Perpetual's innovation fund returned over 40% in FY23. Here’s what PM Thomas Rice is backing for the coming year

Innovative technology has been on a roll in 2023. After a disastrous 2022, investors have watched tech companies reassess their strategies and initiate cost-cutting to improve their fundamentals. Many are also beginning to reap the rewards or eye the potential benefits of artificial intelligence.

There’s no question that investing in this space has supported Perpetual’s performance for FY23.

The Perpetual Global Innovation Share Fund, also available in listed format on the ASX, generated 43.62% for the year ending 30 June 2023. It also topped Livewire’s performance rankings for global equity funds.

While noting that a focus on innovative technology was a painful place for any fund to be in 2022, the strategy has recovered its losses and certain stocks had more of a key role in this than others.

I spoke to portfolio manager Thomas Rice for insights into the top returning stocks he backed over the past year, what he’s holding going forward and where he sees the big opportunities for investors. If you love gaming, AI and all things tech, this is one for you.

Two elements of the Perpetual investment process that contributed to the fund’s returns for the year

Rice believes having a deep understanding of technology, along with a broad and nimble approach is key to investing successfully in innovative technology.

“You need a fundamental understanding to work out what's real and what’s hype in technology. And that's really a prerequisite for working out what are the impacts on different stocks in the market.

For example, the work we did on LLMs (large language models) led to our positions in stocks like Nvidia (NYSE: NVDA) and Palantir (NASDAQ: PLTR), which did pretty well during the year,” he says.

He also references the work he and his team did to understand ChatGPT at its base levels when it was launched, investigating the LLM, its capabilities and limitations.

“There are some companies that will benefit and others that won’t when it comes to AI. We try to differentiate ones where there’s a real economic impact from those where there won’t be. I’m a bigger fan of Palantir than C3 AI for example, which has rallied a lot,” Rice says.

Technology moves fast, so it’s essential to look broadly and act quickly when required.

“A lot of our best performers came from situations where we were able to react very quickly, even pre-emptively, to market events before there was time for the stock to improve,” he says.

The three stocks with the most meaningful contribution to performance over the last year

Rice’s top three are CD Projekt S.A (WSE: CDR), Meta (NASDAQ: META) and Unity Technologies (NYSE: U). 

CD Projekt SA

CD Projekt SA is a Polish game developer, best known for its Witcher series of games, launched at Cyberpunk 2077 in December 2020. The launch was a disaster because the game at that point had a number of bugs and this affected the company’s reputation. While they’ve since fixed the issues with the game, it can be a challenge to get audiences to reconsider games down the track.

“We’ve been watching the company for the last few years. Last year, they launched a new series on Netflix set in the games universe and we thought that would be a good catalyst for people to reconsider the game, which has flow-on implications for the value of the franchise and the company value as a whole,” Rice says.

He purchased the stock in August last year at $86.46, a month before the Netflix series launched and then increased the position when the series launched. The stock is up 78% since that point. Perpetual still has a large holding.

“The long-term story for that stock is around them being one of the highest returning developers in the world because they create very popular games with a small team. Over the next 4-5 years, they’re moving from a game release development cadence of one every 5-6 years to every 1-2 years. The economics of it are about being able to invest capital at a high-rate return, at a greater scale,” Rice says.

Rice views gaming exposure as a staple for the portfolio on the whole.

“It’s a pretty important part of entertainment that is seeing structural growth as more young people become gamers than in previous generations,” he says.

Meta

Perpetual had sold Meta in February 2022 for $213 but continued to monitor the company.

The social media giant has had a tough few years, and Rice notes it looked cheap for a while.

“I’ve tried to pay attention to what will change the market’s view on a particular stock and what is the catalyst that can add incremental value if you time the short-term better,” he says.

“The market hated Meta because the perception was that Mark Zuckerberg was blowing a lot of money on VR and AI. He has total control.”

During this period, Rice kept an eye on what Elon Musk was doing at Twitter – Perpetual had previously owned Twitter before Musk’s takeover. He wondered if Musk’s cost-cutting exercises could usher in a new period of austerity in Silicon Valley companies.

“The moment it seemed like Meta would start cutting costs, we bought in. That was in November. It was $94 when we bought back in. It’s up three times since then and we still own it. It’s a smaller holding now because the opportunity is not what it was back in November,” says Rice.

Unity Technologies

Given Rice’s focus on the future of gaming, it’s unsurprising that Unity Technologies would come onto his radar. The company is one of the leading development platforms for augmented reality (AR) and virtual reality (VR) platforms.

While the company was one that Rice liked, the trigger for purchase wasn’t a company specific announcement, but in fact, market speculation around Apple (NASDAQ: AAPL).

It was highly anticipated in June that Apple would launch a new VR AR headset at its worldwide developer conference (which turned out to be a correct assumption). Rice bought into Unity Technologies a week before Apple’s conference.

“If the greatest consumer electrics company in the world enters this space, it becomes a bigger category and there’s flow on effects to Unity,” he says.

Rice increased the position when Apple confirmed the release of the headset. He actually sold out of the position last week.

“It re-rated a lot faster than I expected. The risk-reward is different now. We’re always thinking, based on prices, what are the best stocks to position the portfolio in.”

Looking to the future: the largest positions in the fund going forward

Two of the biggest positions in the fund going forward are SES-imagotag (EPA: SESL) and Opendoor Technologies (NASDAQ: OPEN).

SES-imagotag

SES-imagotag is the world leader in electronic shelf labels. Perpetual recently purchased it.

“A short report came out on the stock in late June and the stock fell 58%. We know the industry well but didn’t hold the company and I thought the short report was one of the lowest quality short reports I’ve ever read. Riddled with inaccuracies. We took the opportunity to buy a position,” Rice says.

He increased that position further after SES-imagotag’s systematic rebuttal of the short report and it is currently the biggest position in the portfolio today. It is up 82% from purchase price three weeks ago.

“There’s quite a lot of upside from here if you think about the roll out of electronic shelf labels and retailers. They signed their first contract with Walmart to start rolling them out in US stores. That will be a multi-year engagement and I think will be a tipping point for a lot of other retailers,” he says.

Opendoor Technologies

Opendoor Technologies is an online company that buys and sells residential real estate. It is the second biggest position in the fund and was one of the biggest detractors in 2022. It ended up being one of the top 10 contributors in 2023.

The reason for the detraction is that the US had its fastest deceleration in house prices in recorded history in July and August last year. This meant that it had effectively overpaid for many of the houses it bought in the second quarter of the year.

“It’s recovered a fair bit and the reason is the properties it has bought since the third quarter of last year have been a lot more profitable. They are buying them at bigger discounts. They’ve also cut their operating expenses from $200 million a quarter to $90 million a quarter. The combination of these mean it is on track to become sustainably profitable by mid-next year,” Rice says.

“If they do succeed in building a transactional platform for residential property in the US, I think it will be the most valuable real estate platform in the world.”

A laggard due for a rebound

One of the biggest detractors to the fund in the past year was gaming company Embracer Group (STO: EMBRAC B) but Rice is a believer in its long-term prospects.

It’s been hit hard by a number of poor game launches, along with a prospective deal that fell through. Rice suspects the other party to the deal was Microsoft which has been in the process of taking over Activision Blizzard. While Rice previously reduced the position, he has recently increased it.

“Microsoft’s acquisition of Activision Blizzard clears the path for them to enter into large deals with a company like Embracer to build out their development library for Xbox,” he says.

He also argues that Embracer is trading at trough earnings and can see a scenario where the company could double or triple in the next few years.

What to expect in markets going forward

“Particularly in this calendar year, we’ve seen a tremendous bull run in US technology and high growth sectors. My view is that we’re not likely to see the same pace going forward. I’ve been reducing names like Nvidia and sold out of Unity. I’m not expecting a severe downturn but it’s prudent to prepare for more modest growth going forward,” Rice says.

He has also adjusted the portfolio away from US stocks towards more international opportunities, with half of the top 10 stocks now outside the states in Europe and Asia.

Looking to the future, Rice is paying close attention to the impact of generative AI, particularly in terms of LLMs. Some shorter-term use cases he sees are call centres and helping with writing.

“One of the most interesting ways to think about large language models is a way for code to interact with text. Text is everywhere. It’s your emails. It’s most business documents. If you want to write code that interacts with any of that text, it’s now feasible to do that with LLMs in a way that you couldn’t before,” he says.

He thinks the market has under-appreciated the potential in this space and is monitoring developers who could be winners or beneficiaries of that trend. Nvidia and Palantir have already had a good run and Perpetual still owns these but are monitoring for the next winners in this space.