And we're thinking about this deeply and even going to put on a conference about it at the end of June discussing how we need to put human rights and good jurisdictions at the very heart of a new type of ESG investing.

Merryn: Now I can say, on that happy note, thank you both very much for joining me today. We hugely appreciate it and we hope we will talk to you both again soon. For those of you who want to hear more from MoneyWeek, you know where to go, moneyweek.com, where you can sign up for our daily e-letter, Money Morning, written by the brilliant John Stepek. You can follow us on Twitter @MoneyWeek. Follow me on Twitter @MerrynSW. And Anna, you're on Twitter?

Anna: Yes, @_Anna_Macdonald.

Merryn: And Mikhail?

Mikhail: I'm a Twitter watcher, not a participant. But now that all the changes are coming to Twitter, I should reconsider.

Merryn: I think it's very, very wise. And if you enjoyed the podcast, please do review us on your podcast provider of choice. It’s only thanks to the good reviews that we get the brilliant guests that we do. Thank you very much. More from us next week.