Motley Fool Hidden Gems Investing - Smart Money ≠ High Returns

Episode Date: November 5, 2024

A red hot software company is continuing to impress investors. (00:21) Ricky Mulvey and David Meier offer up some counter programming for election night. They discuss: - Palantir’s impressive results. - Harvard’s “just ok” endowment returns. - Why individuals have advantages over institutional investors. - Stories causing them to be rationally optimistic. Companies discussed: PLTR, ACN, CTSH, VRTX Host: Ricky Mulvey Guest: David Meier Producer: Mary Long Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. if you want wall-to-wall election coverage well you've come to the wrong place you're listening to motley fool money i'm ricky malvey joined today by david meyer david i usually ask analysts how they're doing i'm gonna ask how is your uh how's your stress level you stay insane today absolutely absolutely stay insane good what's your uh what's your what's your plan for for election night? Are you glued to cable news? Are you staying away from your phone? We've got a lot of people on this show that claim they're going on walks on Tuesday. Look, the Bruins are

playing the Maple Leafs and the Flyers are playing the Hurricanes. So I'm going to be flipping back and forth between those two hockey games. But I'll be following the election. I mean, we have to. It's a huge event in our country. Obviously, for me, the things that will be interesting are the battleground state seeing how all that plays out so those are things i'll be paying attention to but i having having been around a while and been through a few elections you know we won't get a winner tonight just you know so from that standpoint uh i'll pay less attention we shall see and i will tell uh you know i don't think we have a ton of stock picks today i will say if you're in the denver colorado area the colorado avalanche you're playing the seattle kraken at

home tonight oh that's a good game too the ticket in well what's also going on the ticket inventory for that demand is far outstripping supply so i would imagine if you're listening to this show right at the right time right in the right location there's going to be some good deals to be had if you're interested in professional sports now's a great night to go look for a game if you're interested checking on your phone a little bit and having a nice distraction in front of you all right that's the uh that's the end of that um let's focus on some businesses because Yesterday, we had no other way to describe it than Red Hot Software Company reporting lights out earnings. This is Palantir. For those unfamiliar, Palantir builds artificial

intelligence platforms. It first made its name in defense. I'll use the company example. If you're a company, you bring Palantir in. It works across all of your software platforms, and then it can help you make real-time business decisions. One example they gave in the earnings call was insurance underwriting, taking a process from three weeks down to three hours, supply chain management if you're looking for alternate routes, weather, all sorts of data that people need to make decisions with. Palantir can help you. And a lot of companies are taking them up on this offer, Mr. David. Revenue rising 30%, 3-0 year over year. Here's the highlight, U.S. commercial revenue. So we started as a defense company, but a lot of companies are

buying this stuff u.s commercial revenue up more than half boom uh 54 to about 180 million for the quarter signing a lot of deals more than 100 deals just in the quarter worth more than a million dollars that's a lot for a software company and also palantir joined the s&p 500 that's a menu you were so excited you were jumping in on the points you didn't even wait for the i feel like a i feel like a waiter where you're given the specials and then the person's like yeah i'll take that one. No, no, no. I already know what I want. Okay. What do you want? I will say going up to that commercial revenue, that is actually the thing that really stood out to me. First of all, it's growing faster than everything else in the business. And as you so rightly mentioned,

this company has its roots in helping governments take control of their data and make better decisions, whether it's via military or any other agency within a government. But we have to remember, the commercial sector is enormous. And it's somewhat untapped now. I mean, we know AI is huge. We know what businesses are looking to figure out what plans and strategies they're going to enact in order to get the most out of AI. But that's where the growth is. And for Palantir to see growth 54% in that sector, it is very clear that they are capturing that demand very well. The other thing, cash flow generation. Oh, my goodness. This is amazing. Over the past nine months, the company has generated $694 million of operating cash flow on just over

$2 billion of revenue. That's a 35% margin. That is outstanding. Even if we account for stock-based compensation, which this company uses quite a bit of it to incent its employees, the margin is down. I think it's probably on the order of some quick math in my head, call it 15%. But the flow is still good. And since this is an asset-light company, meaning they don't have to make heavy investments in infrastructure. Free cash flow production is also incredible. We're not the only people that have noticed these results in what this company is doing, David. I want to get into the bull case because I don't own the stock. I'm interested in it as a story right now. And I think you got one of the best talkers in the game and CEO Alex Karp

saying, quote, our unchallenged ability to channel and guide the demand for integrating AI seamlessly with essential data distribution and decision-making structures is what truly sets us apart, end quote. So if you're a bull on Palantir, you're believing that a lot of the LLM stuff is commoditized. The gathering and making inferences with AI is a commodity. And then building these workflows and processes to drive decision-making is, is, is not a commodity. And in fact, led by Palantir. So I know that's a, that's a weird setup, but it's, it's central to the bull case for Palantir. Is Palantir's ability to do stuff with AI and data to integrate AI with data, if we're going to use Carp's words, truly unchallenged?

First of all, you, you summarize CEO Alex Carp perfectly. He is nothing if not bold. and I do have to appreciate it. I may not always agree with it. And I don't agree with it in this case because that statement of being unchallenged does not pass the smell test at all. There are plenty of companies out there who are trying to do the same thing. Let's take a company like Accenture, another one like Cognizant Technologies, consulting firms that are trying to do this, just to name a few. So, nope, I don't agree with that statement. But that being said, I absolutely agree that Palantir's execution is extremely strong. All we have to do is go look at the growth in the number of customers, the sales growth, the net dollar-based retention

of 118%. The rule of 40 score, rule of 40 is where as a software company, you take your revenue growth plus your margin is an astounding 68%. That is extremely high, especially for a company that's going to generate just below $3 billion of revenue by the end of the year. So it is very clear to me that Palantir's platform is the stuff of envy. And one quick comment about a case study that they highlighted a while back that has always stuck with me in really, I think it does a good job of showing just how powerful Palantir can be in the commercial realm. So Ferrari Racing hired Palantir to help them improve data analysis, especially real-time data analysis. Formula One races, they're decided by very small time differentials, right? That's the way the

racing works. Everyone is so competitive that you're just fighting for tenths of a second here and there. So, with Palantir's platform and AI capabilities, they help Ferrari's engineers and crew find opportunities to increase speed, maybe find fuel savings, and it's all done in real-time. Literally, at the snap of a finger, they're seeing all this data is being processed in real-time as the car is going around the track. They can make in-race adjustments to help them incrementally improve their lap times, which incrementally improves their probability of winning. Just think about that for a second. That is the most stressful environment to test a business case right that absolutely carries over to any other commercial entity

looking to take their data and make better decisions from it and not even have to do it in real time when the car is racing around the track ferrari also in number two in the constructor standings this year beating out red bull and mercedes kind of interesting isn't it it is a little it is a little interesting so yeah um we got time today we're not doing a b segment. So I want to ask you, why is the rule of 40 score? So even if you're not interested in Palantir, if you're looking at software companies, if you're a tech investor, why is the rule of 40 score something that investors should pay attention to? So a while ago, and I cannot remember Paul's last name, apologize to listeners, but there was a VC who basically was

looking at his portfolio and said, huh, there's something interesting here. If I draw a line through my companies that have revenue at various points in their lives, and I combine revenue plus margin, if I draw a line through the 40, if I regress and find 40, if you are at or above 40, you tended to do very well. If you're below 40, you tended to not do well. And so what that helped as a VC was say, hey, you know, keep doing what you're doing if a portfolio company was doing well, or hey, as a portfolio company, I recommend that you make a change here, try to do something better. So it was sort of a line of demarcation. And if you think about it, right, you could be growing at 100% a year, and your margins could be at negative 60, right? But as long as you keep

growing. At some point, you will get better. That's where the idea comes from. But as you get more and more mature, growth levels come down. You want to see, okay, does this company achieve scale? Well, Palantir is growing quickly and it's clearly at scale. If not, maybe even achieving more scale. So 68% is a pretty incredible number for a mature company like Palantir. so it's it's a way for investors to look at uh you know if you're going to make a trade-off between efficiency and how quickly you're growing sales this is a way to measure both mature and younger companies what do you what do you need me for you summed it up perfectly there because i i i'm trying to i'm trying to take what you're saying and then distill it down so you hear

it and then you have the takeaway perfect for people reading a transcript they can go back and look at the transcript you did it perfectly there it's exactly what you're trying to do speaking of speaking of valuation measures that's the revenue growth that's the operating margin on the other side you have investors who are hungry for this stock and i'm not trying i i don't want to dismiss it because if this really is like like the bulls say this is the software version of nvidia please be careful in the transcript i am not saying that this is the software version of nvidia i'm saying that this is what the bull case is right and you have a lot of customers coming in that's why you're seeing the 54% commercial revenue growth. Clearly, there's a differentiator

here. Then maybe the stock is a steal. After all, we're looking at $113 billion market cap. And if this is the best unchallenged software provider in the artificial intelligence arms race, then that's a steal. On the other side, this is a company that trades at 50, 5-0 time sales in 138 times forward earnings. Can we use these traditional valuation measures to make sense of a company like this? So I love the lead in. And what I'll say is, and I'm not trying to be snarky here, but you can always use traditional valuation metrics to analyze any company. So we should never forget that. But as an investor, what you need to make sure is you understand the context of the situation, the environment that the company is operating in, as well as you have to have

a reasonable understanding of what can happen in the future and how the company can capture those growth opportunities. So long-winded way of saying, does this company have a competitive advantage? How are they using that competitive advantage to go after a big total addressable market. And then I have to, as an investor, I have to make some estimation of, okay, I think they can get X percent of that total addressable market. But let's go back in time just a bit and see where we're coming from. So in December of 2022, Palantir was trading at just under five times forward sales. That's lightweight. That's very lightweight. Okay. And yes, the profitability numbers weren't as good as they are today, but given the opportunity ahead,

that was probably a little bit low. Today, we can go back and forth about what the number is, but let's take one between, let's say it's 40 times forward sales. What that is telling us, the journey from five to well into double digits, means that investors have reformulated their expectations and now see Palantir as the huge winner in the space. We have to remember market prices are some combination of fundamental performance and investor attitude, investor psychology. What's interesting, so my back of the napkin math is 45-ish times sales. And we quickly round that up to make numbers easier to 50. But when we're doing these leaps, even from one to two to three times sales these are significant for a company absolutely and to

to be perfectly fair to you there what's the difference between 35 and 50 times sales when we're talking about a number that is just so high right one to two is a double 35 to 50 is uh 25 30 increase so anyway and you know i know you don't want to be snarky this is the best time to be snarky. We can go SMCI with this thing. If you've got anything that you need to let out from an accounting firm, we've got the election night shift. If you have just an opinion you really need to express in a public way, but make sure there's not a lot of ears on it, this is a great place to do it. I want to get to this other story. This was in the Bloomberg Business Week, October-November issue, written by Janet Lauren. Great story about Harvard's endowment and the underperformance

that's been going on there. This is interesting to talk to you about because you've been on both sides as an individual investor and as an institutional investor. And my headline for this is, how about a victory lap for the individual investor that's not smart money? This story reveals that over the past 20 years, Harvard's endowment achieved an annual return of about 9%. This lags most large university funds. You think of Harvard being in the top one of the top 1% for those universities. It's in the bottom 40% of endowment funds, and they got a lot of smart money there. What?

You've spent time on the institutional side. Are these lackluster, I'm calling them lackluster results. Are these lackluster results surprising? It depends on how you define lackluster. I define it as spending $800 million for people to make money over the past 20 years and you underperform that much. That's very, no, your point is well taken.

Let me provide a little context about how it tends to work on the institutional side, especially on the endowment side. So we had a consultant come when we were trying to grow the funds down in Motley Fool Asset Management, come and explain to us how the endowment market works from an asset management side of things. And I can't stress this enough. They certainly want to see their investment portfolio grow. But what they most want is they most want it to have as little volatility as possible. And the reason is, and this is especially true, the smaller the endowment you have for your school, you don't want to lose money. That is completely anathema. Students are going to get

hurt. They're going to feel that pain. And the schools say, OK, we don't want to do this. So how do we reduce volatility and still get some acceptable level of return based on goals that we have? Well, the way that you do it is you try to find as many non-correlated assets that are providing some level of risk and return. And you smoosh them all together in a portfolio. And you see how it works out. We were talking before the show about Brazilian land. Why would you do that? Now, it very well could be because there was return opportunities associated with it. You're not going to invest in something that's going to lose money. You don't go into anything trying to do that on the long side. But that land is not correlated with the S&P 500, let's say.

It doesn't matter what's happening in the S&P 500. The land is going to do what the land does in that market. Since it's non-correlated, maybe it's in fact going up at a time when the S&P 500 is going down. And so it provides you a benefit, a ballast, dampening out that volatility that as an institutional investor, that's your job, to dampen out the volatility and to give some level of return. Clearly, when you compare it to what other endowments are doing, Harvard is behind the curve, but we'd have to start looking at what are the goals, what is the investment committee saying, things like that. Some of the goals are that they want this investment fund to be thinking in terms of hundreds of years. And in that case, they ramped

up their risk exposure to things like private equity, venture capital. And the Brazilian land thing is sort of easy to dunk on. They took a $1 billion write down on it. And when that kind of thing doesn't work out, it's easy for me as a person who talks smack on the internet for a living to say, you got outside of your circle of competence. What were you doing? But that's the thing. The way the endowment is also set up is they're trying to go find investment managers where that is their circle of confidence. They're not trying to make that investment themselves. They're hiring it out. And so that's the committee's job is to say, okay, we want to have exposure to all sorts of different asset classes, and we're going to go find experts to

do it. And we're going to give them part of our asset base to manage. So I think this gets into some of the advantage you have, you the listener, as an individual investor, is what was going on at the Harvard endowment. And one reason they performed a little bit less than you may expect for smart money. I won't call it underperformance. We just had that talk. But basically, the story explains that, quote, the school ratcheted up risk before market downturns, then cut its exposure right before markets recovered. It bought once hot investments only to watch them go sour, end quote. One example is they got out of equities with a hedge fund right in, I think, in the latter half of 2022, when it would have been, over the past few years, the best time

to get in some of those riskier technology stocks. Why is the smart money doing this? Why can't they move like an individual investor? Oh, this is such a good question. So, one thing that we have to remember is that the investment managers in this situation are, in fact, reporting to the investing committee, and the investing committee puts them on the hook for certain goals. So, if the strategy isn't working, and in this particular example, let's say stocks in 2022, because stocks in 2021, especially if you were on the tech side of things, you were feeling the pain. That hurt. I was there. I got half my gray hairs because of that. What tends to happen at that point is those investment managers may be forced to, because

of the rules of the game they're playing, to make a decision they don't necessarily want to make. Again, feeling that pain, the investment committee seeing that pain, everybody is saying, hey, there's pain, there's pain, there's pain. What do you do? You try to get rid of the pain. And as an institution, the institutional imperative is saying, look, you just got to get rid of it. I don't care. Sell the loser. We got to get it into something else. What do you think the lesson is for individual investors looking at this, pointing their finger like Nelson in The Simpsons saying, ha-ha, because they see this underperformance? What's the lesson for individual investors from this story? So, we talk about temperament being a critical asset for investing success here at The Motley Fool. And the individual investor can use that to her advantage way more often than the institution can. There's just so many different incentives and so many different pressures that an institution

is feeling that as individuals, we don't feel them. That's the way it is. But it does require lots of internal reflection. You have to know who you are. So let me give you a quick example. I am okay with risk. I invest in technology-related stocks. I'm looking out. I'm just like Harvard. I'm trying to think of these in terms of 100-year increments when I take an initial investment. But I typically do not invest money that I need to be liquid. I'm okay with that. so I can be a little bit more patient with my investments, especially during volatile times. And institutional investors just may not have that luxury. We talked about the investment committee. These investment managers have risk managers who are looking at this going,

hey, this is going to hurt your portfolio if you don't get out of this. Or hey, you've got a nice gain here. You need to take some of it off the table in order to protect your performance. because lack of performance, whatever the metric is, means money is being pulled. Nobody's pulling as an individual investor. It's just you and your money. Once you know your temperament and your timeframe, you can make better decisions as a result of that. As we wrap up here, I've been feeling this. I don't know if you've been feeling this this past week. I know a lot of listeners have been feeling this. I'm feeling it itchy. I'm feeling on edge. I feel that I am in a place that is divided and uncertain, and I don't like it.

And I am trying to return to this place that David Gardner talked about on Friday's show of rational optimism, not unfettered optimism, but rational optimism. And when I try to actively look for that, it's harder to find, but there are stories that can make me rationally optimistic. one being from Vertex Pharmaceuticals that they are going to launch in early 2025 a non-opioid painkiller. Boom. If that works out, what a wonderful and incredible thing that could be. Imagining a world without opioid addictions that this could help with is something that brings me an immense amount of joy. A game changer on so many levels. I will use that as a lead-in as I try to lean into this. The world is slowly getting better,

not every day, but slowly getting better, what is a story, trend, something that's making you rationally optimistic about the future on this November 5th show of 2024? Oh, I love this question. And because it gives me an opportunity to plug arguably the most influential book of my investing career. And that is Matt Ridley's, R-I-D-E-L-Y. Get ready for this. It's called The Rational Optimist. shocking i know but basically what the book says is it pays to invest in progress because progress is relentless and he goes back thousands of years to show why progress is relentless and how it's made life better over time you may not see it right now right but it's happening you may not

feel it right now, but it's always happening. So the first thing I'd highly recommend everyone listening do, go find Matt Ridley's The Rational Optimist and read it. It is a phenomenal book. That'll get you out of your doldrums right away. You don't even have to do anything more than that. But so like I said, I spend most of my time in the tech sector. That's my background. I was an engineer before I joined The Motley Fool. And there is no doubt that artificial intelligence is and will continue to be an incredibly important technology innovation going forward. We've seen the success at companies like NVIDIA on the hardware or infrastructure side of things. There's no doubt those trends are in place and they're going to continue to keep working in

that direction. And we're just starting to see software companies rolling out AI-based tools to their customers. I don't think that's fully appreciated yet. And the reason I don't think it's fully appreciated yet is because within those companies, it's still very difficult to see the revenue streams. Palantir is a different animal, right? You can see they're using the technology. We know it's the fundamental basis of what they're doing. And you can see the revenue streams that it's generating. But for those other companies, they're there. One example I would have is Smartsheet, which recently it was announced that it's going to be acquired by a private equity firm. They were just touting after years of development, they were touting, hey,

we're rolling it out. Customers are liking it. So we're rolling more out, more AI-based initiatives. Customers are liking it. The private equity firm probably got them for a steal if that's the case and it keeps going. So like I said, those revenue streams are there. They're growing, it's hard to see them. And I think that could be a decade-long opportunity for growth within the AI application space. We're still in the very early innings of a trend that seems very, very much intact. If you're about a half hour into an investing show on November 5th, I'm guessing you're one of the hardcores of investing. And I just want to thank you for the time you've spent with us today, for the time you spend with us on Motley Fool Money.

And now I'll talk to David, who's actually on the show. David, thank you for your time, for your insight. Thanks for joining us on November 5th, 2024. My pleasure. Thank you. As always, people on the program may have interests 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 standards and are not approved by advertisers.

The Motley Fool only picks products that it would personally recommend to friends like you. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.