Letter #262: Kelly Granat (2024)
Co-CIO of Lone Pine Capital | The Ebb and Flow of Public Markets
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Kelly Granat is the Co-CIO, a Managing Director, and a Member of the Management Committee of Lone Pine Capital. Prior to joining Lone Pine, Kelly was a Senior Analyst at Angelo, Gordon & Co., a Vice President at Chilton Investment Company, and a Financial Analyst at Gilbert Global Equity Partners. She started her career as an Analyst at JP Morgan Securities.
Today’s letter is the transcript of Kelly’s responses on a panel at the Milken Institute titled The Ebb and Flow of Public Markets. On this panel, she addresses the outlook for public markets, transparency in public markets, the state of the economy, how she thinks about valuations, on global investment opportunities and AI, the business model implications of AI, the investibility of China and India, whether passive investing is distorting the public markets, the split and impact of fundamental investing vs following the crowd on public markets, the macro environment and duration, investment themes outside of AI, and the most important qualities to hire for.
I hope you enjoy this panel as much as I did!
[Transcript and any errors are mine.]
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Transcript
On the Outlook for Public Markets
Host: They gave us a really broad topic here guys, I mean, the ebb and flow of public markets. And I don't know if you've been walking around the hotel, but these private capital guys, they've gotten pretty cocky over the last few years. And I mean, we talk about--I won't say the death of public markets, but they kind of say, Oh, the public markets are passe. Everybody's moving into private. But there's still a lot there. And for all that bluster, there's still a big investment strategy tied around that. So maybe we can just start off, and you guys kind of give me your views, on just kind of what the state of it is right now, in your view.
George: Well, first of all, thank you, Romaine. Kelly and I were just talking about it a few minutes ago. Even after 10 years of a massive bull market in public equities, public equity still doesn't get any respect. We feel like we're Rodney Dangerfield--what else do we have to do? I'll tell you that there's incredible innovation secularly happening across public markets that makes it still very intriguing to deploy capital in, and I think that's true from a global perspective.
Host: Kelly?
Kelly Granat: Yeah, I would totally concur. Given both the evolution of market structure, with so much of the marginal trading volume being non-fundamental in orientation, whether that's passive and algorithmic models driving a lot of non-fundamental activity, our view is there's--as an active manager who's fundamentally based, very research driven organization, there's tons of dislocation in the market, lots of opportunity. And I'm sure we'll get into some of the thematics that are, in our opinion, more able to be capitalized upon in the public market structure than they actually are in the private market structure. So we're pretty excited about the outlook for publics.
On the transparency in Public Markets
Host: Now, is it fair to characterize all of you as kind of mostly bottom up investors, bottom up managers. If that is true, and when we look at public markets and the need to value things properly, individual companies here, do you feel right now--and I'll pose this to you, Kelly--that there is enough transparency and enough trust in price discovery to do that properly?
Kelly Granat: I mean, we do. Reg FD is probably a good thing, and that came to the industry, and it has helped with a lot of disclosure. There's, I think, certain companies who honor it more religiously than others, I'll say. But broadly speaking, I think that disclosure is--there's a lot of transparency and disclosure, and we do a lot of work to obviously verify a lot of what we find in public financials through both our own independent work, working with third party data sources, spending a bunch of time with management teams, researching the people that we're aligned with. So yeah, I think there's a lot of good material to work with.
On the State of the Economy and Valuations
Host: Last year here at Milken and what everyone was talking about were some of the issues with regional banks, were all those recession calls--100% chance of recession--which we didn't get, that doesn't mean it's not coming, but we didn't get it. And then the question then becomes, is the environment right now, with interest rates in theory stable, with economic activity, at least here in the US relatively healthy, even globally, you can make a case that, with maybe the exception of a couple of countries, we're doing pretty good here. That would seem to suggest here that the next move is probably better, right?
Kelly Granat: I would guess so. And I think one of the perversities of the market that we talk a lot about is, if you asked me five or seven years ago, are you going to own a bunch of trillion dollar market cap companies and they're going to be the ones who are innovating at the fastest rate, who are doing all the most interesting things, I would have told you you're crazy. But that's the market that we have today. And so to the IPO conversation, the market's not as reliant on those businesses to be leading in establishing the innovation path for public companies because it's become a scale game. And we've been in this panel for 10 minutes, and we haven't talked about AI yet. So that feels like a win--we can go there now, we can wait till later, you tell me, you're running the show here. But this is a scale game, and the public market is the best way to express an opinion on that, in our in our opinion, as a firm. And so what's interesting about that is the biggest companies are getting bigger. They have the data sets, the customer profiles, the capital and monopoly global businesses that fund all of this exploration into what we believe is going to be transformational technology. And that is just a very different set of facts and dynamics in the public market than we've had for a very long time. And the most bizarre part about it, honestly, is that the prices you're paying to own these market leading businesses is not exorbitant, which is quite different than what we had, for example, in the late 90s with the internet boom, you were paying huge prices for speculative things that didn't actually materialize. Our view is that this is very real. It's a question of when and where do the economics accrue, ultimately, in terms of profit pools, but the big players are the ones who are best positioned to capitalize on this opportunity, and they are all public companies.
Host: What are you basing that valuation on? Is that on traditional metrics, or if you have kind of adjusted those metrics for whatever this new age is?
Kelly Granat: Yes. So look, we're looking at earnings and cash flow, and that's--I think you don't have to do spreadsheet gymnastics to justify owning these businesses. And that's the beauty of having these monopoly positions in globally dominant businesses that are funding all of this capital. This is a capital intensive game. This is not the internet, right? This is not mobile businesses that are being built on top of technology that were better funded in the private market, right? These are billions and tens and hundreds of billions of dollars of capital required. And whether the value accrues at the large language model level, which is not our house view, or at the application layer, which is where we think it ultimately resides--we'll see with the benefit of time--but I think in the interim, you're owning very high quality businesses and not paying for the optionality of what the AI opportunity presents.
On Global Opportunities and AI
Host: Kelly, we talk about the companies that dominate, or at least the ones we talk about, obviously they're mostly US centric, with the exception of a few companies over there in Asia, and I guess a couple of big chip firms out there in Europe here, but do you think we're going to start to see more global investment opportunities in the AI space that we don't just have to maybe look to the homegrown US company?
Kelly Granat: I think we don't know is sort of the honest answer. And I think what makes it really hard is right now, we're very focused on the foundational piece and all the capital required to build that. And what's difficult, and we talk about a lot how we're going to track whether there's a return being generated on all of this spend. And the complexity around that lies in the fact that there's not distinct line items for most companies, in getting away from picks and shovels and talking about sort of a higher value add that says AI revenue. The way that the tools so far are being deployed is to make existing products meaningfully better. So when you talk to people at Meta, when you talk to people at Google, what's amazing is hearing them describe how these capabilities are enhancing core products, their core business. So how do you isolate the revenue contribution from that to justify the capital expenditures that are going into all of these GPUs and other infrastructure build? It's very difficult, right? And so there's a little bit of a trust me factor that there are returns being generated, and it's creating more stickiness, pricing power, innovation within these very large companies. Hard for somebody new to Greenfield kind of compete with that without having the same resources, from a financial perspective, and also intelligence that comes from having very large global captive customer bases, which are effectively their research laboratories, right? So it's hard to know.
On Business Model Implications of AI
Host: But do you have confidence, George, that the way AI is being developed, and the companies that are developing them--that this will end up being, I guess, truly cross border in a way, or will it be more segmented?
George: Boy, it's great question, whether or not we're going to be cross border or not. Initial reactions are that I do think it has to be across borders. There are geopolitical ramifications, and so one of the things that we've seen, and this is going back a few years now, the United States, Taiwan, and the Netherlands have engaged in a basically a semiconductor almost closure pact, where they have agreed not to deploy semiconductor capital, equipment, high end, to China. So why the Netherlands? And why Taiwan? Taiwan Semiconductor, ASML. They are the enablers of high end compute, right? And that's been going on for years. So it's clearly indicating that you're going to have a geopolitical segmentation of where high end compute, including AI, is going to be. It does make the dynamic more challenging, and we'll see what what evolves from this. But given the scale economics and the compound economics that are happening here, it's hard to argue that it's not going to be proliferative.
Kelly Granat: Just one thing to add on is just while you were speaking, I was thinking about business model implications of that question. And so one of the things we talk a bunch about internally is open source versus closed right? So what Meta is doing with Llama, open source, obviously no charge associated with that, versus LLMs, which in most cases are for profit in some way, and so what are the implications of that in terms of going cross border and having open access?
On the Investibility of China and India
Host: Yeah, well, that's a nice segue. We have some questions from the audience. I'm just going to kind of weave them in from time to time when it becomes appropriate. And if you have questions, just use the QR code and submit them. It kind of comes through the magic of the iPad here, and I can pose them to the panelists. But I do want to stay on international for a second here. And a question from the audience here is he/she wants to hear your views on China and India. And I think it's better if we start with China first, because it kind of dovetails some of the issues with AI and the technology and whatever the heck is going on between the US and China here. Is China for you all--is it still investable? Was it ever investable for you?
Pedro: I can start. It is investable for us. I mean, we cannot, as a global equity owner, as I said in the beginning, a large asset owner, we cannot ignore China. So like, 3% of our assets are in China. It has been going through a very rough period in terms of unlove from the markets. It seemed to have, like, turned a bit the corner, at least over the last month and a half. People will be well versed with what has been happening over the last three years. But I think that, like thinking that China is uninvestable is really where the opportunity may be.
George: So I think China is actually quite compelling right now. I think, look, we all know that China is risky. Everybody knows China is risky, especially coming from a Western, a US, a European dynamic. It's clearly opaque. There's clearly geopolitical tensions, regulatory changes happen all the time. Well that's been the case for a long time. What's interesting now is that the negativity towards China has gotten to extreme levels. So China's trading as cheap as it ever has as a function of current free cash flows. There's still a lot of dynamism that's happening there, innovation that's happening there. There's growth. You're seeing much better regulatory environment and much more pro business stance by the by the government. You're seeing companies act in a much more shareholder friendly way. If you were to go back a decade ago, they were just acquiring hand over fist. There didn't seem to be any strategy other than we've got money, we're just going to go buy stuff with it. Now you're seeing buybacks. You're seeing dividends. You're seeing dividends increasing. You're seeing a thoughtfulness that hasn't occurred before, and at the same time, they've never been cheaper. You're looking at on current free cash flow yields in the mid to upper teens--and these are growing. These are indicative of true bear market weariness. And I think as a contrast, India, which I think is incredibly dynamic and attractive, but still in a very early developing stage, has benefited from all of the capital moving out of China has gone and found India. And in fact, if you look at EM flows, EM flows are negative, but if you look at EM ex-China, they're flat. And so all that money is just really transferred out of China and elsewhere, primarily into India. India is a little bit tougher, even with all the cool stuff happening there. Those valuations seem, let's say, more optimistic, and I think it's creating a compelling opportunity for a longer term investor in China.
Host: Interesting. You feel the same way, Kelly? Or not?
Kelly Granat: We do not. I agree with the valuations are compelling. My struggle is, how do I--what's the valuation framework or paradigm that I should use? Particularly because a lot of the companies--and just backing up, but we are global investors. We've had, in one moment in time, in our 26 year history, as much as a quarter of the fund in China. Not recently. We've been out for three years and are struggling to get engaged there, just because I'm trying to pick stocks against a backdrop that's non fundamental, and I've seen things happen in the last handful of years of--let's talk about the for profit education stocks in that space, with the stroke of a pen, the entire sector was wiped out. And so I don't know how to apply appropriate discount for that risk. And furthermore, the companies that we have owned in that market historically are just more mature in their life cycle, so they don't have the same rate and level of innovation and growth. They're profitable, and they screen attractively on a free cash flow, but I don't have confidence in the prospects in front of them. And for the global businesses that are domiciled there, I think there's potential political blowback in terms of their ability to operate successfully with non-Chinese partners, which will limit, again, how to think about that growth algorithm going forward, which further complicates my ability to value the business.
Host: Would your confidence be improved if we had more listings of Chinese companies here in the US, meaning they would also be more beholden to SEC disclosure rules, et cetera, or no?
Kelly Granat: No.
On if Passive Investing is Distorting the Public Markets
Host: Maybe it's just yesterday or the day before, forgive me, David Einhorn was making a comment about the role of passive investing, and his view how he thinks it's really distorting the public markets in a big way. And I would, I am curious whether you all a) if you feel that way, but more importantly, what is going to be the role of passive? Is it just going to get bigger? Is this just kind of a juggernaut that never stops? And if so, I mean to Todd's point, I mean, where does that leave you as an investor, as an active investor?
Kelly Granat: I think it benefits those of us who have duration, honestly, because there's so many non fundamental setup oriented dynamics that happen around events now, which is, having been in this business for 20 something years at this point, used to be able to study a company. You would print out the press release for me when they report, and I would tell you how the stock was going to react. That exercise is an exercise in futility today, because it all depends on what are the third party data sources saying? What's the Whisper number? They were at a conference five minutes ago, and they told people this, and that's not a set of expectations. And so you read the release, and on a fundamental basis, I can give you the answer, but that might be entirely wrong. And so for those of us who have duration on our side and are taking a longer term view, there's dislocations that are non fundamental that we can capitalize on. However, from a portfolio construction perspective, the outgrowth of that is we have to think about exposure differently, and how we size things differently, because you can't be fully sized and fully expressed perhaps in the same way that you would have historically because of these dynamics. You want to be have gross and net exposure and position sizing that leaves you some room, because these non fundamental things are happening very frequently in the market, and you want to be able to lean into them as opposed to playing defense in those moments.
On Fundamental Investing vs Following the Crowd
Host: And I've got three questions all kind of on the same topic, so I'm just going to kind of mash them up, and they're all about kind of crowding in certain positions. And I'm going to ask set this up in a very loaded way, which is we talk about fundamental bottom up invest. How many people are really doing that, though? Because I know people say they are, but it also seems at times that people are just kind of following the crowd. I mean, maybe they're doing some diligence on their own, but there does seem to be a lot of just monkey see, monkey do. And I wonder if that creates distortions as well.
Kelly Granat: I would say two different observations that perhaps go together, perhaps don't. I mean, one is that the consensus often gets it right, and so maybe there's crowding, and maybe we want to talk about the MAG7, but the execution for many of those companies has been phenomenal, and the stock price activity is deserved, in our opinion, largely. So sometimes--everyone likes to be highly differentiated in their theses and counter consensus, and that can be right and productive and profitable, but I would also make the observation that--let's pick on Apple. Apple was a consensus long for two decades, and has been right for two decades, right? So you could pick apart parts of that thesis and poke holes, but owning it's been a good thing. That's one thing. The second thing I would say, which is perhaps related, is all of the narrative publicly around the MAG7 and crowding and one series of stocks and AI as a thematic has, in our opinion, created lots of interesting investment opportunities away from that. And so there's incredible businesses hiding in plain sight, trading at very fair multiples, that are executing incredibly well, and with the cost of capital that we now have in the market, there's real winners and losers, and a dynamic now that we haven't seen really for almost 15 years of being public market investors. And so it's an exciting time to be a public market investor because you've got thematic things which are establishing market leadership, which we think are both fundamentally interesting and priced relatively attractively, and then lots of other sectors that we've been looking at for many, many years. And execution is fantastic, and lots of runway in front of these companies, and they have nothing to do with AI and nobody wants to talk about them.
On the Macro Environment and Duration
Host: I want to pivot to another question, and this is really about kind of the macro environment and really the uncertainty around it. And I don't really want any of your predictions specifically on the economy or anything, but as you're trying to look long term, and you were talking a little bit earlier, Kelly, about long duration, if you--in equities--and if we are in a sort of this big structural change in our economy, whether it's because of AI or something else, or trade wars, or geopolitics or whatever, I mean, what gives you the confidence, or, I guess, some degree of certainty that that duration is not going to work against you?
Kelly Granat: Would you like me to start?
Host: Yeah, sure. Why not?
Kelly Granat: So look, this cycle is pretty different, right? When I think and reflect back across other hiking cycles that have been--that I've been witness to in my career and even prior, they end in crisis. And we've been--our investment careers on this stage have been punctuated by crisis, starting with the Asian crisis, 9/11, financial crisis, housing bubble, right? And what's different about this is I don't see a crisis. I mean, there's a lot of turmoil in the world, I don't want to discount that, and it's very real, but when I think about disruptive financial market crisis, I don't see the thing that's coming. And when we think about fundamental investing and backdrop, many of the positions inside of our long book today are exposed to sectors that have already been in their recession. Or when I think about end markets, right, I think about the advertising market post IDFA, I think about what happened with travel during covid and coming out the other side, I think about supply chain disruptions that really hurt many industries that couldn't get parts and service done, right, to get product into the market. Those markets have all bottomed or are in some varying phase of recovery. And so when I think about the outlook and this sort of doomsday scenario, we're about to go into a deep recession, maybe by some crisis that we can't see, or just rampant and pervasive slowing from an end market perspective when I look across industries, I just don't see it.
On Themes Outside of AI
Host: When we talk about investment themes, and when we spend a lot of time talking about AI, there's got to be something else out there other than just AI, in terms of those big, overarching, structurally-changing themes out there, are you finding that outside of AI? Anyone?
Kelly Granat: One of the big things we've spent a bunch of time on internally is just the sort of institutionalization of the alternatives class as a public market sector, right? You've got a bunch of companies that have come public in the last handful of years. I mean, Blackstone has been public for a while, but you've got almost half a trillion dollars of market cap now in alts. These are companies that haven't really been battle tested as public market companies yet. They're very strong platforms that are strong marketing, innovation, product cycles. They've got great distribution, great relationships. And that world was consolidating massively from an AUM perspective, and now starting to pursue retail. And so, just in the beginning phases of getting added to indices, just capturing the attention of kind of the fundamental long-only community, which has not really paid that much attention to these businesses thus far, but there's a whole asset class sort of being created in the public market domain that is new, and we think is pretty interesting.
Host: I'm glad you brought up that theme, and before I get to George, I would want to get your thoughts on that, because we've seen a lot of new products come down the pipe, whether it's the actual companies themselves going public, whether it's the business development companies going public, or whether it's like these new ETFs that are basically sort of a wrapper for companies that are still private, and these are more closed end funds, and it's a totally different animal here, but I'm wondering what you make of that. I mean, do you think those are going to be effective vehicles for the private space in the public markets?
Kelly Granat: We do. I mean, we're most focused, in the list that you mentioned, on the platforms. And there's a flywheel that is happening from a capital raising, product innovation, talent, hiring, and retention scale dynamic that is clearly benefiting these businesses. And there are pools of capital in the world, we've got one alongside of us on stage here, that need scaled managers to help them invest their capital thoughtfully. And these are incredibly responsive organizations that are sitting down with the sovereign wealth funds and other big sources of capital in the world and figuring out what are the unmet needs, and creating products that accommodate those needs. So there's a real role, I think, in the world for these businesses. And it's another example of scale begets scale. And it's hard to compete with them.
On the Most Important Qualities to Hire For
Host: One audience member had a question about talent, and what type of talent you look for--and I want to kind of put that in the context, particularly of the younger talent, sort of the next generation of Todds, Kellys, Georges and Pedros, like, what is going to be most important for, if you were looking at that person to hire them, what's kind of the biggest thing that matters most to you?
Kelly Granat: Curiosity is always my number one answer, but two and three are close behind. Two would be resilience. So I love hiring people who went to colleges I've never heard of, worked three jobs, were valedictorian of their class, because they're jugglers. And our job is about juggling and prioritizing and time management. And then the third would be, behind those two, would be a balance of IQ and EQ. I think EQ is an incredibly important part of what we do. So much of it is around relationships. We're in the information gathering business, and getting people to connect with you, relate to you, trust you, assessing management teams, how they motivate people, how they partner with their team, how do they retain them, how do they pay them? There's so much about what we do that is beyond a spreadsheet. And I have found the most successful people that we have hired and managed to retain have a good balance of the two and know when to distort to one or the other in terms of solving a problem.
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Wrap-up
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