July 2, 2024 • 56min

Modest Proposal - AI Commoditization and Capital Dynamics - [Invest Like the Best, EP.380]

Invest Like the Best with Patrick O'Shaughnessy

In this episode, Patrick O'Shaughnessy speaks with Modest Proposal, an anonymous but highly respected investor who oversees a large pool of capital across public and private markets. They discuss a wide range of topics including AI, post-COVID economic dynamics, public vs private market investing, and more. Modest Proposal offers nuanced perspectives on many of the key issues facing investors today.

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Key Takeaways

AI and commoditization: There is debate over whether frontier AI models will maintain a significant advantage or if open-source models will become "good enough" and commoditized. This has major implications for which companies will capture value.
Post-COVID capital cycles: Many industries are still dealing with overcapacity issues stemming from demand spikes during COVID, including transportation, beverage cans, and Amazon's logistics network.
Public vs private markets: The guest argues there has been an over-allocation to private markets by institutional investors, driven more by return smoothing than superior risk-adjusted returns.
Difficulty beating indexes: Both public and private market investors have struggled to outperform public market indexes like the S&P 500 and Nasdaq 100 over the past 5-10 years.
GLP-1 drugs: These weight loss/diabetes drugs could have massive economic benefits, but face challenges around long-term adherence.
Market structure changes: Smaller stocks (up to $15B market cap) are often ignored now. Price trends also tend to persist longer than in the past.
International equities: Japan may present an interesting opportunity due to corporate governance reforms, but many international blue chips trade at similar valuations to US peers.

Introduction

In this episode, Patrick O'Shaughnessy speaks with Modest Proposal, an anonymous but highly respected investor who oversees a large pool of capital across public and private markets. They discuss a wide range of topics including AI, post-COVID economic dynamics, public vs private market investing, and more. Modest Proposal offers nuanced perspectives on many of the key issues facing investors today.

Topics Discussed

Comparison to Mid-2000s Commodity Markets (00:04:00)

Modest Proposal draws an analogy between the current AI boom and the mid-2000s commodity boom:

In both cases, surging demand met relatively inelastic supply, leading to price spikes
Markets tend to capitalize temporary surpluses by putting high multiples on companies benefiting from the boom
Eventually supply catches up, leading to overcapacity and price crashes
"The willingness of markets to continually put multiples on this temporary surplus is a constant source of confusion for me," notes Modest Proposal

The Role of AI and Power Consumption (00:07:18)

They discuss expectations for massive growth in power consumption to support AI:

Some projections show 30% aggregate growth in US power consumption over next 7-8 years
Modest Proposal is skeptical, noting "the idea that we're smart enough to build AI and AGI but not figure out how to power it efficiently strikes me as a curious combination"
Expects efficiency gains and price increases to moderate growth

NVIDIA and the Future of AI Investment (00:09:29)

On what it would take to be very bullish on NVIDIA:

Need to believe frontier AI labs will dramatically increase compute intensity
Question is whether NVIDIA can maintain its position as a choke point long-term
Modest Proposal notes: "I have to believe that this enormous surplus is not the prime target for capitalism right now. Where the hyperscalers, where every chip designer, where every smart kid in a garage isn't aiming at this entity generating...it's going to be $200 billion in sales at an 80% gross margin."

Commercialization of AI and Market Dynamics (00:13:10)

They discuss the current state of AI commercialization:

Limited revenue traction so far from AI applications
Need to consider both revenue gains and cost savings/avoidance
Still early to see if there will be major architectural shifts in products/markets
Modest Proposal observes: "SaaS is the best business model in the world three years ago and now everyone's wondering hey how come all these things are growing 10-11-12% and they don't have any margins. So the fact that we're even discussing whether or not there's an architectural shift coming to that SaaS is insane but it just shows how fast that world moves."

Public vs. Private Market Performance (00:23:14)

They discuss the challenges of outperforming public market indexes:

Very few public or private investors have outperformed indexes like S&P 500 over past 5-10 years
Nasdaq 100 has returned ~5x over past decade - better than most VC fund families
Private equity IRRs often overstated due to not returning capital
Modest Proposal argues: "The public indexes, I think, have stressed all forms of investing, not just public investing, in saying on a relative basis, why is money going elsewhere other than these indexes?"

Post-COVID Capital Cycles (00:28:03)

Modest Proposal highlights industries still dealing with COVID-induced overcapacity:

Transportation/freight markets have excess capacity after demand surge
Beverage can makers dramatically increased capex, now face oversupply
Amazon built massive logistics capacity in 2 years, now pulling back
"You just go through one by one and you see how distortive Covid was," he notes

Capital Expenditures and Post-COVID Market Distortions (00:30:32)

Further discussion of COVID's impact on capital cycles:

Many industries saw demand spikes requiring rapid capacity expansion
Now dealing with overcapacity as demand normalizes
Creates potential opportunities to invest at trough of capital cycle

Amazon's Capacity Expansion and Market Inflections (00:31:47)

They use Amazon as an example of COVID-induced overcapacity:

Amazon built equivalent of UPS's logistics network in just 2 years
Now pulling back as e-commerce demand growth slows
Illustrates potential for market inflections as capital cycles normalize

Challenges in Displacing Market Leaders (00:33:45)

Discussion of which companies would be hardest to disrupt:

Apple seen as very difficult given its integrated hardware/software model
Google search was long seen as unassailable, but now facing AI challengers
Some niche industries like aggregates (rocks) have high barriers to entry
On Apple, Modest Proposal notes: "You almost have to believe in AGI. You have to believe in a model so powerful that it basically abstracts away the need for the integrated hardware software solution."

Behavioral Barriers in GLP-1 Adherence (00:37:50)

They discuss the potential impact of GLP-1 weight loss/diabetes drugs:

Could have massive economic benefits if widely adopted
But face challenges around long-term adherence
Even cancer drugs only see ~60-70% adherence long-term
Modest Proposal observes: "The economic benefit of taking a huge chunk of the country out of obesity, out of diabetes, out of the long term healthcare costs that we absorb via Medicare, Medicaid, via health insurance, that would free up productive resources in an unimaginable way. But again, human behavior is a very difficult thing to change."

Public vs. Private Market Allocations (00:39:58)

Modest Proposal argues institutional investors are over-allocated to private markets:

Driven more by return smoothing than superior risk-adjusted returns
Questions whether 30-45% allocations to illiquid privates are optimal
Early venture investors benefited, but now a smaller part of portfolios
Later entrants getting "non-persistent performers" at high valuations
"I just question whether the efficient frontier is being properly calculated, taking into account the inherent risks that are there," he states

International Equities and Japanese Market Potential (00:45:08)

They discuss the case for international equities:

Many high-quality international companies trade at similar valuations to US peers
Japan may present an interesting opportunity due to corporate governance reforms
Tokyo Stock Exchange pressuring companies to improve capital allocation
Modest Proposal notes: "For anyone who has paid attention to Japanese equities over a long period of time, these are wildly overcapitalized for the most part. They have huge cross shareholdings. They don't do buybacks, they have very low payout ratios."

Market Structure and Trading Dynamics (00:47:35)

How market structure has changed over past 10-15 years:

Stocks up to $15B market cap now often ignored if no major news
Price trends tend to persist longer before reversing
More algorithmic trading may contribute to these dynamics
"It definitely feels more like a trending market and it definitely feels more like if you don't have a story, the size at which you are irrelevant is much larger than it used to be," observes Modest Proposal

AI Models and Future Market Implications (00:53:22)

They close by discussing the key debate around AI models:

Will frontier models maintain a large advantage or will open-source models become "good enough"?
Has major implications for which companies capture value
Investment community seems to be assuming commoditization
But some AI researchers still predict rapid progress to AGI
Modest Proposal notes: "It is interesting to me that the investment community has written that path off."

Conclusion

This wide-ranging conversation covered many of the key issues facing investors today, from AI to post-COVID economic dynamics to public vs private market investing. Modest Proposal offered nuanced perspectives on these complex topics, highlighting areas of opportunity as well as potential risks. The discussion underscored the challenges of navigating rapidly evolving markets and technologies, while also emphasizing timeless investing principles around capital cycles and market structure. Overall, it provided a thoughtful examination of the current investment landscape from an experienced allocator's perspective.