A game-changing tech theme

The facial recognition systems that unlock smartphones and the software behind online search engines are just two examples of how artificial intelligence has already permeated our everyday lives. Google CEO Sundar Pichai even recently suggested that AI will rival the invention of both fire and electricity in terms of the profound effect on humankind. Thomas Rice, portfolio manager of the Perpetual Global Innovation Share Fund, is perhaps slightly more circumspect but believes it’s a compelling investment theme.

AI technology underpins one of his more recent additions to the portfolio, Opendoor Technologies. The NASDAQ-listed firm is an online company in the “iBuying” space that’s been shaking up real estate sales in the US. The “i” stands for immediate or instant, Opendoor and its competitors aiming to streamline the process of buying and selling residential property.

As Rice explains, the company charges a 5% service fee, replacing the commission that a real estate broker would earn. The company then holds the house for between 90 and 110 days before reselling it, often using this period to undertake a few minor renovations.

“But their model is really around earning that 5% fee rather than looking to get an uplift on the valuation,” Rice says.

“We view it as a real disruptor in the sector, which has traditionally seen minimal disruption, but this brings a far more seamless process for sellers.”

With a presence that currently stretches across 21 markets, Opendoor’s management plans to roll out in 100 markets. And with an estimated market share of 50% of the total iBuying industry in 2020, Rice says it is capturing a good market share in each of the markets it enters.

Where does AI fit in? As Rice explains, the company uses machine learning – particularly “deep learning” – which uses algorithms inspired by the human brain to learn from large amounts of data.

“This technology has now got to the stage where it can value properties,” says Rice.

“Opendoor has also coupled that with a funding model where the inventory is essentially financed by non-recourse debt, so I think they’re handling the risk correctly. I think Opendoor will continue to gain share over time and is a really interesting stock to watch.”

A style-agnostic approach

Founded around seven years ago, the company isn’t exactly a start-up but sits at the younger end of the spectrum – though Rice and his team are equally interested in more mature businesses. “Style agnostic” in its approach, the fund isn’t considered either Growth or Value-oriented and invests across multiple markets.

“When I think about the traditional value stocks or growth stocks, to me it’s all about lifecycle. It’s about where in a company’s life you want to play as an investor,” Rice says.

“I’m comfortable looking at both (early-stage and mature) and I think that gives us more scope to find undervalued stocks in the market. So, we’ll have industrial conglomerates like German company Siemens, which has been around for 100 years, but also much younger tech companies like Nitro Software (ASX: NTO) here in Australia.”

Focus on areas of change

Rice believes thinking about stocks in large tranches, such as the value or growth cohorts, is a very “blunt” approach he prefers to avoid.

“When you have a big selloff in a particular part of the market, like growth stocks, that provides opportunity. You want to look at those occurrences and pick through the pieces because you’ll find some great companies that have been sold off and for us, that will provide the next leg of growth for the fund,” he says.

“When you think about whether large sections of the market will go up or down, that’s a very blunt way to think about the market. What I’m really trying to do is find individual businesses I think are cheap,” Rice says.

“A lot of the industry will say it only looks at specific factors, such as small-cap companies, or value stocks or things in a particular geographic area. My view is that you’re really trying to find undervalued securities, and I think you have the greatest chance of doing that if you focus on areas of change.”

A key part of his team’s process is to ask themselves whether they have a particular angle or insight into a company they’re considering. “And can we understand the economics of this business and how it will evolve over time?” says Rice.

“Everything comes back to valuation – we’re very interested in the cash flows these businesses will generate over time, and that’s true whether you’re looking at mature or early-stage businesses.”

Building resilience, managing volatility

He emphasises that resilience is a core consideration for him in building and maintaining his portfolio of between 20 and 60 stocks. To try and keep a diverse set of stocks driven by very different factors, Rice looks at the cross-correlations of companies and their individual volatility, to get an idea of the overall fund’s risk

“For example, last year when COVID hit in March, I made Zoom the biggest position. I thought that the company, which we already owned, would be a key beneficiary if COVID got worse, it would act as a hedge on the portfolio. And, obviously, it turned out that was right," he says.

An 8-bagger biotech

The fund has also done quite well out of the "life sciences" space in more recent times. The biggest contributor to the fund’s performance last year, when it beat the MSCI AC World benchmark by more than 10%, was NASDAQ-listed biotech firm Twist Bioscience (XNAS:TWST), a low-cost provider of synthetic DNA.

Having bought into the stock at around US$24 in early 2020, Rice sold it at US$195 in the first quarter this year. He has since re-added an exposure, buying the stock again in the June quarter for less than US$100.

Lessons from the short side

The complexities inherent in the highly innovative areas in which the Global Innovation Fund invests is part of the appeal for Rice. “There are greater chances people might misunderstand, so focusing on these areas of change increases your chances of finding stocks that might be mispriced - that was a core idea of the fund,” he says.

Prior to joining Perpetual in mid-2014, Rice spent 11 years at PM Capital, where he ran the Australian Long-Short Fund.

“I think learning to short helps you become a better long-only investor because it shows you the other side of the market and helps you become more skeptical of stocks,” Rice says.

“I think that’s particularly relevant in this area, because if you’re focused on innovation, you naturally come across a lot of hype, and a lot of the work lies in sorting the hype from reality.”

What he’s learned as an “angel”

When he’s off the clock from Perpetual, Rice also likes to dabble in start-ups, as a mentor and an investor through a Sydney-based angel investor and accelerator program. This has reinforced for him that cash flow is the key distinction between mature and early-stage businesses.

“For mature businesses, what they earned in the last year is a lot more relevant to predicting the future, but for earlier-stage businesses such as start-ups that might have no history, it’s very theoretical,” Rice says.

“For start-ups, it’s very much about trying to understand the business model, the economics of the business, and why it can earn a profit that doesn’t get competed away over time.”

But in the middle ground of companies that are neither start-ups nor mature – such as many of the companies in which he invests at Perpetual – it’s a combination of the two.

“The history is important but the theoretical is a lot more important. That gets back to understanding the basics of business, which includes:

• The service the company offers
• The value of this to customers
• How the company can monetise the service
• Why competitors can’t compete it away.

“Valuing any stock is about future cash flows, but the particular metrics you focus on might be different,” Rice says.

“It doesn’t mean these earlier stage companies are all expensive. Of course, some will be, but if you have the skillset to invest in that area, it provides a lot of opportunities.”