The Active Investor: Gauging the Potential for Innovation Growth

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Brian Foerster: This is Brian Foerster, and welcome to The Active Investor podcast, our monthly look at asset classes and investment styles that have the potential for delivering alpha, and we also get a chance to hear how some of our own investment leaders at Lord Abbett are looking at opportunities today.

And for this episode we are talking about growth investing, and to be more specific, the area we, and now many other investors, call "innovation growth." And Lord Abbett was one of the first pioneers in this space, going all the way back to 1973, when we launched the Developing Growth Fund, one of the first funds to invest in Nasdaq-listed stocks.

But then in 2003, we really took on the mantle of being innovation investors with a new team, a new lead PM [portfolio manager], and we really transformed our small-cap portfolio to be one that was looking at early disruptors, like Netflix and Intuitive Surgical, which are of course now mega-cap established market leaders.

Today, we manage innovation strategies from micro-cap all the way up to mega-cap, and the investor behind all of these strategies, who really has become a legend today in growth investing, is Tom O'Halloran. And wouldn't you know it, Tom is here today to talk to us. So welcome, Tom.

Tom O’Halloran: Thank you, Brian.

Foerster: Tom's background is fantastic, and we could probably do a whole other podcast on it alone, because it's filled with great stories from the legal profession--he was a prosecutor; his years at Dillon, Read in venture capital and sell-side research; as a trailblazer in bringing insights around technical analysis and momentum to the mainstream equity portfolio; and finally, leading a team here at Lord Abbett for over 20 years that has delivered top-decile performance for retail and institutional investors.

Tom is a partner at Lord Abbett, a CFA charter holder, an MBA from Columbia, a J.D. from Boston College. But I think in Tom's mind, he's always looking forward. What is the next big stock, the next great innovator, the next big game-changing technology? And we'll get into some of that here today. But first question Tom, let's talk about the 2021-22 innovation growth bear market. Do you think it's over, and are we back in a bull market?

O’Halloran: I do think it's over, Brian. Thank you for that nice introduction. I think the bear market began the day Pfizer announced that it had a vaccine that was 95% effective against COVID-19. On that date, some of the innovation stocks peaked, and yet, that signaled that we were not going to have a [new] Great Depression from COVID-19, yet the fiscal and monetary stimulus continued, which brought about inflation, which had not been present post the 2008 financial crisis.

And then the Russian invasion of Ukraine in February of '22 exacerbated it, and inflation went from under 2% to a peak of 9%. And all of that led to a shredding of the innovation growth stocks, many of which went down by 50-95%. And if you look back, post the '08 financial crisis, you can see a lot of bull markets that were wiped out by that event, the '21-'22 innovation growth bear market.

Then in 2023, there was a healing process. And as '23 progressed, a lot of stocks began new bull markets. So today I am seeing a multitude of bull markets, long-term bull markets for innovation growth stocks. So I believe the innovation growth bear market has ended and that a new innovation growth bull market has begun.

Foerster: Okay, that's great to hear. So, you talked about the experience of innovation stocks in the face of inflation and the rate shock in '21 and '22. Some managers had it a lot worse, and I can think of a few big mutual funds and ETFs that lost 80% of their value in that time.

Some, like us, were down, but managed that period a lot better, and I think that really speaks to the need for risk management as part of an investment approach. Maybe you could just talk to us a little bit about your overarching philosophy on investing the way that you do.

O’Halloran: Well, the overarching philosophy is that innovation is booming today, and the technology revolution is providing abundant digital resources, and the free enterprise system is enabling the some of the greatest companies we've ever seen.

And the innovation is most present in technology, in consumer, and in healthcare. It's just abundant. And we have a process, and our philosophy is that [the growth potential of innovation] is underestimated. Nobody could've imagined that Intuitive Surgical, and Netflix, and NVIDIA would go from a $1 billion market cap companies when we first owned them, up to as high as $2 trillion today, in the case of NVIDIA.

Nobody could imagine that compounding [i.e., accelerated rate of growth] would result in hundreds of billions times more digital resources than we had 25 years ago. And so, our philosophy is that this is something we can exploit, but we need to have a very good team. So, we have a mixture of very experienced people and young people.

I don't think we would've been on top of ChatGPT immediately like we were, were it not for Eugene on our team, who brought it to our attention as soon as it came out. So, a good team is really critical, and then an investment process is probably the most important thing.

And focus is important here. We can't be all things to all people. We can't own all different types of companies across all different industries. We have to be focused on the innovation and the companies that are best positioned to capitalize on it.

So, our process is threefold. First, we try to make sure we're identifying very good businesses that have a lot of potential. We look at four things here: we want to see an inherently good business model, a company run by competent and credible people, a business that's demonstrating a competitive advantage, and one that is in a market that is healthy and has a lot of growth potential.

But we own stocks, not the companies themselves. And all of these companies that our process was designed to identify when they were very young all had very bad bear markets. For example, Netflix, over the course of the last 20 years has had three 80% bear market [declines].

You have to get out of the way of those things. It's critical that you be a good seller. And a lot of these stocks that went down 50-95%, we got out of them. We didn't necessarily get out of them at the top, but our investment process was flagging us that their big bull markets were coming to an end, and we did a pretty decent job of getting out of them. A number of our peers rode them all the way down. And the math of going down is worse than of going up. If you go down 80% you have to make 160% just to get back to even on the other side.

Foerster: Yeah. That's so interesting, and I think still very unique. You don't hear a lot of managers who talk about sort of like the intersection of business momentum and stock price momentum. And in fact, when you hear the term "momentum" it's often thought of as simply adding risk and chasing trends.

But I think the way that I've heard you talk about it is that momentum is simply a way to verify fundamentals and to select stocks and avoid biases of selling too early or holding on too long, which is what you were just highlighting and kind of talking about that “math of loss,” and it's clearly worked over a very long time.

I would imagine one of the reasons it's so important to use momentum analysis in growth investing is you often don't necessarily know who the big winner is going to be early on in a new industry. Like when you look at artificial intelligence, you talked about ChatGPT, we've already seen a big winner today in NVIDIA, and when you look at the next decade, I'd think you have some thoughts on the potential big winners, but you also don't want to end up buying and holding, say, the next Blackberry in 2007, or MySpace, or Pets.com. So, it seems like being agile and willing to change horses when the facts change is a key part of the process. So maybe you can go a little bit more into how momentum is a part of the investment process.

O’Halloran: Well, I would say momentum has become a very emotional word. We look at it and we say, "We like great businesses that are realizing their potential." And we often refer to those healthy fundamentals as "operating momentum." We also like to own stocks that are going up.

We refer to that as "stock price momentum." And we say, "Why wouldn't you want both of these? Why wouldn't you want good businesses that are doing well whose stock prices are going up?" The problem is that the stock prices don't go up forever.

They start with an uptrend, they go into a pullback, they go into a downtrend, then they go to a snapback, and back to an uptrend, and they go through these cycles of bull and bear markets. And a blind adherence to price momentum can steer one in the wrong direction, and that's where it gets emotional.

We believe that if you use both fundamental and technical momentum and simplify it, that that can be the source of alpha generation. You see the Blackberry when it starts to falter fundamentally, and its price starts to falter fundamentally, and you get out.

Some of the stocks go through all the four cycles I just mentioned, but some of them don't. Some of them just keep going down and down and down. There are many examples of stocks that have lower prices today than they did in 2000. So, we think momentum is an emotional word, that it doesn't need to be, and we think it's a very important part of our process and has helped us generate alpha over the years.

Foerster: Yeah, so interesting, just thinking about how do you take that emotion out of how you feel about a company and focusing much more on how is the stock behaving? Or not much more, but as a complement, can help you to kind of avoid riding things all the way down.

O’Halloran: You know they say that ego and emotion are the two assassins of the business. And so, it's very important to be flexible and to have humility, because things change and investors are often wrong. And when they are, the worst thing they can do is compound it.

Foerster: Yep. Another key area our investors and listeners may want to hear your thoughts on, and you really can't turn on financial news or read The Wall Street Journal or anything today without hearing the reference to the "Magnificent Seven." And a couple of those names might not be so magnificent this year, and then by comparison your outlook on, say, small-caps, the other end of the spectrum. We've been hearing about a shift to small-cap leadership for years now, and it hasn't happened. So maybe your thoughts there, but also just how are you thinking about the Magnificent Seven?

O’Halloran: Well, I would say, first of all, the Magnificent Seven reflect the amazing things that free-market capitalism can do when it's benefiting from the technology revolution, like it is right now. My gosh, Google wasn't even born 25 years ago, didn't even exist, and today it has a $2 trillion market cap.

But these are like all stocks: they go through the different cycles. They go through bull and bear markets. I mentioned Netflix having a big bear market. NVIDIA went down 65% in 2022 and we got out. We got back in in '23, but we were out when it had that big bear market.

So, it was very frustrating last year when the Magnificent Seven did so well. This year, five of them are doing better than the other two, and we own five of the Magnificent Seven, but we'd be open to owning all of them at any one point in time, because they didn't get to be the Magnificent Seven without doing extraordinary things.

But they go through their stock cycles. One of them, Tesla, right now is struggling fundamentally, and we don't own Tesla right now, but we have our eye on it. I would expect we would again at some point. I hope we will own it again at some point. I hope the fundamentals are not going bad over the long term.

But the market's clearly broadening out. There are so many companies out there with market caps north of $2 billion that are great companies that have more upside potential than any of these Magnificent Seven.

So currently, they're still leading the market, but they are joined by many others. In the $100 billion market cap category and up, we have the Netflixes [i.e., companies like Netflix]; and the Spotifys below that in market cap at $40 billion, all the way on down to some of the small-cap names that we own.

And we believe that small caps have been out of favor for a long time. They're very cheap relative to large-cap stocks, and we think we will have a big bull market in small-cap stocks at some point soon. Maybe this year, maybe next year.

And we're very well positioned for when that happens, because we have the micro-cap and small-cap funds that just about all of our large-cap peers do not have. I think right now we still don't know whether inflation is slain, and that is the most important enemy for innovation growth stock investors, because it reduces the value of the future.

But we think inflation has peaked and is coming down. Its descent has stalled over the last three months, but we still think it's coming down and that we're not going to have an economy that gets crashed by the Fed [U.S. Federal Reserve]. And the geopolitical situation is troubling, but we think that all of these things will lessen in their impact going forward, and I think that will be necessary to begin a small-cap bull market.

Right now, there are too many worries to allow it to begin. We don't know what it will take to flip that switch, but when it happens, we will see it in the stock price action, and we will tilt accordingly. Right now, we don't feel the need in large-cap to move down cap, however, we have naturally moved down cap away from the Magnificent Seven because there are so many good small-cap and mid-cap and large-cap stocks. The market has broadened out, and that's a good situation.

Foerster: Okay, great. So, one last question for you, Tom, and it's back to the dominant areas of what you always refer to as the "tech revolution." There's a lot of hesitation out there among investors who've been sidelined from equities altogether, and whether that's about rates, the economy, all the things you were just talking about, whether the valuations, the election, geopolitics, lots of risks, what could go wrong?

But I think when you hear about the amazing things happening within the tech revolution, you hear about what is going right, specifically across technology, healthcare, and consumer. Could you maybe take us through a quick look at some of those areas, because I know they make up the bulk of your investments and could end up generating enormous wealth creation for long-term investors. And then also, what do you say to all the equity market naysayers?

O’Halloran: I had a long walk up a hill with my 90-year-old neighbor in Bronxville over a decade ago, a very wise man, an economist. And the whole way up I was agonizing about all the things you just talked about: geopolitical, interest rates, blah blah blah. And I got to the top of the hill, and he looked at me and he said, "That's what they've been saying for the last 40 years."

So, I think a lot of the concerns that are keeping people out of equities today are those that have been transpiring for decades, and I think it's a huge mistake to not be exposed to equities.

Equities, over the long term, have returned very good returns, and when it's compounded it makes a big difference. The [Lord Abbett] Growth Leaders Fund is up about 15% per year since inception, that's five or six times your money. So compound, and stocks are up 70% of the time.

So I think things are skewed in your favor to be in stocks. And unless you tell me that we're going to have a war that wipes out the world, or unless the United States is going to descend into socialism, I'm going to be bullish on stocks and continue to own them, and especially innovation growth stocks, given all the great things that are happening.

And in particular, we have a brand-new gigantic opportunity that has just come along in the form of generative artificial intelligence, and I think this is going to be even bigger than the Internet was in terms of a wealth creation and productivity enhancement.

We really don't know how this is going to unfold, though. In 1999, we didn't know anything about cloud computing, e-commerce. We did about e-commerce because Amazon had come public in '96, but we didn't have an iPhone, we couldn't have foreseen the mobility boom, we didn't have social networks, Facebook wasn't even started then, we didn't even have Google Search.

So, all of these magnificent things, these gigantic new markets that were created over the last 25 years, we didn't even know what they were going to be back in 1999. I think we are in 1995 Internet time, which is to say we have a big bull market ahead of us around generative AI.

It's very different than the Internet. The Internet was a way to enable us to conquer distance, space, and time. Generative artificial intelligence is going to enable that to become ever more pervasive and powerful, and it's also going to enable us to replicate our brain, so the search that we're going to be able to do is going to be vastly more powerful and effective.

We're going to have digital assistants that are going to be huge productivity enhancers. We don't know whether we're going to put them on as eyeglasses, we don't know whether they're going to be a pin. Maybe they'll bring about a comeback for ties and the tie pin will be the AI assistant.

We don't know a lot, but we do know that the technology processing power now enables the re-creation of the brain, and these large learning models are extraordinarily powerful, relative to what we've experienced in the past. So, it's just a great time to be an innovation growth investor. It's been so for the last 20 years, and now it's got a brand-new gigantic new market for us to exploit that lies ahead of us.

Foerster: Great. I would just bring up a couple points you just said and reiterate them. You're talking about that walk with your neighbor, and just that people have been saying all these negative things for however many decades. And I still remember, I wasn't even that old when this came out, but the publication [of an article in BusinessWeek on August 13, 1979] titled “The Death of Equities,” and it was the exact wrong time to be out of equities over the next few decades. And then also bringing up 1995, right after, say, Netscape came out with the first browser, and it does sort of feel like there's a lot of negativity, and yet there's also a lot of opportunity from innovation.

O’Halloran: The bears always sound so much more intelligent than the bulls, and they love to scare the daylights out of you. But I think there's reason to be very bullish.

Foerster: All right, good stuff. So, with that, I think we can wrap things up. And I'll just say thank you to Tom O'Halloran for joining the podcast. Some really interesting insights on growth investing and what's likely to drive investment returns in the coming years. Definitely look forward to having you back again for a check-in.

O’Halloran: Thank you for having me, Brian. Great to speak with you.

Foerster: Great. Thanks again, Tom. And for listeners wanting to learn more about Lord Abbett's views on the markets, please visit the insights section of lordabbett.com. We have some recent papers on there about generative AI, healthcare, and small-caps that tie in very well to this discussion today.

And lastly, we'd also like to hear from our listeners. So, if you have any comments about today's podcast, or ideas for future podcasts, we welcome your thoughts, and email podcasts@lordabbett.com.

And so, we'll leave it there. I'm Brian Foerster, this has been the Active Investor podcast. Thank you for listening.