Baidu Abandons Moonshots to Search for Earthly Profits

By Wenting Shen, CFA, Portfolio Manager | March 13, 2024

In early January, Chinese internet giant Baidu surprised markets with the news that it was donating a cutting-edge quantum computer, the lab where it was built, and all the associated technology to the Chinese government.

Given the opaque relationship between the Chinese government and private companies, the exact terms of the exchange are unknown; Baidu’s move could result in the US putting the company on the restricted list that blocks US investments in companies that could be supporting China’s military. However, there is a plausible market-based reason for the donation: the quantum computer was expensive to build and maintain and the effort wasn’t profitable.

At a meeting with analysts in January, Baidu’s chief financial officer, Rong Luo, explained that the kind of “moonshot research” the quantum computer represented was too expensive and didn’t add to the company’s bottom line. Donating it helped cut costs and foster goodwill with the government. It was the kind of pragmatic move that the company had gotten away from in recent years.

Like their global peers, Chinese internet companies enjoyed years of growth and strong cash flows. That allowed them to expand beyond their core operations to invest in new business formats and technologies, such as Alibaba in offline retail and Tencent in fintech. They usually focused on creating scale even if the business itself was initially unprofitable. That goal depressed margins in the sector. But as growth has slowed, Baidu, Alibaba, Tencent, Netease, and other Chinese tech companies have been refocusing their operations on turning a profit.

At Baidu, this included bringing in Luo, who has a PhD in management science from Peking University and had been the CFO at TAL Education Group. During his tenure there, Luo played an important role in TAL’s transformation from operation-driven to data- and technology-driven, and from offline to online.

When Luo arrived at Baidu two years ago, some senior management didn’t recognize the importance of return-focused performance metrics. That has changed. Expenses have been cut. Research and development spending as a percentage of sales, which had been about 20% (and more than its peers), has been reduced. The company was making investments in innovative technologies, such as quantum computing, but there wasn’t likely to be a return on these investments in the foreseeable future. The effectiveness of projects is now measured on the return on investment and efficiency. Thus, the decision to give away the computer.

Now the company is focused on the parts of its business that are or can be profitable: its core ad business, cloud computing, and AI. In the highly competitive business of search, Baidu released an AI-based advertising platform called QingGe. The new platform essentially examines a users’ interactions with a chatbot and generates a new ad specifically tailored to them. The goal is to create a better advertising platform, with the goal of improving the click-through rate by 10x. Hitting that goal would add several billion in incremental RMB in 2024, the company said.

That’s one example of how management is employing AI, a crucial test. In 2017, Baidu was the leader among its peers in AI. It had Andrew Ng, the former head of Google Brain, as its chief scientist and signaled its intentions with its slogan “All in AI.” But Ng left the company in 2017.

Despite his departure, Baidu was the first among Chinese companies to launch a chatbot in 2019, shortly after OpenAI released ChatGPT. That chatbot, called Ernie, is not as advanced as ChatGPT 4.0 but is more advanced than its Chinese peers and many Chinese companies are using it to train their own more specialized models. In December, Baidu reported Ernie had more than 100 million users.

Even with a technological lead over its peers, Baidu hasn’t yet shown it can make AI a profit center the way some US-based companies have. It is testing monetization models, such as a subscription service, and fusing it into its search business, but neither investors nor Baidu itself can be certain how the AI efforts will affect the company’s profits (the company does not provide revenue projections for its AI business). What investors do know is that the company’s criteria for the success of that effort and everything else it does will be measured on the bottom line.

Image source: Ascannio – stock.adobe.com

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How Persistent Are Quality and Growth?

By Safia Williams, CFA, Associate Analyst | February 28, 2024

At Harding Loevner, we are quality growth investors, which means we seek to invest in well-managed, financially sound businesses that can sustain profitable growth across economic cycles. But what do we mean when we talk about quality and growth as attributes of a company? While there is no standard definition of quality or growth in the investing world, our quality rankings consider factors such as the stability, level, and trend of a company’s profitability as well as its balance-sheet strength, and our growth rankings consider historical and estimated future changes in sales, earnings, and cash flows.

How companies perform on those measures can change over time. Industry dynamics evolve, which can lead to a shift in competitive positioning. Macroeconomic cycles and deviations in management strategy can also alter the long-term outlook. Even companies that consistently rank highly for quality and growth must be continuously assessed for signs of deterioration in their financial health, competitive advantages, and other factors. The challenge isn’t just determining the businesses that meet our criteria today, but also which businesses will sustain their quality and growth characteristics over the long run.

The charts below illustrate how variable those characteristics are. The bubbles represent the roughly 2,700 stocks that were in the MSCI All Country World Index (ACWI) at the end of 2018. In the tab for 2018, they’re split down the middle such that the top half of stocks (the orange portion) were considered high quality, based on their Harding Loevner quality scores at the time. But over the next five years, the characteristics of the companies changed. Now click the tab for 2023. It shows that only 25% of index members were also above the threshold that was set in 2018.

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HOLT, FactSet, MSCI, data as of December 31, 2023

In fact, in any five-year period only about a quarter of companies were in the top half of quality at the start and the end of the period:

HOLT, FactSet, MSCI, data as of December 31, 2023

Identifying a persistently high-quality and fast-growing company is even more difficult, as the following charts show. Clicking the tab for 2023 reveals that only 10% of companies in the index remained above the threshold for quality and growth that was set in 2018. This means investors can expect that the majority of high-quality, growing businesses today will not score as high-quality, fast growers in five years.

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HOLT, FactSet, MSCI, data as of December 31, 2023

TSMC and France-based Dassault Systèmes are among companies that, because of their strong competitive advantages, have managed to sustain their quality and growth rankings in our measurements. TSMC is one of the few reliable, high-volume global manufacturers of advanced and specialty semiconductor chips, a strength that stems from decades of proprietary technology development and disciplined execution. Dassault is a provider of software for virtual product design that has one of the broadest offerings in the space, able to be used by customers in multiple industries. Its high proportion of recurring revenue from software subscriptions and a loyal customer base have insulated the business from economic downturns. In fact, both TSMC and Dassault have remained in the top quadrant of quality and growth every year for the past 15 years (and have been owned in Harding Loevner’s International Equity model portfolio for that entire time). But as the data show, such companies are the outliers.

Quality growth investing also isn’t as simple as buying and holding companies that score in the top quadrant of our rankings—or immediately discarding the stock of a company that has strayed from that territory. These scores are merely proxies that attempt to capture each company’s financial strength, competitive advantage, and the projected trajectory of their growth. Indeed, fundamental analysis can sometimes lead us to identify companies that meet our investment criteria even if they don’t, at the moment, score in the top quadrant. Therefore, it’s better to analyze and monitor a business’s quality and growth through the fundamental research that informs these scores rather than speculate on potential movements in the scores themselves.

At Harding Loevner, this process begins with an analyst examining a company’s competitive position within its industry using the framework of Porter’s Five Forces, which is based on Harvard University professor Michael Porter’s book, Competitive Strategy: Techniques for Analyzing Industries and Competitors. Once a company is affirmed to meet our investment criteria, analysts continue to track and debate the strength of its fundamentals and growth potential, communicating with colleagues when these factors are at risk of deterioration. It’s because we know quality and growth may not always persist that our research process to evaluate these characteristics must.

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Low Debt Companies Fare Better in High Interest Rate Times

By Andrew West, CFA, Co-Lead Portfolio Manager | February 08, 2024

Portfolio manager Andrew West, CFA, explains how selecting companies with strong balance sheets and low debt safeguards against the potential erosion of the value when interest rates are elevated.

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NVIDIA and the Cautionary Tale of Cisco Systems

By Chris Mack, CFA, Portfolio Manager and Analyst and Rick Schmidt, CFA, Portfolio Manager and Analyst | November 22, 2023

NVIDIA, the giant semiconductor company founded by Taiwanese American Jensen Huang, seems invincible these days. Annual revenue has more than doubled since 2020. Its stock price has more than doubled this year and is up more than 700% over the past five years. It is one of the rare trillion-dollar market-cap companies.

Perhaps most intriguingly, NVIDIA is a leading company in the biggest tech-driven trend to come along in years, artificial intelligence. It makes the chips that power AI-based computer systems, and it sells the software and services companies need to operate their own AI programs. And NVIDIA was a big company before AI took off.

As if to emphasize the point, this week the company posted third-quarter revenue of US$18.1 billion—tripling from a year ago and setting a company record. Earnings were also a record at US$10 billion.

NVIDIA meets all our core criteria for a quality growth company: It has a sustainable business and a competitive advantage, solid management, and financial strength. Over the last six years, its revenue has grown from nearly US$7 billion in fiscal 2017 to just under US$27 billion in fiscal 2022.

But as NVIDIA reaches dizzying valuations—it currently trades at 118 times earnings—we can’t help thinking of another good technology company whose stock once commanded nose-bleed premiums: Cisco Systems.

Cisco makes the networking equipment that enables much of the internet. As the World Wide Web was taking off in the mid-1990s, Cisco Chief Executive John Chambers was telling people a new era of computing was coming, and the company’s hardware played a big part in making that new era real. Between 1995 and 2000, its revenue surged 850%, from about US$2 billion to US$19 billion.

Cisco stock did even better, growing an incredible 3,800%, from US$2 in January 1995 to US$79 in March 2000. The title of its 1999 annual report exhorted investors to “Capture the Momentum.” Many took that advice. In March 2000, at the height of the dot-com bubble, Cisco became the most valuable company in the world, with a market capitalization of more than US$500 billion.

Then the dot-com bubble burst. Cisco shares fell 88%, dropping from US$79 to a low of US$9.50 two years later. That drop wasn’t the result of any large change in the company’s performance. Revenue was nearly US$19 billion in fiscal 2000, US$22 billion in 2001, and about US$19 billion in 2002. But the premium that investors were willing to pay for the company disappeared as the hype around the web faded.

Over the next two decades, Cisco kept growing. Its sales in 2022 were nearly US$52 billion, more than double the US$19 billion it hit in 2000. Yet its stock has never traded as high as it did on March 1, 2000. Today it’s at roughly US$53. On a total return basis, it took 20 years for Cisco stock to recover from the dot-com crash.

So, are there lessons we can learn from Cisco as we look at NVIDIA? Just as Chambers argued 25 years ago that a new era of computing was at hand, Huang has been talking up AI. Just this month he said “In the last 40 years, nothing has been this big. It’s bigger than PC, it’s bigger than mobile, and it’s gonna be bigger than the internet, by far.” The enthusiasm for AI’s future has led to very high valuation multiples for NVIDIA, although not as high as Cisco reached in 2000.

Source: YCharts

By all accounts, NVIDIA is strong—in its last full fiscal year (2022), it earned US$9.8 billion on US$27 billion in revenue—and in an enviable position. Semiconductors are the oil of the 21st century, an essential component for the tech-fueled modern world. The company produces chips that allow for the most advanced computing, expanding from its core gaming prowess into related lucrative areas like data centers, autos, and of course AI.

But as Cisco shows, the success of a company and the performance of its stock aren’t the same thing, and as valuations increase, it’s more and more difficult for a stock to outperform. Over the past 50 years, 231 companies have reached a similar multiple. Only 20% of the stocks trading with a price/sales ratio between 30 and 40 outperformed the market over the next 12 months. The more you extend your time horizon, the worse the results get. Over a 10-year period, that number drops down to 6%.¹

NVIDIA is a good company with all the quality and growth prospects we look for in an investment. The critical question is how much one is willing to pay for those prospects. As Cisco showed in the waning days of the dot-com boom, overpaying for a good company is a bad choice.

Endnotes

¹ Siegel, Jeremy with Schwartz, Jeremy. Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, Sixth edition. McGraw-Hill Companies, 2022

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Out of Our Minds

Baidu Abandons Moonshots to Search for Earthly Profits

How Persistent Are Quality and Growth?

2018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

HOLT, FactSet, MSCI, data as of December 31, 2023

2018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

Low Debt Companies Fare Better in High Interest Rate Times

NVIDIA and the Cautionary Tale of Cisco Systems

Source: YCharts

Endnotes

Disclosures

Out of Our Minds

How Persistent Are Quality and Growth?

2018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

HOLT, FactSet, MSCI, data as of December 31, 2023

2018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

Low Debt Companies Fare Better in High Interest Rate Times

NVIDIA and the Cautionary Tale of Cisco Systems

Source: YCharts

Endnotes

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Disclosures