Can value investing work in the age of artificial intelligence? A case study with Super Micro | from Dr. of John D. Kiambuthi | March 2024

How one fund manager found a hidden AI gem using value principles

Is value investing, a strategy championed by legends like Benjamin Graham and Warren Buffett, still relevant in today’s technology-driven market? For nearly a century, value investors have focused on identifying undervalued stocks with strong fundamentals, believing that their prices will eventually reach their true value. However, the recent dominance of growth stocks, which are often priced high because of their future earnings potential, has called into question the effectiveness of the value approach.

The past decade has seen a significant performance gap between value and growth stocks in the US, particularly evident in the Russell 3000. Despite this short-term trend, historical data suggests that undervalued stocks tend to outperform over the long term.

This begs the question: can value investing be adapted to the age of artificial intelligence (AI)? The answer could lie in finding “hidden gems” in sectors poised for AI-driven growth.

While the recent underperformance of value stocks relative to growth stocks is undeniable, some argue that value investing can still thrive in the age of artificial intelligence. Critics point to the current market disparity and suggest that undervalued stocks may not recover. But proponents believe that a slight tweak to the traditional approach can unlock hidden potential.

The Needham Aggressive Growth Fund exemplifies this concept. Despite its name, the fund has successfully used value investing principles to capitalize on the AI ​​boom. In 2009, they identified Super Micro Computer Inc. (SMCI) as an undervalued company with a strong foundation in data centers and industrial servers—key components for AI training. This long-term, patient investment has paid off handsomely, with Super Micro’s stock up nearly 1,000% over the past year, outperforming even AI leader Nvidia.

John Barr, manager of the Needham fund, attributes their success to a nuanced interpretation of value investing that reflects the philosophy of Charlie Munger (co-founder of Berkshire Hathaway). Munger emphasized acquiring “great businesses at a reasonable price” rather than just cheap stocks. Needham took this approach, looking for companies with solid fundamentals, reasonable valuations and growth potential.

Super Micro’s inclusion in the S&P 500 index further confirms this strategy. Increased demand from passive and institutional investors underscores the company’s long-term prospects. While SMCI’s investment took a long time to blossom, it exemplifies the potential rewards of taking a value investing approach with a focus on future growth in industries such as artificial intelligence.

While Super Micro’s current valuation may not scream “value buy” to traditional value investors, a closer look reveals a compelling story. By comparing its historical price to the S&P 500 Value Index, we see that for more than a decade, SMCI has traded at a discount, making it a prime target for value investing strategies. This highlights the importance of considering a stock’s long-term trajectory, not just its current price.

The key to Needham’s success with Super Micro lies in identifying a potential catalyst for future growth. In this case, the catalyst appeared to be the emergence of killer apps like ChatGPT in November 2022, driving the demand for AI hardware. While predicting such specific events can be challenging, value investors can identify companies with strong fundamentals that can benefit from broader industry trends such as artificial intelligence.

Super Micro’s price-to-book (P/B) ratio reflects this growth potential. The P/B ratio measures a company’s market value compared to its book value. SMCI’s P/B ratio has skyrocketed from around 2 in late 2000 to over 20, indicating a significant increase in investor confidence due to the company’s role in the AI ​​revolution.

Super Micro wasn’t just a win for the Needham Aggressive Growth Fund; it was their crown jewel. This single holding, representing 5.2% of the fund at the end of 2023, exemplifies the power of patience in value investing. While Super Micro’s P/E ratio has soared from 15 to a dizzying 92.9 over 14 years, the Needham fund’s long-term commitment has paid off handsomely.

This case study raises questions about the effectiveness of value investing in a post-pandemic market. Manuel Monge’s 2023 study suggests that growth stocks could outperform value stocks in uncertain times such as pandemics. However, Needham’s performance contradicts this notion. John Barr, the fund’s manager, attributes their success to focusing on individual companies with strong long-term potential regardless of short-term economic fluctuations.

This philosophy is evident throughout Needham’s portfolio. The fund boasts impressive cumulative total returns, even outperforming benchmarks such as the MSCI World Growth Index and the Russell 1000. Barr attributes this success to its strategy of identifying “hidden blends” – undervalued companies with the potential for significant long-term growth. Examples include companies in sectors poised to benefit from AI, such as Aspen Aerogels (thermal insulators), PDF Solutions (semiconductors), Unisys (data center operators) and Vertiv Holdings (data center solutions). The average holding period of the fund in excess of 12 years further underlines their commitment to long-term value creation.

While some advocate passively managed index funds, the success of the Needham Aggressive Growth Fund challenges the notion that active management is obsolete. Rooted in traditional stock picking, Needham’s strategy shows that active managers can still outperform the market, particularly by identifying undervalued companies with significant growth potential in emerging industries such as artificial intelligence.

However, repeating the success story of Needham will not be easy. Their long-term holding of Super Micro, which turned out to be a goldmine in the AI ​​boom, required patience and a keen eye for identifying “hidden gems.”

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