Capital Appreciation & Spectra Strategy Update
The following is a transcript of the Alger Capital Appreciation & Spectra Strategy Podcast.
KEVIN COLLINS:  Hello, this is Kevin Collins, Client Portfolio Manager at Alger.  And you’re listening to the Alger Podcast.  Today, I’m talking with Patrick Kelly, Portfolio Manager and Head of Alger Capital Appreciation and Spectra Strategies, which encompass our Capital Appreciation, Capital Appreciation Focus, and Spectra portfolios.  In today’s podcast, Patrick joins me to share his economic and market observations as well as provide an update for the portfolios which he and Ankur Crawford manage.  

PATRICK KELLY: Thanks, Kevin.

KEVIN: To start off, you continue to have a very positive outlook on the current U.S. economy.  Can you elaborate on that?

PATRICK: The economic environment in the U.S. continues to be very strong.   The U.S. economy accelerated in Q2 with 4.1% GDP growth, highlighted by strong labor force growth, rising productivity and a spike in capital spending.   Productivity is showing signs of improvement after muted growth for most of the past decade.  The unemployment rate is down to 4% and unemployment claims are now near a fifty-year low.  Consumer sentiment is at seventeen year highs.  And S&P 500 earnings are on track to grow close to 25% year over year in 2018.  U.S. capital spending also continues to be strong.  Last month, Duke’s CFO Global Business Outlook survey indicated that U.S. firms expect a capital spending increase of over 8% over the next twelve months, which compares to a 4.4% average quarterly growth rate over the past five years.  

M&A activity is trending at a record pace in 2018.  Through the first four months of 2018, global M&A activity is up 11% year over year to $1.4 trillion.  We think this pace will remain strong given high CEO confidence, highly competitive global industries that require scale to compete, and still low financing rates.  S&P 500 companies are also on track to repurchase as much as $800 billion in stock this year, a record pace.    

Another key reason for our positive view on the U.S. economy is that the U.S. continues to lead the world economy in innovation.  Many of the most innovative companies in the world are U.S.-based companies such as Apple, Alphabet, Amazon, Facebook, Netflix, Microsoft, Tesla and many others.

KEVIN:   What about activity outside the U.S.? ​

PATRICK:   Strong U.S. economic growth is being somewhat offset on a global basis by softer conditions in Europe and other areas of the world, where near-term optimism is tempered by trade tensions and political uncertainty.  

Trade conflict risks could cause some volatility through the direct impact on higher pricing and the secondary impacts on confidence, growth and decision making.   It’s difficult to predict the timing or outcome of the trade conflicts.  In the near-term, we expect certain aspects of trade conflicts to be resolved but we do think there could be escalation in other trade negotiations.  Trade issues create near-term uncertainty but we think that ultimately the end result could be a positive outcome in which multiple countries reduce trade barriers.   

KEVIN:  In our last conversation, you said you were paying close attention to the possible impact of rising interest rates.  Where do you stand on that now?

PATRICK:   We noted in our last podcast that we expected fiscal stimulus coupled with a full U.S. economy would lead to higher interest rates.  But we also noted that we expected technology and globalization to keep rates contained longer term.  We continue to have the view that rates can go higher in the near term but we expect technology, competition and globalization to keep rates contained longer term.   We also continue to believe that technology is a long term deflationary force and that remains underappreciated.    We feel that the S&P 500 at a bit over a 16 forward PE multiple is attractive with the 10-year U.S. treasury yield around 3%.  Now, if we thought rates would move significantly higher from current levels that would have negative implications for economic growth and would also lead to lower PE multiples which would obviously not be good for the market.  The good news is that we think long-term rates will remain contained which is positive for the economic backdrop and the stock market.

Amidst the short-term noise of trade conflicts, concerns of rising rates, and debates of growth vs. value, we continue to focus on the bigger picture – that we are in the early days of one of the most innovative times in history.  Our focus is to find companies that are innovating and benefitting from change and avoiding those that are being disrupted.  

KEVIN:  Let’s turn to your portfolios.  Can you describe which themes and trends you and the investment team are currently tracking?

PATRICK:  There are a number of big picture trends which will have a significant impact on companies across sectors.  There are the continued trends in the Internet and mobile Internet and the emergence of trends such as cloud computing, digital transformation, artificial intelligence, electric vehicles, autonomous vehicles, augmented reality, IoT, blockchain, and 5G.    

Our investment philosophy centers around our belief that companies undergoing positive dynamic change offer the best investment opportunities.  The good news for us is that we continue to expect a tremendous amount of change and innovation in the market over the next five to 10 years.  One of the reasons that we like to invest in change is that people often underestimate the change that is occurring, especially when it is as significant as it is today.

KEVIN:  an you drill down on some of major themes that you’re focused on?

PATRICK:  The first is digital transformation, which we believe will be a major theme over the next five years.  We believe we are in the very early stages of digital transformation which is creating substantial opportunities across the software and technology landscape.  Companies across sectors need to digitally transform themselves.  Digital transformation should lead to an acceleration in IT spending as companies across sectors need to increase their spending on technology as a percentage of revenue in order to effectively compete.  For example, JPMorgan will increase its tech spending by 15% this year to $10.8 billion, with most of it going toward enhancement of mobile and web-based services in its four main lines of business.  Jamie Dimon, CEO of JPMorgan, referred to the investment as table stakes for competing in global markets reshaped by technological advances.  Marianne Lake, the CFO of JPMorgan stated, “The case for digital everything is compelling.”  And she pointed to surveys showing that 57% of millennials would change banks for a better platform and 76% of customers cite digital capabilities as highly important in choosing a financial institution.  

We have stated in the past that historically customers selected a bank based on proximity and services.  Today’s customers are increasingly choosing a bank based on the breadth and quality of mobile and digital services.  The large banks such as JPMorgan and Bank of America are well-positioned to benefit from these trends as they can invest significant amounts of money into technology given their scale.  

We are seeing this theme of digital transformation play out in financial services and across all sectors.  According to Evercore ISI’s CFO survey, the percentage of cap-ex ear-marked for technology investment is at its highest levels since the survey began in 2001.  And Alliance Bernstein’s IT survey suggests that IT spending could grow 5%-6% in 2018 versus the 2011-2016 average of 2.1% growth.   

On its fourth quarter 2017 earnings call in February, Salesforce.com’s management team described the global selling environment as one of the best environments they've seen going back over 35 years.  They stated that “every CEO is using the positive economic environment but also the domestic tax cuts as a way to accelerate their digital transformations.”  

Microsoft reported very strong Q2 results and their CEO noted the strength of the results reflects innovation and the trust customers are placing in it to power their digital transformations.  Microsoft and Salesforce.com are our two largest software holdings and we feel they will be primary beneficiaries of the trend in digital transformation.      

KEVIN:  What about artificial intelligence and machine learning?

PATRICK:  Artificial Intelligence, or AI, is another major theme that we believe will be a multi-decade cycle and will have more of an impact on the world than just about any previous innovation.  AI allows businesses to be more productive and efficient, and it can potentially change the competitive landscape in various sectors.  The CEO of Google recently said that AI could have a more profound impact than electricity or fire.   

The widespread adoption of AI will create a tremendous amount of economic value.  It will drive significant cost savings for companies and drive significant productivity gains over the next decade.  It is difficult for any of us to fully appreciate the amount of change this will drive. 

Google has emerged as the worldwide leader in AI and is deploying it across their entire business.    Google Sites’ constant currency revenue growth accelerated in its recent second quarter to 23% year over year, benefiting from new AI-based ad tools.  Google is using AI technology to create a host of sophisticated advertising solutions for customers including: more automated ad creation, increased ad personalization, more sophisticated local ad targeting, and real-time optimization of text ads.  Google is also using AI and machine learning to improve its News, Maps, Photos and its Google Assistant services. 

One of Googles’ largest AI projects is autonomous vehicles.  A major first step in the roadmap toward fully autonomous vehicles could be reached later in 2018.  Google’s Waymo unit is on schedule to launch robo-taxis in the Phoenix market by year end. Google’s Waymo unit is looking to expand its autonomous technology into areas such as logistics and delivery services, public transportation services and for personal use vehicles.   

The autonomous vehicle market opportunity is substantial.   We think the market opportunity for the autonomous vehicle market ecosystem will exceed $1 trillion by 2030. We feel that Google’s leadership in AI is not accurately reflected in its stock price.   

S&P Global is an example of another company that is employing AI across its business lines and recently completed an acquisition of an AI-based company, Kensho.  As one of the largest global financial data companies, there is a big opportunity for S&P Global to better leverage its wealth of existing financial data and package it with alternative data to create more insightful and timely data and analytics.  We think AI can improve the value of its offering while at the same time reducing costs and we feel S&P Global is another example of a company that could significantly benefit from AI.  

AI and data go hand-in-hand.  Everything is being digitized.  You may have heard of the phrase that data is the new oil.  We are in the early innings of an inflection in data generation.  Data is doubling every 12-18 months.  AI and big data are transforming major industries and have the potential to create trillions of dollars of economic value.

KEVIN:  You told me that IoT is another primary focus within your portfolio.

PATRICK:  IoT is another multi-decade theme that will have a tremendous impact on the world.  The “Internet of Things,” or enabling of everyday objects to be smart or connected, will generate massive amounts of data that will need to be stored, processed and analyzed.  Masa Son, the Chairman of Softbank, said that he expects IoT will lead to an explosion of new technologies that will lead to one trillion connected devices in the next 20 years.  By 2035 he estimates the amount of data will grow more than 2,400 times from one exabyte to 2.3 zetabytes.   

We continue to think that many of the large technology platforms, particularly the cloud platforms, will be some of the biggest beneficiaries of AI.  We also believe the semiconductor industry will be a big beneficiary of AI, an inflection in data generation and the explosion of connected devices.  Applied Materials is our largest semiconductor holding.  Applied materials provides semiconductor capital equipment to the semiconductor industry and trades at a very attractive 10x forward PE multiple.  We believe Applied Materials is a primary beneficiary of AI, data, and connected devices.

Cloud computing is another theme that’s helping to enable much of the innovation in the economy.  Cloud computing remains in the early stages of disrupting the $3.5 trillion global information technology market.  The rationale for cloud adoption is evolving from a cost saver, to the need to keep up with technology advances which continue at an accelerating rate. 

We continue to see explosive growth rates for cloud-based companies.    Amazon’s AWS (Amazon Web Services) business accelerated slightly to 49% year-over-year growth in Q218 on an over-$24 billion annualized base of revenue.  Microsoft’s Azure revenue growth was 89% year-over-year in its most recent June quarter on a $7.6 billion annualized base of revenue.  Google noted cloud growth accelerated in 1Q and is seeing larger and more strategic deals.

KEVIN:  You’ve also mentioned that mobile continues to be a strong theme.

​PATRICK:  Mobile adoption is leading to a new generation of computing.  The ability to have a computer at the tip of your fingers at any time is creating new business models and disrupting old ones.  On average, people spend almost three hours per day on their mobile phones.  Those under 25 spend three times more time on their phones than those over 40.  This is leading to increased Internet usage and continues to drive very strong growth in Internet advertising and ecommerce spending.   

We believe that ad spend as a percentage of GDP should continue to increase as companies sell directly to the end consumer over the Internet while cutting out physical retail, wholesalers and other distributors.  Retail e-commerce generates two times the ad spend as a percentage of sales as physical retail, as the savings associated with not operating a physical store or distributing through a physical store are reinvested in marketing.  Brands will increasingly market directly to the end consumer, which will drive the need for ad budgets to increase as a percentage of revenue.  Companies will take those dollars that have traditionally been taken by retailers and other distributors and will reinvest them in advertising as they market directly to the end user.  We believe digital advertising will be the primary beneficiary of those dollars given most of the direct-to-consumer efforts are done over the Internet.  

The executive VP and Chairman of Johnson & Johnson has stated that “we are seeing a digital disruption which  is changing the face of the consumer industry, lowering the barriers to entry, and paving the way for a new class of entrepreneurial entrants.”   As a result of these trends, many consumer staples and branded companies are facing increased competition from a new class of entrepreneurial entrants and from large retailers who continue their push into private label.  We continue to be underweight the consumer staples sector given we think that many of these companies that have traditionally been perceived as bastions of safety are now coming under secular pressures.  

Despite its recent disappointing quarter, we believe Facebook will be a primary beneficiary of the mobile internet and the trend of selling direct to consumer.  Companies are using Facebook and Instagram platforms to establish their brands, acquire customers and sell their products.  Google continues to benefit from these trends as well, and their ad business accelerated to 23% year-over-year growth in their most recent June quarter.  And we continue to believe that Amazon could emerge as one of the largest ad platforms in the world over time.

KEVIN: Any final thoughts?

PATRICK:  Amidst a lot of the short-term market noise, we continue to focus on the bigger picture: that we are in the early days of one of the most innovative times in history.  This is creating a number of exciting investment opportunities.  Our in-depth, fundamental research process focuses on investing in many of the most innovative companies in the market.  Our competitive edge is identifying companies in the midst of positive dynamic change and seeking to capitalize on that change before it is recognized by the rest of the market.  

KEVIN: Patrick, thanks so much for speaking with us today about Capital Appreciation and Spectra strategies, and giving us your broader view for the markets.      

PATRICK:Thanks, Kevin.  And thank you for listening and for your continued support.  Thank you.

KEVIN: For more information on Alger Capital Appreciation and Spectra strategies, please visit alger.com.


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Companies discussed reflect the top holdings for various accounts in the strategy and is subject to change. Actual client holdings may vary. Portfolio holdings may change and stocks of companies noted may or may not be held by one or more Alger portfolios from time to time. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall portfolio rebalancing. The Strategy can leverage, and the cost of borrowing money to leverage could exceed the returns for the securities purchased or securities may actually go down in value; thus, the Strategy’s net asset value could decrease more quickly than if it had not borrowed. Unlike the Russell 3000 Growth Index, the Alger Spectra Strategy is an active investment strategy that is able to invest in companies of all sizes and sell securities short. In order to engage in a short sale, the Strategy arranges with a broker to borrow the security being sold short. In order to close out its short position, the Strategy will replace the security by purchasing the security at the price prevailing at the time of replacement. The Strategy will incur a loss if the price of the security sold short has increased since the time of the short sale and may experience a gain if the price has decreased since the short sale. The use of short sales could increase the Fund’s exposure to the market, magnifying losses and increasing volatility.

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