Coordinator: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and Investment themes.

Rich Forslund: Welcome everyone. Thank you for taking the time to join us today. My name is Rich Forslund and I’m a Consultant Advisor here at JPMorgan Asset Management.

In speaking to the consulting firms that I work with, who many are discussing the shift in corporate behavior because of COVID-19 particularly with everyone working from home. Another aspect that has come up has been the importance of technology and the growing reliance on the cloud.

So with that in mind, I’m really pleased to be joined by my two colleagues Susan Bao, US Equity Portfolio Manager, and Mark Ferguson, Global Head of Research for Equities. Mark recently launched a white paper on the digital transformation and the shift to public cloud.

I want to provide a little bit more background on our speakers today though. Susan has been at the firm for 23 years and has been an integral PM on our US equity strategies. Currently, she manages the Large Cap Core Plus 130/30, Tax Aware Equity and Large Cap Equity SMA strategies.

Mark has also been at the firm for over 20 years, always in research. He was a financial analyst in Europe, Asia and Emerging Markets, was Head of Emerging Markets Research for almost 10 years and is now the Global Head of Research for Equities.

Susan and Mark thanks for joining me.

Susan Bao: Good morning everyone, great to be here.

Mark Ferguson: Thanks Rich, morning everyone.

Rich Forslund: Great. So over the next 30 to 40 minutes we’ll have a discussion about COVID-19, the equity markets and the findings from the white paper.

So with that, let’s get started. Mark, let’s begin the conversation with you. Talk to us about the goal of the paper and some of the high level themes that have emerged from it.

Mark Ferguson: Great. Thanks Rich. So maybe just to start with some very quick background, as many of you are hopefully aware we have a large team of fundamental equity analysts. So around 90 analysts across the world covering emerging markets and developed markets, around 17 years average industry experience between them covering about 2.5 thousand stocks.

Now these analysts they work very closely with the respective Portfolio Managers in each region such as Susan but at the same time, we also organized them into 17 global sector teams and that’s something that we think gives us real sort of additional insights and competitive advantage.

So with that backdrop, after the COVID crisis began we tasked these sector teams with really thinking very carefully about some of the longer term consequences of COVID that we expect to see changed, what would stay the same, et cetera.

And I think and that being the theme, (at the recent) talks that we’ve done over the last three weeks. I think that if I was to sum it up in one line I would say the main conclusion that’s come out of all of it is in most cases we see an acceleration of existing trends so we don’t see a lot of very new trends coming as a result of COVID but we do see a lot of existing trends accelerating.

And that’s true in some of the consumer behavior which is something we discussed a couple weeks back. I think it’s true in terms of relations with society at ESG which is something that (Jennifer O’Neill) discussed on the call last week. And then I think is also true with respect to some of the trends around business resilience and corporate behavior which is the topic for this week’s call.

So I would say more specifically on that there are three themes that I want to draw out in that area. The first one as Rich alluded to earlier is around cloud computing and specifically an accelerated shift to the public cloud which we’re seeing as a result of COVID.

But the second (main) theme is around localization or if you like diversification of supply chains and related to that is an important theme of factory automation which is again something that we’ve seen accelerated as a result of the crisis.

And then finally this whole idea of strong companies getting stronger which I think is as we go through and come through more examples, we’ll see again how the COVID crisis has led to that outcome as well.

So I’ll stop there. That’s basically the high level themes and I think we’ll hopefully be able to explore them in much more detail over the next 20, 30 minutes or so.

Rich Forslund: That’s fantastic Mark. Susan, maybe let’s turn it over to you. How have the themes that Mark outlined just now affected your thinking as an investor?

Susan Bao: Thanks Rich. I think Mark summarized the themes very nicely. And I agree with Mark. Many of the secular trends we’re about to discuss today are not new. And they were underway well before the pandemic.

And COVID is just a catalyst that triggered a behavioral change and a change we think that’s sustainable.

And let me give you an example. On last quarter’s conference call, Microsoft CEO stated, as COVID-19 impacts every aspect of our work and life, and we have seen two years’ worth of digital transformation in two months.

And what Satya said is not unique. We have heard similar comments from many companies across many industries ranging from grocery delivery to digital entertainment to financial services.

And speaking of financial services digital payment is another example to online shopping and from a physical cash, which is dirty and inconvenient to cashless we have seen faster adoption of digital payments.

And Dan Schulman, the CEO of PayPal, he said three to five years of secular trends have happened in a very condensed period.

And also it wasn’t that long ago PayPal aims to add 3 to 5 million new users per quarter. They added 7.4 million just in the month of April. And they may add total 20 million new users in the second quarter which is 4 times more than normal.

And also on a supply chain side which we’re going to talk about in a second, we noticed some companies who were caught off guard during COVID. And there’s an increasing need for digital access to manufacturing plants such as remote monitoring and remote control.

So as investors it’s very clear to us that in the wake of pandemic, companies with a greater digital presence, flexible supply chain, and healthier balance sheet will emerge from this crisis even stronger.

And the opposite is also true for structurally challenged companies.

So to echo Mark’s point earlier, we have many analysts with boots on the ground across the world helping us unpack these trends from individual stock perspective. It’s more important than ever to focus on bottom-up fundamentals.

Rich Forslund: That’s great. Thanks so much Susan. Mark, maybe we can go back to the first topic of your paper, the increase in public cloud spending and cloud penetration.

How is your Research Team thinking about the scale and duration of public cloud migration and then the longer term impact to businesses over time?

Mark Ferguson: Yes. So digital transformation and migration to public cloud is scaling up a new theme, it’s a theme that we have been thinking about very seriously as a team for some time. We reflected already in some of our portfolio positioning as well.

I do think COVID seems to accelerate it from two angles if you like. The first from an infrastructure perspective, the idea of managing your own equipment on premises is less desirable as has been highlighted by the pandemic and the difficulties associated with that so that’s the further emphasis to switch to public cloud.

And then I would say also from the application side, the idea of having applications available and accessible on mobile, on cloud rather than only through a corporate PC network. Again, I think the advantages of that has been particularly highlighted during this period.

So we do think there’s an existing very strong trend which has been further accelerated.

Now in terms of trying to quantify it, we do have a proprietary data which our technology analysts look at which effectively monitors, emphasize IT spending, public cloud spending, tries to assess the market size and the penetration. And our assessment is that currently the addressable market is around about $1 trillion and it’s roughly 20% penetrated as of today. And it was already growing at 30% a year even prior to COVID.

So our forecast is about 20%, goes to 40% by 2026 which is a bit of an upgrade on where we were pre-COVID as a result of some of these accelerating trends. So Susan mentioned as well, just everything gets fast-forwarded a bit more.

So if you think about just the magnitude of the market size and so going from 20% to 40% of a $1 trillion market is obviously a massive opportunity in terms of kind of dollars of available addressable market.

So probably Susan can talk in much more detail about some of the examples, maybe some of the corporates that are well positioned to benefit from that very large opportunity.

Rich Forslund: That’s great. A perfect Segway like you say Mark. Susan, from a portfolio management perspective, who are the winners and losers here?

Susan Bao: So actually before discussing the winners and losers I just want to share one anecdote.

And I think it’s an example of a faster adoption of digital application. So the Mortgage Department of JPMorgan Chase was planning to roll out DocuSign over the next 12 months. And DocuSign as you know offers a way to sign paperwork electronically.

And in a world of social distancing the Chase IT Department rolled out DocuSign within one week. And they did it so fast because they had no other option. Fortunately, they have the right infrastructure enables them to do it quickly.

So as Mark mentioned in the past some CIOs were reluctant to move their mission critical workloads to the cloud. But then when COVID hit they realized that it’s more challenging to manage the data centers because people have to be there physically during a lockdown.

So COVID may change their mind. The total addressable market may be even bigger post-COVID. And scale is another big issue, as more people, pretty much everybody working from home, the legacy infrastructure can now scale up and down to accommodate more volatile demand pattern.

So the obvious winners are the Big 3 public cloud providers, Amazon, Microsoft and Google. And (unintelligible) revenue was $55 (billion) last year. And Amazon AWS was $35 billion. And over next 3 years our research analysts expect their cloud to grow over 20% and 30% respectively.

And mathematically because cash flow streams got pulled forward the net present value or NPV should be higher. But unfortunately this is not breaking news, right. The market is more appreciative this view today versus just a few months ago. We can all see the cloud beneficiaries outperformed the S&P significantly year-to-date.

But besides the Big 3 there are many ways to play this trend. And AMD and Nvidia, these companies provide semiconductor components to the hyperscale data centers and cell tower providers sitting on top of the infrastructure layer such as Salesforce and Workday. And also there’s a long list of the smaller, high flying, fast growing SaaS companies are all beneficiaries of this trend.

And by the way, many of them are trading at double digit price to sales ratio these days. And also the IT services companies will benefit from this theme.

But on the other hand, who are the losers? Who are on the wrong side of the change? We think the stronger cloud comes at expense of all the legacy On-Prem providers such as IBM, Hewlett Packard, NetApps of the world.

And one of the research firms estimate that $1 of incremental cloud revenue result in about $2 to $3 of decline in the revenue of legacy lenders.

So take Hewletts of the world as an example. Two-thirds of Hewlett’s profit was generated by printing last year. And the printer hardware revenue have declined 5% per year over the past five years.

And COVID as you know forced millions of people like you and me who work from home. And I don’t know about you, because we use virtual desktops which connects to the network printers back in our office, I haven’t printed anything for over four months.

And humans are creatures of habit. So even when we go back, eventually one day, we will print less than before which is calling into the question the long-term viability of a printing business.

So I think I’m going to stop here and then pass it back to Mark and maybe Mark you have some examples from international perspective.

Mark Ferguson: Yes. And clearly, I mean the sort of direct beneficiaries, the Big 3 are the big US companies which you’re all familiar with and which Susan mentioned.

But if you look (unintelligible) into the supply chain, I think the international companies that benefit the most from this I would highlight semiconductors, TSMC which makes the chips which drives the computer intelligence behind the infrastructure and which is really gaining market share, has a very strong position in the cloud, leading edge chips in that area.

And then again sitting behind TSMC is ASML which is a leading manufacturer of the equipment which is used by TSMC and the other semiconductor companies.

So in effect the rising tide of cloud adoption benefits I think with the strong companies all the way down the value chain and as I say including some of those international names.

Rich Forslund: Mark, you just touched on the topic of supply chains. This pandemic gives many companies the opportunity to rethink their supply chains whether that means diversifying suppliers or bringing production closer to the end consumer.

Susan, what are your thoughts on this localization of supply chains from a Portfolio Manager point of view? Are there any particular trends worth mentioning there?

Susan Bao: Yes. Thanks Rich. Again, the supply chain issue is nothing new. And it has started since the last election and further intensified during the US-China trade war.

For example Walmart purchased $250 (unintelligible) in domestic products over 10 year period through 2023.

And then you have this initiative called Investing in American Jobs. And as a part of this initiative the company opened its first US food production facility in Indiana.

But COVID related shortages have given companies the real urgency to reevaluate their supply chains and to make them more localized. And we saw that two months ago the company Mark just mentioned, Taiwan Semiconductors, which is the largest foundry in the world announced its intention to spend $12 billion to build a facility in Arizona.

And this facility and this plant will (unintelligible) Apple and Qualcomms of the world to fabricate their semi products domestically.

But whenever there’s a change, there are going to be risks and opportunities. So let’s start with the risks. Since China joined WTO 20 years ago, the profit margins of US manufacturers almost doubled from 9% to 17% during the past two decades.

And this (large supply) savings associated with global outsourcing. And that profit pool, that profit support could reverse quickly and materially if we don’t do it right because we could face wage inflation and overcapacity.

And revising supply chains especially away from China is not that easy because China’s infrastructure and access to electricity, transportation and a labor supply is still very competitive.

So companies need to manage it carefully. And take Apple as example, Apple uses Foxconn to assemble most of its products. And Foxconn has 1.5 million workers just who work on Apple products and mostly located in Shenzhen, China. Obviously there’s a geographical (compensation) this year, and Foxconn -- by the way -- is a world-class operator and then Apple has been very happy with them. 

We actually recently had opportunities to catch up with the CFO of Apple during our (unintelligible) Silicon Valley (unintelligible) tour and Luca said to us he was very impressed by how quickly and how smoothly Foxconn was able to bring its facility back online post-COVID. And by the way, assembling Apple products is actually a very complicated process and needs special training. So even Apple wants to diversify - it may take years. 

So who’s going to benefit, who’s going to make money on all this localization with diversification of supply chain? Vietnam -- as a country -- is one of the big winners. I was traveling in Vietnam last summer when the US/China was in the middle of (phase 1) negotiation. The hotels in Ho Chi Minh City were packed with Western businesspeople. 

And from a stock perspective, some (unintelligible) companies will benefit from rearrangement of manufacturing capacities. Remember, one person’s spending is another person’s revenue. And companies that specialize in automation and robotics will benefit from this trend. And in US, Rockwell Automation is a good example. They provide software and customized solutions for new facilities and also to (fix) existing facilities as well as sensing and motor control devices. But I think the majority of the automation companies are in Europe and in Japan. Maybe, Mark, you can share some examples in the international markets. 

Mark Ferguson: Yes, sure. I would say (unintelligible) automation is really another great example of an accelerated (spectral) trend and I think it’s safe from a pandemic resilience perspective. I - the idea of replacing human labor in the context of social distancing is clearly good from a resilience perspective. But then also to this point -- and Susan’s been talking around cost savings. I think as one of the European companies we spoke to recently commented (that) making significant investment in automation is really seen as the only way that you can make manufacturing in higher-cost countries competitive - vis a vis China and some of the other (unintelligible). 

And I think maybe just to give some data points and that’s it - I think it’s a trend which has been already accelerated as wage costs in China have risen. And they’re up three times over the last ten years so it is an existing trend. But if we look -- for example -- at the robot density that we see in industrial manufacturing, this is basically the number of robots per 100 workers on average. 

So for China the number is 0.7. For Japan and Germany the number is more than three. For Korea the number is more than six. So the US -- interestingly -- actually it’s a bit lower. It’s slightly less than two although it’s still much higher than China. So we do see this as being a very clear accelerating trend. 

As Susan mentioned, there are a lot of strong players internationally -- particularly in Japan and in Europe. I think one name in Japan (I) particularly highlighted (unintelligible). So this is a global leader in manufacturing (unintelligible) for the use - for factory automation. It’s a very good high-margin business, innovative company, well-managed, et cetera. (And you see) business growing very quickly as this trend plays out and there are several other well-positioned examples in Europe -- I think -- as well as (Schneider Electric) would be one that I would particularly highlight there. 

Rich Forslund: Great. One kind of common theme that I’ve seen though this pandemic -- and, Mark, you know, we’ve seen companies with strong quality characteristics perform well through the pandemic. As global head of research, how are you approaching this idea that the strong will keep getting stronger and the weak will get weaker? 

Mark Ferguson: I think this is a theme that’s really run through a lot of the work that we’ve done around COVID and we tried -- to some extent -- encapsulate it in the quote that we gave (unintelligible) white paper from Andrew Grove -- the former Intel CEO -- around how bad companies are destroyed by prices, good companies survive and great companies are improved by them. I think that’s something that we’ve really seen, and I think it makes sense, A, from the perspective of accelerating the existing trends. 

So I - the winners -- from an industry perspective -- become the winners to a greater extent, so that’s consistent with (the theme). And I think also -- just from the perspective of in the face of the crisis -- having scale and having balance sheet strength and the ability to continue investing is something that’s a very valuable thing. 

So if we go back to our favorite example of (unintelligible) semiconductor -- which just happens (to report) results -- but as far as all the what you might think is the headwinds in the world - they reported 20% revenue growth, 53% gross margin, and they upped their CapEx for the year to 16 to 17 billion US dollars. So they’re able to really invest through the crisis in order to further increase their competitive advantage which I think is a very privileged position to be in to be able to do that. 

So from a research perspective to come back to the slightly more general question, one of the things that we spend a lot of time thinking about and having our analyst do work on is just this thinking within a common framework around corporate quality. So we introduced a tool which we call strategic classifications. And this is something we’ve rolled out globally. It’s (unintelligible) across all of the (unintelligible) companies that we cover globally across both emerging markets and developed markets. 

And we have a framework for thinking about corporate quality in terms of the economics of the business, the durability of -- i.e. the franchise strength and the ability to continue compounding value over time -- and then the governance of the business -- i.e. the competence in management, ownership structure, et cetera. Then we find that framework as being very helpful through this crisis and ultimately, we classify companies into one of four different categories (unintelligible) what we call premium businesses -- the very best businesses -- and a lot of the examples that we’ve talked about already on this call would fall into that category of premium business. 

And then at the bottom end what we call the structurally-challenged businesses - so these would be in some of the industries that Susan was talking about earlier - some of the -- if you like the (unintelligible) from this -- and we have found -- as you would expect -- across the kind of (unintelligible) universe the companies that we think of as the premium-quality businesses (that) when it comes (unintelligible) they out-perform the others during this period. 

And clearly, we need to think about other things like valuation as well, but just as having a common framework - so really getting the analysts thinking around corporate quality in that kind of manner is something that we find very useful across the research team globally. 

Rich Forslund: (Unintelligible) Susan, Mark just touched on the strategic classification. As (a portfolio) manager, how do you utilize the strategic classifications to make investment decisions? 

Susan Bao: I think it’s a very useful tool in my toolbox and it’s complementary to our (evaluation) process. In the past, PMs and analysts have always considered aspects of quality and durability when we’re deciding whether to invest in the company - we’re deciding on the (unintelligible). But still, we didn’t really have a formal structure around it in the past. So I think strategic classification is a very good solution. 

Also, Mark just quoted Andy Grove, the founder of Intel, and he talked about bad companies get destroyed by crisis and good companies survive it, great companies improved by it. So I think it’s critical for us -- especially now than ever -- to work with our research team to identify the bad -- which is structurally challenged -- the good -- which is the quality companies -- and also the great ones -- the premium companies. 

So to Mark’s point earlier -- and, Richard, you mentioned this, too -- the basket of premium and quality companies outperformed the basket of (trading) and structurally-challenged companies during this period in the past five months by almost 15% in the case of US. So given I have the flexibility of (sorting) in our (1/30/30) strategies, I find the category structurally-challenged very useful -- especially if they’re (being) - identifying long-term short (candidates). 

And it gives me much higher conviction and gives me stronger staying power. And for example, the department stores -- without naming the names, you all know who they are -- they’re classified as structurally-challenged companies. And we’ve been (underweighting and shorting) these companies through thick and thin and despite the volatility of their stock prices. And on the other hand, the auto part retailers within US -- such as O’Reilly and also AutoZone -- they are classified as quality and premium because they have a strong competitive mode. And these are the great long-term investments in our portfolios. Mark, do you have a couple examples maybe from EM? 

Mark Ferguson: Yes, sure. Thanks, Susan. I would say in emerging markets, we work with this concept of strategic classifications for the last ten years or so, and I think - I would say in emerging markets, you get a particularly broad range of corporate quality. Even within the same country and within the same sector there can be an enormous spread between the best businesses and the worst businesses to the extent that the corporate skill really is the biggest driver of research. 

So a good example of that would be a company like HDFC Bank in India. So it’s in India which is a country -- as many of you are aware -- is facing some challenges at the moment associated with COVID and other issues and it’s in the banking sector -- which is a sector which, you know, traditionally, one wouldn’t think as being very resilient (unintelligible) at the moment. But in fact, all of that is overwhelmed just the fact that HDFC Bank is vastly superior to a lot of the other banks in India. 

It’s gained a lot of share, has a completely different client base and a completely different level of underwriting skill versus a lot of their competitors and also has compounded value year after year after year notwithstanding the kind of external pressures on the banking sector in India, et cetera. 

So that’s an example of the premium business (not in a) premium industry, but just a premium business with the (unintelligible) kind of differentiation coming through the corporate skill versus the competition. And with that, though, you tend to see the (unintelligible) divisions within emerging markets (unintelligible) than you do within the developed world. 

Rich Forslund: Great. Mark and Susan, I want to thank each of you for your thoughts and perspectives today. 

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