Motley Fool Hidden Gems Investing - Another Semiconductor Stock Is Headed to the S&P 500

Starting point is 00:00:00 There's another semiconductor stock headed for the S&P 500. You're listening to Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm Jon Quast and I'm joined today by contributors Matt Frankel and Rachel Warren. We're going to dip into our mailbag today, not once, but twice. But first, we wanted to start with our lead story, and that is about once a quarter, the S&P 500 removes some companies from the index and adds other companies. This is an index that tracks roughly 500 of the largest, most profitable U.S.-based companies. There are some times where a company gets acquired or something like that, and then another company is added in between the regular rebalancings. But we had this regular one,

Starting point is 00:00:50 and Pool Stock and Campbell Soup Company are out. As a shareholder of Pool and a lover of goldfish crackers, I'm disappointed with that. But we have a couple new ones heading in and that is Marvell and also Flex. And so while the indexing itself isn't really something material that we foolish investors really base an investment thesis on,

Starting point is 00:01:13 sometimes it is fun to bring a new stock to our attention as they get added to the large index here. And so we thought it would be fun in this episode to talk about these. And I'm going to start here with Rachel. We want to talk about Marvell going into the index. And basically, my question here for Rachel is, what is Marvell? What does it do? And what is so interesting about the timing here is NVIDIA CEO Jensen Wang says he believes

Starting point is 00:01:39 that this can be a $1 trillion company someday. So I want you to speak to that as well, Rachel. Yeah, I do think that this could very much qualify under the moniker of a hidden gem. So Marvell technology, for anyone who's not familiar, this is a data infrastructure powerhouse. They specialize in the high speed optical interconnect chips and custom AI silicon that's really essential in today's day and age for transmitting data across massive server clusters. And as you noted, John, Jensen Huang recently declared Marvell the next trillion dollar company. And he said this because as AI models scale, computing has to be distributed across an entire data center. So this makes Marvell's high bandwidth connectivity a key solution to the industry's biggest physical bottleneck, which is data movement. Now, you might be thinking a $1 trillion milestone sounds outrageous for a company that's currently valued in the $200 billion market cap range. But I think that Huang's prediction is actually a reasonable long-term thesis. It's also backed by NVIDIA's own $2 billion equity stake in Marvell. That's something that's very important to note as well.

Starting point is 00:02:45 But Marvell's path to $1 trillion, there's a few key drivers here. There's the massive dual-engine revenue expansion. Hyperscalers are using Marvell to design custom AI chips. That's a business that's projected to cross $10 billion in revenue by the company's fiscal 2029. The optical business is growing at a 70% plus growth rate, and that's as they're linking distributed GPU clusters at the speed of light. So if Marvell stains this very robust growth trajectory in the mid-double digits, if they're able to hit that estimated $50 billion in revenue, $25 billion in EBITDA by 2031, you could be looking at a premium of about 40 AI infrastructure multiple. but I think that you could see where there is a mathematical justification for that trillion dollar valuation. Obviously, this addition to the S&P 500, it triggers mandatory index fund buying. And I think it also cements its role in global AI architecture. So it will be interesting to see whether the company hits this $1 trillion milestone. Whether it does or not, I think we are very much looking at a company that is playing an indispensable role in the AI infrastructure

Starting point is 00:03:53 or build out. And I think that's a very exciting thing to watch. Yeah, as we're using the term hidden gems, not necessarily a small company, but one that might not be consumer facing very often. So it's hidden in that sense. Most people are unaware of the company and what it does. And so Marvell would qualify under that. But we're also looking for these companies that can deliver for shareholders. And you're pointing out basically that you think it is realistic that this company could be a trillion dollar market cap company someday. That would be, based on these projections, right? I mean, the 2031 timeline, that would be, if it could reach a trillion by then, by the time it's making 25 billion in EBITDA, I mean, this would be a four bagger in five years. Let's have

Starting point is 00:04:37 a little fun here. Matt, would you agree or disagree that it has a realistic path to this in the next five years? A chance, yes. A realistic path, maybe. And there's a lot we don't know about what AI infrastructure will look like in 2031. And what I mean by that is right now, you know, demand is soaring for this. I mean, Alphabet's AI spending is double what it was last year. Other companies, it's the same. Who knows if that demand is going to keep growing kind of at an exponential pace for the next five years? We just don't know. Even if it does, are we going to be able to solve the energy problem that it would require to keep building out all this infrastructure? AI could get more efficient. Every new technology gets more efficient over its first

Starting point is 00:05:14 few years. We could do the same amount of work with fewer AI chips by 2031. We don't know. If Jensen Huang's right and this is really the future of, you know, data movement and we get the appropriate tailwinds, yes, a trillion dollars is possible. It's not my base case for this company. Yeah, I appreciate that little bit of pushback. It's always good to balance our perspectives on a company. But let's go ahead and turn now to Flex, the other company that is being added here to the S&P 500. Basically, I want you to talk, Matt, explain to us what Flex is and whether or not you think it could be a hidden gem stock. Well, if you haven't heard the company's name, it's probably because it used to be called Flextronics. So Flex, it's one of the largest

Starting point is 00:05:58 electronic manufacturing service businesses, also abbreviated as EMS, even though that does stand for more than one thing. One of the largest companies of that kind in the world. Think of Flex is a factory that serves electronics companies that design products, but don't want to manufacture those products themselves. The big, you know, customers send their designs to Flex, they make the product, they ship it. The big tailwind right now is their AI data center business, kind of like everything else here. It's a big operation. They make their power management, they make power management products, cooling products, electrical infrastructure products for data centers. It's a big company. This is a, you know, a lot of electronics

Starting point is 00:06:37 manufacturers don't make their own products. Flex did $28 billion of revenue in its last fiscal year. It's a highly profitable business. It's grown its earnings at a double-digit rate for the past six years in a row, and management expects acceleration because of this AI data center part of their business in the current fiscal year, which their fiscal year runs through March. 18% revenue growth, 32% earnings per share growth is what's expected right now. The most interesting development that I think could make this a hidden gem investment is that Flex is spinning off its cloud and power infrastructure business, the most exciting part of it. The other part of Flex's business is just electronics manufacturing, very low margin,

Starting point is 00:07:15 very predictable single digit revenue growth over time. So the rapidly growing part is spinning out. So is it a hidden gem? Maybe. The stock has more than tripled already over the past year. The forced index buying, which Rachel correctly referred to with Marvell, could give it a nice little short-term lift, but it's not going to be a long-term catalyst. The stock trades for about 35 times forward earnings. And like I said, historically, it's a low margin, modest growth business. The spinoff is the wild card. That AI infrastructure business could command a very high multiple as a standalone business. They're expecting that part to grow by 65, 70% this year. We've seen some much crazier valuations than 35 times earnings for businesses that go into that

Starting point is 00:07:58 category. Still, as it is now, it seems a little expensive for new buyers, and I probably wouldn't buy at these levels. But if we saw the 20%, 30% pullback that we've seen in other similar businesses, I might become very interested in this. Well, and thanks for pointing out that spinoff, because one of the things that we do look for in a hidden gem, a potential hidden gem, is something that's misunderstood by the market. And certainly a spinoff can be something that is misunderstood when you're trying to calculate that value. However, you're alluding to the fact that perhaps you believe that this stock is overvalued going into it and that may diminish some return potential here. So, Rachel, I want you to agree or disagree with Matt's premise here

Starting point is 00:08:39 of flex stock being slightly overvalued, overvalued. What do you think? I think it's possible that it's overvalued, but I think what might justify that valuation as we move forward is how the business is fitting itself into the reality of where the economy is heading. You know, it had been this kind of low margin contract manufacturer that just built electronics for other brands. They've been really transforming and trying to rebrand themselves into this very sophisticated engineering partner for the mega cap tech giants and become one of those companies that is one of the more indispensable backbones of the AI boom. I think it will be very interesting to see if and how, you know, that spinoff occurs. But I think as we're really

Starting point is 00:09:21 seeing that shift from customer gadgets to focusing on the complex industrial tech, you know, manufacturing that massive power infrastructure, advanced liquid cooling systems required to keep modern generative AI data centers from overheating. I think that's where their business model has, you know, developed into kind of the most fascinating part of where it needs to be looking ahead over the next, you know, five to 10 years. So I think if they can continue to capitalize on that shift, I think we might see the valuation be justified. As it stands right now, though, I tend to agree with Matt, it is a little bit overvalued. All right. Well, when we come back, we're going to pivot and we're going to go into the mailbag to talk about a health care stock question that was submitted. You're listening to Motley Fool Hidden Gems Investing.

Starting point is 00:10:05 Welcome back to Motley Fool Hidden Gems Investing. We certainly love taking mailbag questions whenever we can. And this question I wanted to throw to Rachel here because healthcare is kind of a little bit more her circle, her area that she spends a lot of time for sure. And so let me, this question actually has two parts. So I'm just going to read the first part here and then I'll read the second part in a bit. But this is from Drew, says, love the podcast. Thank you very much. I've been highly unimpressed by Bristol-Myers Squibb for years now. Stock remains in the doldrums. I had high hopes when it acquired Celgene in late 2019, which seemed brilliant for its products and pipeline and got it cheap, but they've really

Starting point is 00:10:50 struggled since, it seems. Thoughts. And of course, Drew here is referring to the $74 billion acquisition that happened in 2019. So we're past the five-year mark and Bristol-Myers stock is up less than 1% since then. Why hasn't this acquisition helped the stock? Yeah, it's a great question. I think it's really the exact tension that's frustrated investors in this business for years. So the Celgene acquisition, it delivered what, you know, was at the time really an incredible cash cow for the business. But it also, on the flip side of that, it saddled Bristol Myers Squibb with massive debt, as well as some structural dependencies that they're still trying to outrun. And one of the biggest challenges

Starting point is 00:11:33 that Bristol-Myers Squibb has been facing has been a really brutal front-loaded patent cliff. Now, obviously, patent cliffs are part of the life cycle of every pharmaceutical business. These are expected. These are planned for many years in advance. But sometimes you see these periods of transition, and that has very much been what Bristol-Myers has been going through. So a lot of the mega blockbusters that used to really anchor the business are facing really aggressive generic competition as those patents have expired. So, for example, their primary cancer asset, Revlimid, saw revenues plummet from over $12 billion down to $3 billion as they are seeing loss of volume to those generic competitors. And that creates a tough timing mismatch because

Starting point is 00:12:16 that means that legacy sales are dropping faster than new drug launches can scale up. Again, this is not uncommon in the world of pharma, but it is very much the dynamic we've been seeing with Bristol-Myers. Now, I want to say overall revenue has been flat, but internally we're seeing I think the business is hitting a really pivotal turning point. So they had a massive milestone in their recent financial report, their newer growth portfolio. So those more newly launched products led by a few of their rising stars that actually expanded by 12% year over year in revenue to more than $6 billion. So their growth portfolio of these newer assets is out earning their declining legacy assets for the first time. Now, we're still seeing the stock trading at a very compressed

Starting point is 00:13:00 multiple. We've seen a lot of skepticism from the market about their upcoming patent losses, including on major drugs like Eliquis. But I do think, you know, for long term investors in the stock, the growth portfolio, I think over time is going to outmatch the drag from those legacy assets. So basically, patent issues, debt being very high, those things are kind of weighing the stock down. The second part here of the question is, how would you compare them? So Bristol-Myers Squibb, how would you compare them to Pfizer and other competitors? Yeah, I mean, these are different businesses in many ways. Obviously, they're all navigating industry-wide patent cliffs. Pfizer is a great example of that. I mean, for anyone that's watched that stock,

Starting point is 00:13:43 they obviously had to really absorb the steep collapse post-COVID demand for their COVID franchises. But I will note, and I've said this before, Pfizer used that historic windfall of cash and profits from their vaccine, from their antiviral medication to plan for the future. They famously executed a $43 billion acquisition of the oncology powerhouse Segan. That basically meant they absorbed a massive powerhouse and clinical pipeline in oncology focused on antibody drug conjugates. They actually recently announced a $10.5 billion cancer partnership with a company called InnoVent to secure that long-term pipeline runway. So Pfizer is heavily focused on oncology. They've made a range of other acquisitions outside of that space, but they have planned to have eight

Starting point is 00:14:34 or more oncology blockbusters in their portfolio by the early 2030s, and they seem well on their way to that. Now, to compare these businesses a bit, I mean, they both are dividend payers. So Pfizer, its current dividend is just under 7%. Bristol-Myers is around 4.4%. And you look at an oncology giant like Merck, they have a slightly lower yield. I'll note Pfizer has a very, very high dividend ratio. Their payout ratio is about 131%. Bristol-Myers is around 70%. So ultimately, when you're looking at these businesses, it's really important to understand how their pipelines work. It's really important to understand where their competitive advantages lie. A lot of times when you're putting cash into pharma businesses like these, you're really doing

Starting point is 00:15:21 it for the dividend payout. So you really want to make sure that that is safe and well-supported by cash and profitability. I think that is very much the case with both Pfizer and Bristol-Myers, but this is not a space for every investor. So it's important to make sure you understand it before you put your capital to work. So let me turn it to you here, Matt, because I know that you like dividends and we definitely, as Rachel brings up the dividend here, we want to get some more commentary and some thoughts here from a dividend perspective. Both Bristol-Meyer and Pfizer would be classified in the high yield category. But is there one of these two that you would prefer as a dividend stock today? Yeah, I am not the most knowledgeable

Starting point is 00:16:00 in the pharmaceutical industry. So that was actually a great rundown. I feel like normally when people try to explain pharmaceuticals to me, it's like when I try to explain AI to my grandfather. So I'm going to dig in a little bit more on the dividend side, because that's what I know really well. So both of these, as Rachel said, are fairly mature pharmaceutical companies. I think it's fair to say that. And it's not just about comparing the dividend yield. If all you want is income, Pfizer all day. But look at their capital allocation preferences. Bristol-Myers, they have a lower payout ratio. Their 10-year average is about 40%. I look at long-term averages. Right now, both have high payout ratios artificially because of things like one-time costs

Starting point is 00:16:37 related to acquisitions and things to that effect. So their long-term average is about 40%. The dividend is well covered by their current cashflow, even right now. Pfizer not only has the highest yield right now, but they have the more steady dividend payment track record. That's one other thing that I like to compare. They have a long-term average payout ratio of 50 to 65%. So even in what I would call a normal year, they pay out more of their income than Bristol-Myers does. Bristol-Myers has been more acquisition focused and opportunistic other than that big one-time Pfizer deal. So in a typical year, it retains more of its earnings for opportunities like that and to anticipate the patent cliff and things like that. Pfizer has slowed its dividend

Starting point is 00:17:17 growth recently, roughly 2% annualized rate since 2020. It seems like it's trying to conserve capital and delever its balance sheet as a priority. So that's all to say, I don't necessarily think one is better than the other for income investors. Pfizer obviously has the higher yield, but for predictability and steadily growing income, that would be my choice. If you want a slightly more aggressive growth approach, I think Bristol Myers would fit to that category and still a solid dividend. But like I said, I don't think one is the clear winner here. Both are great options for income investors. Well, it's interesting you highlight one as being more aggressive than the other, because after the break, we're double dipping into the mailbag and talking to one of

Starting point is 00:17:59 our youngest listeners. You're listening to Motley Fool Hidden Gems Investing. Welcome back to Motley Fool Hidden Gems Investing. We do like to make you part of the conversation. So if you have a stock or investing question for anyone on this show, we have different hosts throughout the week, but you can email us at podcastatfool.com. And we'd love to read it on air. We'd love to speak to it. We do need you to keep it foolish. If you can keep it short, that's even better. But that email again is podcastatfool.com, podcastatfool.com. And so here's our final segment, our second question of the day. I'm going to throw this to Matt as our little bit more on the financial planning side of the spectrum when it comes to our contributors. But here's the question here. My name is, and I won't read the name on air, but I'm 16. I'm from Abu Dhabi and I'm a daily listener. That is incredible. I follow the markets, a managed small portfolio built on buy great companies and hold philosophy the fullest preach since before I was born.

Starting point is 00:19:02 A question for the show, when you're 16 and your edge is time rather than capital or information, how should that change what kinds of companies you study? Should a teenager's watch list look different from an adult's? So basically here, this question, Matt, is speaking to age-related things when it comes to investing. And as a 16-year-old, which is incredible that they're already taking investing seriously, how should they be thinking about what they should be putting their emphasis on? First of all, if you're listening to this podcast, not watching a video, I hope you can hear me clapping right now that a 16-year-old is getting involved in the markets that early. One of my biggest regrets in investing, and I'm sure some of us are in that group too, is that I didn't start earlier. So I wish I had the foresight to, when I was working at Burger King in 16, to put some of those paychecks in the stock market. It would have been a different world today. So that's a great question, and it's one that

Starting point is 00:19:57 doesn't get nearly enough attention. So most of the coverage you see around the time advantage of younger investors gravitates toward put your money in stocks when you're young and gradually shift to fixed income when you're older, but not nearly enough is said about what kinds of stocks you should focus on at what age. So as a more general guideline, so at The Fool, we classify every stock we cover as either cautious, moderate, or aggressive. As you get older and closer to retirement, it makes sense to shift a greater percentage of your stock allocation toward that cautious end of the spectrum. Now, cautious stocks don't necessarily mean things that are, you know, immune to market downturns or won't react to market volatility, but generally they're

Starting point is 00:20:35 the more established businesses with resilience and predictable cash flow. I would have to bet that Pfizer is one of those from the last segment. To be clear, at any stage of the game, it's fine to have a blend of all three types in your portfolio, even if you're 70 years old. But the mix should skew more toward the aggressive side when you're younger and toward more cautious when you're older. But for a little bit more color, consider that there is a wide range of investments within each of those categories. And a portfolio of aggressive stocks isn't always going to beat a portfolio of cautious stocks. In fact, some of the best performing stocks over the past few decades have been companies like NVIDIA, Amazon, Apple, no big surprises there. But you'd also be

Starting point is 00:21:17 really surprised to find in those same return realms, boring companies and conservative companies like public storage, you know, those big orange storage facilities. NVR, one of the leading home builders, is a massive success over the past few decades. So as a final thought, the best stocks for you at your age also depend a lot on your comfort level and competence. We mentioned Rachel is a healthcare investor. I like dividend stocks. So my portfolio has always had more dividend stocks, especially when I was starting out, I had a lot more dividend stocks than you would expect the average 20-something to have. So it really depends on what you're comfortable evaluating is how you're going to find the biggest winners. And of course, I want to clarify that Matt isn't

Starting point is 00:21:59 speaking to that one question, that one listener's question specifically. He's definitely widening this out to anyone listening to the show, how to think about investing depending on your age and time horizon. And so hopefully it's a general takeaway for everyone, not seen as personalized advice. But Rachel, I want to turn here to you. Matt mentioned that one of his areas of competence is dividend stocks. And I think it is important to be investing in an area where you feel like you have a certain edge, something that you're good at and something that you know well. And I guess my question to you here is, do you have any advice for our young listener here on how to build that area of competence, how to build that own little circle of competence

Starting point is 00:22:46 that Warren Buffett talked about, maybe something from your own personal investing journey. Yeah, I think it's such an important question because I think we all have industries that we know better than others that we're really interested in. As you mentioned, healthcare has been a key area of focus for me. And when I first started my investing journey, because I had so much knowledge and background in this space, that was where I really gravitated towards to start out investing and putting my capital to work. Now, of course, I invest in a wide range of companies outside of healthcare, across tech and industrials and other spaces of the broader market economy. But I do think the broader point is that it's important to invest

Starting point is 00:23:27 in what you know, what excites you, and to find really quality businesses within those spaces that align with your overall risk tolerance and strategic goals for your portfolio. So that could be growth-driven industries, right? It could be robotics, advanced automated logistics, biotech. The list goes on. There are so many industries that I think are reshaping where the world is going in the decades ahead. And as a 16-year-old investor or investor at any age, you have a longer time horizon. Your watch list might look radically different than if perhaps you're a bit closer to retirement and your risk tolerance level is different. But I think having that long-term mindset, pairing it with steady emotional discipline, staying diversified, ignoring volatile trends, and putting your capital to work in both bear markets, bull markets, and everything in between, I think that that is how one builds a profitable portfolio with time. But certainly invest in what excites you. Make the journey of investing fun. I think that's also really important to building a profitable portfolio. you. And I'll give myself one word here to something that he didn't actually ask about, but that's, I would just encourage, stay curious. I have learned more about how the world works from investing than anything I've ever learned in a book. It's just so incredible to see

Starting point is 00:24:54 what companies are doing out there, what they're working on, where the world is going, how everything works together is very exciting. And so stay curious because there is a whole lot to learn and it feels like it never ends and it only just evolves over time. So never get too down in your ways. Always be looking for what is something I don't understand that I want to know more about. Well, that's all we have time for on the show today. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial guidelines and is not approved by advertisers. Advertisements

Starting point is 00:25:41 are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks to our producer Dan Boyd and the rest of the Motley Fool team behind the glass. From Matt, Rachel, and myself, thank you so much for listening today and we will see you on the next episode.

Motley Fool Hidden Gems Investing - Another Semiconductor Stock Is Headed to the S&P 500

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