Bert Hochfeld On The Investing City Podcast (Transcript)

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Includes: AMZN, ANET, APPL, ESTC, GWRE, IBM, MSFT, NTNX, SHOP, SQ, TTD, TWLO, VEEV, VMW, ZS
by: Investing City
Summary

Bert goes over his own research process to analyze fast growing tech stocks.

Bert talks about digital transformation and why that is a foreign concept to value investors.

He ends with a case study of a stock he really likes right now.

This is a transcript of Bert Hochfeld on The Investing City podcast.

Click here to listen.

Ryan Reeves

We are live and just so excited to have Bert Hochfeld on the podcast. Bert is a legend in the equity research space. And we're just so honored to have you on.

Bert Hochfeld

Well, that's very nice. I don't know if I'm a legend -- if I'm a legend, I hope It's a good one.

Ryan Reeves

Okay, so let's just hop right into it. Bert, can you give us a little bit of your background and how you got interested in the stock market and maybe just kind of your progression to where you are now?

Bert Hochfeld

Sure. Well, that's a bit of a long story. But I've been interested in the stock market for, believe it or not, 60 years or something like that. My parents encouraged my interest. And my father tried to teach me a little bit about the stock market. I've always been fascinated by how the financial markets work. And I was fortunate enough to go to the University of Pennsylvania where the practice of econometrics was being developed in the early 1960s. And then I went to HBS, and then I went to work for IBM (IBM). And so I had a good background in this area.

And I after I worked at IBM, I worked at several other tech companies, Raytheon Data Systems, BMC software, etc. And then finally, I decided I wanted to come back to the northeast after I was in Houston. And so I came back up here 25 years ago and got into working for a variety of companies. I set up my own independent research company, when that became the way of doing this business. I set up a hedge fund as well that invested in the tech area. And over time I decided that I would set up a website subscription service for people that are interested in investing in tech investing. And that's called Ticker Target. And I welcome listeners to subscribe. That's where I am today.

Ryan Reeves

So your first job out of HBS was at IBM. Was that kind of a turning point in you becoming really interested in technology or had you been interested before that?

Bert Hochfeld

I've been interested in technology for a long, long time and had been interested in working at IBM for a long, long time. And I had that opportunity back in 1969, IBM was kind enough to hire me after my military service. And so I went to work there as a financial analyst doing pricing and planning. And I got to understand how the computer industry worked at that time. From the perspective of the dominant player. I mean, it's hard to believe today, it's a sad story. But IBM as you may or may not be aware, basically was the number one company in the space and it had the opportunity to remain a dominant player for many years. Sadly, it didn't choose to grasp the nettle so to speak- it was always an issue with IBM, the level of money they might leave on the table, if they innovated too rapidly.

Ryan Reeves

From your perspective do you think there's something that they, obviously, should have seen -- some paradigm shift in tech, because you read all Clayton Christensen's kind of literature on these big companies being disrupted. And how do you think they could have prevented that?

Bert Hochfeld

Well, I mean, from my own personal experience, IBM simply wasn't prepared to give up current profit dollars to innovate as rapidly as possible. My little area of business was peripherals what today people call storage and memory and IBM had the opportunity to develop that area of their business far, far more aggressively than they did. I mean IBM basically just gave up market share to EMC because they chose not to engage at the level that they should have. And now IBM does not have its own hyper converged solution. I mean, they basically have hardware, but they have to get their software from Nutanix (NTNX). That's a sad commentary.

Ryan Reeves

And you mentioned Nutanix, and it's a company that is really interesting. And I think it would be a cool practice for us to kind of go through that company as kind of like a blueprint for your research process. And let's just start with how you find companies, sort of like your sourcing?

Bert Hochfeld

Friends that have been in the business directed me to do Nutanix oh, gosh, about seven or eight years ago. So when they went public a couple of years ago, I was focused on what they were doing, and I was focused on how they were doing it. Hyper converged is something that people have wanted to be able to deal with for a long time, it's a far more efficient process, how should I put into propagating a data center then having a separate silo storage, a separate silo for networking, a separate silo for processing. So over the years, people have been figuring out how they could combine all those activities in a single package and reduce latency and make it far easier for users to enjoy the benefits of modern technology. I'm not going to try to argue whether a Dell VMware (VMW) or Nutanix got their first because that's kind of a sterile debate, but I will say that the man who runs Nutanix, Pandey is obviously one of the more far-seeing individuals in the world of IT. He has developed a fantastic stack of technology in a very short period of time.

And I was able to figure out that Nutanix would have a very bright future because he was fulfilling a need that people have. And that is to do away with the very expensive, difficult to manage, difficult to customize data centers. Nobody wants to be in the data center business that I can promise you and with hyper converged, you have the opportunity to self-manage a data center that's cheap, very quick to set up and is basically self-mending. It took off and the company had a stumble one quarter right after it became a public company, and you have the opportunity for about six or nine months to buy the shares at a reasonable valuation-we still have that opportunity. The stock in my opinion, is still very cheap. But I focused on Nutanix, because they were the leader in a hot area of the IT world, they still are the Xi product that finally reached general availability at the end of last year. It will disrupt the space yet again, in the first major innovation in backup and recovery that I've seen since the days of data domain, if you remember, data domain, and it sounds to me like you're young, you may not remember that, but this is a very big deal in backup and recovery.

Ryan Reeves

I appreciate all the details there. And it would be awesome to kind of break down your research process when you're looking into Nutanix. So, your friend brings you the name Nutanix and you've been following it for years. And you find out it IPOs What are the kinds of things - obviously you're reading all the statements and I'm sure you're looking into more of the technological differentiation, but for listeners, what would be your advice that they could kind of take actionable steps in order to have a much more informed investing process?

Bert Hochfeld

I would suggest that they try to figure out what the pain points are, or users in the IT world. I mean, generally speaking, what you will find is that the highly successful companies are doing things that people have been complaining about for years, that is to say, you take an example, more recently, example ZScaler (ZS), or if you're at all familiar with the IT world, you know very well that people have had to populate their data centers, with appliances from Palo Alto, or from wherever it's a pain in the, whatever. And it's really not something that anybody wants to get involved with. And the management of trying to coordinate hundreds of different firewalls, because you need a firewall, every place that you have data.

So ZScaler comes along and offers a service, which is particularly attractive if you were morphing to the cloud. And instead of having a hardware box at every data center, it has a facility that ingests all the data and searches for anomalies and protects you in that fashion. The thing about ZScaler is it's way faster, it scales much better. I mean, that's why it's both these pillars and it sounds a bit of a problem for people trained to have to migrate to the hybrid cloud. So, you don't have to be, I mean, the fact that the numbers say that these pillars are growing at 70%, but what you need to do, in my opinion, is to focus on why it's growing. And 70% is because they can buy a huge facility, you can't get out of that and you can't get that anywhere else. And that's how I start looking at companies is how do they make a difference in the IT world.

Ryan Reeves

How would you advise them to do the research in order to find out those pain points by just thinking about it? Kind of common sensical or is there kind of process that you would advise?

Bert Hochfeld

Well, there is a strong amount of common sense involved. I mean, not everybody who's started a company is successful. And the ones that are successful have focused on what it is that people have problems with -- you take the Veeva (VEEV) or Guidewire (GWRE) people who founded these companies for example, the Guidewire CEO was a consultant in the insurance industry I think for 15 years before he founded Guidewire. He knew that insurance companies did not properly address and quote products -- using that he built a solution, he built a multi-billion dollar business. The same with Peter Gassner with Veeva. You asked about process, the first thing I would do is look at who runs these companies and their record. And you can do that so much more easily today by looking at their LinkedIn profile and get a sense of who they are. I think you and I talked about Jeff Green over at Trade Desk (TTD), great. Look at Jeff Green, and his background -- if there's somebody who knows about what people want in the online advertising space it is going to be Jeff Green. I can assure you because he's been there and done that. I mean, for the online advertising company he saw it born -he knows the business backwards and forwards. So, he figured out that programmatic advertising and connected TV were going to present major opportunities and then built a company around that idea. And I would suggest that your listeners go to the web-today research is infinitely easier than it was 10 years ago. You can read all kinds of things about connected TV, you can read all kinds of things about programmatic advertising, you can find out what other people think the growth rate is, you can easily get a hold of conference call transcripts -- I mean not everybody, contrary to popular belief, not everybody in corporate management are liars. Some actually give you good information.

So, I think your listeners should go through a process whereby they become not experts, but at least have some basic knowledge about why companies might be successful. It can start by looking at who runs it and what their track record is. And then they can look carefully at third parties. A company that I like is called Arista (ANET). Anet, is run by for sure the highest talents in the networking space. I think, JayShree, her name is JayShree, her name is hard for me to pronounce, Ullal ,and her colleague, who basically was the technology guy at Sun, they know more about networking than the next 10 people combined really-so it's not terribly surprising that Arista networks has been able to take market share at a huge rate in the network switching business and is run by the people who know more about work switching than anybody possibly can.

Ryan Reeves

Management is obviously very important. So a big emphasis on management -- are there any other indicators that you're typically looking for in that because a lot of investing is just pattern recognition, looking at kind of the same things. So what are some of the other indicators you look for?

Bert Hochfeld

I am looking for companies that are enjoying a fair amount of, well, there are some metrics that most of us use that work well in context --I look at EV sales relative to growth. I actually put together a chart which is kind of my Bible and a best fit line. And I see where companies fall on that, whether they fall above or below. So I look at their growth, and I look at their EV to sales. And I think that's very important. So the second thing I look at is I take the same way with regards to EV to sales ratio, and I look at their free cash flow margin. So you take a company like Viva, Elastic, or some of these other companies, and they look like they're very expensive, because you'll see many commentaries about that. And then you say, are they very expensive, and you will see they have very high free cash flow margin. So investors have been quite rational, they're paying up for great business models, you probably want to try to evaluate competitors. Nowadays, people can go to the web, they can read the Gartner Magic Quadrant Analysis -- I started to suggest that people do that, at least as a background, or they prefer IDC, which has what they call a wave analysis. So I looked at both, and I try to build a mosaic around those things.

I don't mind paying a lot for Elastic (ESTC), although some people think I'm crazy. I don't mind paying 12 times forward revenues because it's profitable and because I love the tech. I don't mean to say I love the technology, I love what you can do with that technology. All this you can accomplish for you. I do look at what's called dollar based net expansion rate. That's a very crucial metric for me, I want to see if a person spent $1 on a solution in year one, how much she's going to spend in year two and year three. Many companies will report that metric and I would spend a lot of time focused on just how high that can be – Twilio (TWLO) is the name that you may be familiar with. The listeners may be familiar with why is Twilio more than triple last year, but you can say the growth is better than expected. But what I would point out as much as that is the dollar based expansion rate stayed above 150%. That's remarkable. That really is remarkable. It means that customers are expanding their usage of Twilio, that's how you get to be a big company.

Ryan Reeves

And you mentioned in all that good information, some valuation stuff. And so the first thing that a lot of people would be skeptical about investing in technology stocks is probably valuation right? And I'm sure you get that a bunch. So how do you kind of think about valuation and you mentioned a little bit with Elastic -- numbers you're looking at, comps and things like that, but what would you say to somebody who is a hardcore value investor who wouldn't touch the type of stocks that you or I do. What would you say?

Bert Hochfeld

I had this interesting conversation with Lee, a colleague of mine about 10 days ago. And I said, 70% growth, sure, is almost anything you need to worry about when it comes to valuation. Elastic happens to be growing at 72 or 73%. So yeah, valuation in the classic sense, you're not going to find companies that are growing at 70%. Part of the problem I would say is that value investors have a difficult time in understanding why it is that a company can grow and 70% for 2, 3, 4, and 5 years, okay. And that's where you have to get involved in understanding what people do with the product. And this is not consumer electronics. This is stuff where people take it and they built it, they use it to create things and invest -- it's hard for some people they just don't have the desire to or the imagination or to try to understand what digital transformation is- it's just so much. Well, it's not okay I mean if you're going to buy auto insurance -when I get an agent involved who's going to make a commission, he's not going to give you the best price -you want to buy it online, you want to be able to compare prices, you want to be able to sign up for it completely online in a self-service paradigm. So you can be able to figure that stuff out.

You can say okay, to guide the buyer or give up because these things they're too expensive. Well, no, they're not. They're not expensive at all. Because that's going on right now. And it's going to continue to go on for several years, want to buy a house, hey, you're gonna get a mortgage, you're going to go to a mortgage broker? Or do you want to go online and look at competing rates, terms, conditions and do it self-service, some older people I suppose that they do want to talk to a mortgage broker. But younger people know that they're there, they want to do it a different way. And that's going to continue to go on for a long period of time. I mean, you look at companies like Shopify (SHOP) and Square (SQ) that have transformed the way people do e-commerce growth. Well, they're very expensive, if you think their growth is going to come to a halt or you can think they're going to continue to innovate for five years, or seven years, and have hyper growth for a long period of time. Well, they're not expensive at all, they're cheap.

And again, I'll get back to management. Jack Dorsey is a genius. I may, you know, not like the clothes you wear, his or his politics, but what he used to achieve, okay, he has figured out how to create a solution that small business people find extremely attractive and has created a business around it. And it's not going to stop growing in 2019, or in 2020. Jack and his colleagues are the fantastic innovators. That's what I'm looking at. That's why I don't think valuation analysis is that the value investors want to cram down people's throat? Is this sensible? I mean, maybe that's bad for me to say, but I think they're looking they're not taking seriously how the world is changing,

Ryan Reeves

Looking at technology, a lot of those same value investors would probably say that the world changes so quickly that how can you kind of stay on top of all of this innovation? What are your thoughts? Or do you have a process on staying up with this because the world has changed, especially in the IT landscape? So how do you stay on top of this ever-changing investment landscape?

Bert Hochfeld

Well, I mean, these days it is so much easier than before, there are many services that allow investors to look at preliminary analysis of IPOs, there are more subscription-based services that are free than you can shake a stick at and you got to read a lot, okay. I mean, you're gonna get to read about but you're gonna get on the mailing list, or the email distribution list of these companies, and they're going to send you product announcements. And then you're going to look at how those product announcements are analyzed by industry experts and you can find that on the web nowadays. And that's what you're going to do. You're not going to get it right all the time. Jack Dorsey doesn't get it right all the time. Tobi Lutke of Shopify doesn't get it right all the time, and so forth and so on. But you, you look at what they're doing, and you would evaluate it. And one of the things I suggest people do is think of themselves as users and decide whether or not if they were buying a solution that they would buy what was being offered. Sometimes that's hard to do. And I don't say it always works.

But I don't know if you remember Peter Lynch and how he ran Magellan. But it's a lot like that. And for example, Jack Dorsey who got together a set of solutions around the restaurant business, the food service business that you would have never in a million years thought was something that would be high growth and profit. But if you thought about it, from the point of view of the restaurant tour needed to figure out how to deliver food to expand the revenue base, and then get paid for it quickly, and then keep track of inventory and pay people in the restaurants. It's all on one seamless platform. And it's proven to be incredibly successful. And people had a lot of skepticism when it was first introduced.

Ryan Reeves

Sometimes it’s hard just figuring out kind of the competitive landscape because one of the flaws sometimes that people point out with Square or maybe even Shopify is that there's a lot of alternatives and it may be somebody says it's a crowded space. So how do you kind of think about that in terms of competition, whereas some other company like Twilio, maybe doesn't have competition at the same level of skill at the same level of scale to competition at the same level of scale? So how do you think about that?

Bert Hochfeld

You know, Ryan, they all have competition in Twilio, if you go to the web today this this afternoon and you go Twilio competitors and you'll see Quora or other answers G2Crowd or whatever they all have alternatives. Believe me it's a matter of execution sales and marketing, it's a matter of aggressiveness. I mean obviously Square and Shopify been the have become the category leaders because they've been willing to be far more aggressive than the other folks in their in their space. I mean Marketo, for example, still it's not a hosted product okay. Tell me: if you want to create a web store, do you want to be in the IT business or do you want to be in the selling business? Well I think you don't want to be in the IT business and self-host and deal with that, so Marketo could have been a big company, but they made that choice. If you just want to create a web store, I guarantee you could go to the Shopify solution.

If you're an SMB and you need to take payments remotely, Square had a first mover advantage. I remember they were running commercials about golf pros and babysitters. God knows what else and they got several hundred thousand users in short order. And they took that and leveraged it to build a business around payments. Dorsey didn't rest at that level. I never would have thought people would pay a point to get their money the same day, but they do. You figure out what that interest rate is. That’s why square became the behemoth it's become today. I still have to shake my head and say, how the heck did he figure out that there was such a demand for getting paid the same day that you sold something and that you could charge somebody 1%? They pay it. Very smart man, very smart.

Ryan Reeves

Sometimes other investors, maybe more low growth investors, more value investors, talk about technology, about how sexy industries get bid up in price and longer term that might not be sustainable, what do you have to say about that?

Bert Hochfeld

The reason people pay a lot of money for IT companies is because, I don't try to look at the macros all that much, but the percentage of GDP going into IT is rising continuously. It's doing so because of the productivity gains. It is very hard to be able to create improvements in productivity any other way. You don't think that these companies that are doing digital transformations are doing it because they enjoy tearing up a business structure that's been in place for 50 years, 75 years. It’s cheaper to do it that way. I mean, it is hard, but cheaper if you can get your customer to be his own salesperson. So you're doing away with insurance agents, real estate agents, when's the last time you just a travel agent? Ryan, I mean, you're a young guy. So you probably never used to travel agent. So what I'm telling you is all the money that used to get spent travel agents now gets spent on building websites for airlines, hotels, etc. etc.

Why people pay a lot is pretty straightforward. You can't operate a hotel or an airline or whatever, unless you have a good website, you will pay whatever it takes to have a good website. Because otherwise you can go out of business. And if that cost you more money, it cost you more money. But I think what you're seeing is that the world is moving that way and will continue to move that way for the foreseeable future. And I think that's why people pay so much money for IT companies is because they're increasing their share of GDP, because they have the various that a lot of people as being as a group, what's different today, than 1999, and particularly than 2000. And I say, the biggest difference is you don't see vaporware. You see very high ROI, tangible. And that's what that that's why people pay a lot of money for this stuff.

Ryan Reeves

You touched on a lot of really good points there. And what do you think about kind of barriers to entry, because typically, maybe in the old world, you had like hard assets, where somebody with maybe a lot of money up front could compete with you. But then that would create maybe, maybe economies of scale? How do you think about that? And how do you monitor kind of competitive advantage?

Bert Hochfeld

First of all, you want to recognize that there are there's always competition, I have yet to see a decent space in which there wasn't competition. So we can take that out of our mind, but that I look at the biggest barrier to entry being the entire process of innovation. And does the company have a culture of innovation or does a company, I mean, I'll get back to what we started with IBM. IBM, you know, it was just in the paper today or yesterday has the most patents of any company in the United States. I think it was 9000 they got granted. But they don't really have a culture of innovation. They're not willing to eat their own children, whereas the successful companies, Nutanix, are always replacing successful products with the next generation and the next generation they're willing to spend it inordinate amounts of money doing so.

I’m not an expert on Apple (OTC:APPL). I absolutely disclaim any domain expertise. But I'll say one thing, and that is that Apple has been unable, for whatever reason, to figure out the next big thing in consumer electronics. And whether it's Mr. Cook, or whether it's the culture or what, it is a strategy of raising prices is exactly opposite what you see in the technology space, where prices come down dramatically, year after year after year, and you get more for your money year after year.

Ryan Reeves

You're talking about kind of the pricing power coming down, because Warren Buffett infamously talked about how, if you need to have a prayer meeting before raising prices, then you maybe don't have a fantastic business, but how does the kind of work in IT world related to that?

Bert Hochfeld

So what I would tell you is that elasticity of demand is alive and well. And if people can reduce prices, things that were not feasible to do become feasible to do, and that's what you see. All your listeners have probably heard about the cloud, right? What do you think the cloud the biggest benefit of the cloud is, it's cheap, it's very cheap, and it comes down in price every year, and yet AWS (AMZN) is still growing at 45%, and Microsoft (MSFT) is growing at what is it 85%? It's a pretty basic thing if I can do something for a buck that used to cost two bucks to do, the odds are, I'm going to have more than the than twice the demand for it. What's going on really is not that it is it's not much more complicated than that: elasticity of demand is very high.

Get back again, to digital transformation. It's so very expensive to do a digital transformation. It's not just the software need, but it's the people. Low code and no code has become a paradigm in IT that basically means you no longer have to know a computer language to implement some of these digital transformations. That's one of the reasons why the demand for these digital transformations has shot up because it's much easier to do when I say it's much easier to do a cost much less than it used to cost that's really what's happened and that will continue to happen.

I first studied multiple linear regression, God knows how difficult it was to do, overnight runs all that good stuff. Now, you take a company like Alteryx, that has made it the AI accessible to what are called CS data scientists, people who really are not trained in to be data science, they're not degree holders, but that’s why Alteryx is growing 59%. It’s because they've been they've democratized access to information so that everybody can get a hold of it and do something with it. And queries that we're not really economic to ask as a few years ago, all of the sudden now you can make better decisions. If you could do that, wouldn't you do that? If it didn't cost too much wasn't too troublesome? A portion would do that. So basically, what you're seeing is price elasticity work.

Ryan Reeves

That's really great answer, but I don't want to take up too much of your time. But I think it would be a fun way to kind of end it for you too. I mean, if you're comfortable with it, to just talk about a company that you think he I mean, it could be the one the ones that you brought up, but just one of the ones that you think looks pretty good?

Bert Hochfeld

ZScaler is a great company Alteryx is a great company, Nutanix is a great company, Trade Desk is a great company. Which one should I talk about Ryan? Your choice.

Ryan Reeves

How about Nutanix?

Bert Hochfeld

It's a fascinating case study. It started out as a hardware company and it basically developed software that facilitated hyper convergence. Its value-add is not it bought a hardware boxes from OEM ,Nutanix has software that runs on everybody else's hardware. Not only does it run a on white boxes, Chinese hardware, on IBM, it runs on HP runs on Dell, there are seven different hardware platforms to run. So this essentially frees buyers from any kind of vendor lock in so they can use Nutanix hyper converged, without paying much attention to whose hardware. It runs the same, and Nutanix has developed something called a hypervisor, which is a way of managing data centers, that is a generation in advance of the other major hypervisor is that are on the market. And now with the backup and recovery.

Until recently, backup and recovery was basically a hardware process, you bought an appliance, and you put the appliance in a mountain or in some hardened site remote from your data. And then if God forbid you had an outage, you would take the data and you'd have to rehydrate it, that's what they call it. I kid you not. Rehydration usually takes about a day. So it's a bad process. Now, rehydration, backup and recovery is basically invisible to the user. I expect in 2019 that we're going to see Nutanix is still growing north and 50% I'm not sure how much faster than 50% but backup and recovery is a market that is actually larger than hyper converged.

Ryan Reeves

Love that example to end but Bert we don't want to take up too much of your time but it has been a pleasure to pick your brain about kind of your investment process and how you think about tech companies. I just wanted to thank you so much for your time.

Bert Hochfeld

Thank you Ryan for having me as a guest, I appreciate it. Look forward to talking to you again.

Disclosure: I am/we are long NTNX, SQ, AYX, TTD, ZS, TWLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Bert may also own securities discussed in this podcast.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.