On Moats and Artificial Intelligence

David Barr and Felix Narhi discussed competitive moats and artificial intelligence at Wide-Moat Investing Summit 2017.

Dave, who serves as chief executive officer of Pender, also presented an investment thesis on Mattersight (Nasdaq: MATR), while Felix, chief investment officer of Pender, presented on Baidu (Nasdaq: BIDU).

The following transcript of selected remarks on competitive moats and artificial intelligence has been edited for space and clarity.

There are two buckets of moats. The traditional definition, as taught by Buffett, is the moat that protects highly profitable, established businesses. Emerging moats are also interesting. With regard to the history of wealth creation, Walmart and Starbucks, for example, compounded shareholder value at high rates before you could put a finger on how wide their moat was. It was in the process of becoming wider. Such companies have emerging moats. Once the moat is wide and large, often the value creation process slows down a bit. We like to look for companies with emerging moats because that is where much wealth creation occurs.

With regard to technology and disruption, increasingly many large legacy moats are being disrupted. Charlie Munger talked about the concept of “surfing” a number of years ago. An early surfer has an advantage because he can catch an initial technology or business wave and ride it for a long time. When a business is accomplishing changes and you catch the wave, you can get a long runway of compounding value. We always look for emerging moats that haven’t been fully identified but potentially have a long runway.

Technological disruption and competitive destruction are bigger forces than we have seen in a long time. These forces favor the “surfers”. With regard to traditional moats — e.g., Borders, Blockbuster, Kodak — two or three decades ago, Kodak had one of the widest moats. It seemed impenetrable. However, anything that could be digitized has increasingly been marginalized. Advances in technology have greatly diminished or destroyed many legacy moats. The basis of competition has changed, and legacy moat owners have often been slow to adapt to change. As a result, a huge amount of wealth has been transferred to the “surfers”.

With regard to where future value comes from, we’re at the early stages of this digitization process. Marc Andreessen, co-founder of Andreessen Horowitz, famously said six years ago that “software is eating the world.” Essentially, a growing portion of today’s analogue world is becoming digitized and value creation has been and will be continue to accrue to the early surfers who are the winner-takes-most digital leaders. The next inflection point on this technology journey is already here today which is artificial intelligence. Jen-Hsun Huang, the founder of Nvidia, last month said that “software’s eating the world, but AI’s going to eat software.” In terms of where tomorrow’s value creation will come from, it’s important to pay attention to some of these secular waves that are emerging.

A problem most people have is conceptualizing exponential growth. An analogy used about artificial intelligence to help put exponential growth into perspective is the story of the invention of chess. One day the inventor of chess showed his King his invention. The King was so impressed with it that he said, “Name your own prize for inventing this,” and the inventor replied, “Well, I’d like to have one grain of rice for the first square, two grains of rice for the second square, four and doubling it so on with each square.” The King thought this was a rather modest request and asked his treasurer to give the required amount of rice to the inventor.

At first, it was by the spoonful, then by the cupful, then by the barrelful. By the time the treasurer finished with the rice need for the first half of the chessboard, he had essentially given one large rice field’s worth of rice to the inventor. That’s still easy to conceptualize. That’s a large rice field, but it is relatable in a human-centric analog world. It’s in the back half of the chessboard where things get crazy. By the time the treasurer reaches the last square of the chessboard, he would have had to have given the equivalent rice fields that covered the entire earth all the way over twice including oceans. That is an unimaginable amount of rice and way more than humankind has ever made. The sheer magnitude of rice reached through exponential growth even when starting from a small number is hard to imagine. In a similar way, we believe many people are going to be surprised by the upcoming advancements driven by artificial intelligence. AI is essentially entering the proverbial “back half of the chessboard” stage of development and innovations over in the next two, three, five, and ten years are going to be mind-boggling and impactful for a lot of businesses.

When we look at artificial intelligence, we see a barbell approach. One area where we see an opportunity for companies to dominate and create big barriers is the platform companies. In North America, they include Google, Facebook, and Amazon. In China, Baidu is one of them. These platform companies have massive datasets, huge talent bases, and high-performance computing power. Competing with those companies is a big challenge.

Some smaller-cap companies have built up niche proprietary datasets. You have focused teams who understand the industry and their customers well. They get up every day trying to deliver ROI to customers. We have spent a lot of time investing in technology. Aside from AI, when we look at software companies, we try to find businesses that provide a solution to businesses. Consumers may buy cool technology and trendy things that look awesome. Businesses want either to increase revenue or decrease cost. They want to increase cash flow as a result of any solution they purchase.

About the instructors:

David Barr is the President and CEO of Pender. He is also the Portfolio Manager of several of Pender’s funds. The Pender Small Cap Opportunities Fund, which he manages, has won a Lipper Fund Award in 2015 and 2016 for Best Canadian Small/Mid Cap Equity Fund over both three and five year performance periods. The Lipper Awards recognize consistently strong performance relative to peers. The Fund has also received a Fundata FundGrade A+ Award in each of the last five years, with the Pender Value Fund winning for the first time in 2016, its third year since inception. The A+ ranking is based on an objective rating system that tracks risk-adjusted returns.Mr. Barr holds a Bachelor of Science degree from the University of British Columbia and an MBA from the Schulich School of Business. He earned his Chartered Financial Analyst designation in 2003 and is a past President of CFA Society Vancouver, having also served on its Board of Directors for four years. He remains an active member.Mr. Barr is a regular guest on BNN’s Business Day program and has been interviewed for his opinions on small cap companies, the technology sector and value investing by the Financial Post, The Globe & Mail and other media. In December 2012 Mr. Barr was recognised as one of British Columbia’s “Top Forty Under 40” business leaders by Business in Vancouver. Mr. Barr is an advocate of value investing as well as a true contrarian. He looks for value in unpopular places to find high quality businesses at a price that includes a “margin-of-safety”. Investing in a company trading below intrinsic value decreases the risk and increases the potential for generating significant long term performance.

Felix Narhi is the Chief Investment Officer of Pender. He is the Portfolio Manager of the Pender US All Cap Equity Fund and the Pender Strategic Growth and Income Fund, and Co-Manager of the Pender Value Fund. Prior to joining Pender in July 2013, Mr. Narhi spent over nine years at an independent and value-oriented investment firm in Vancouver. As a Director and Senior Equity Analyst, Mr. Narhi contributed thought leadership and primarily US equity ideas to the company’s Model Portfolio, a concentrated equity portfolio that has outpaced North American benchmarks since its inception in 1994. Mr. Narhi holds a Bachelor of Commerce degree from the University of British Columbia. He earned his Chartered Financial Analyst designation in 2003 and is a member of CFA Vancouver. Mr. Narhi advocates a business-like approach to investing. Sound investing is the process of determining the value underlying a security and then buying it at a considerable discount to that value. The greatest challenge is to maintain the necessary balance between patience, emotional fortitude and discipline to only buy when prices are attractive and to sell when they are dear, while avoiding the short-term “noise” that consumes most market participants.