Investment opportunities in genetic medicine, automation and cybersecurity
Jared Gross: 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.
Today’s episode is on the Strategic Investment Advisory Group’s latest publication -- “Brave New World” -- and has been recorded for institutional and professional investors.
I’m Jared Gross, Head of Institutional Portfolio Strategy, and guest host of the Center for Investment Excellence.
With me today is Felise Agranoff, Growth Equity Portfolio Manager; Eric Ghernati, Senior Technology Analyst and Portfolio Manager; and Dr. Matt Cohen, US and Global Healthcare Portfolio Manager.
Our discussion serves as a follow-up to a recent publication entitled “Brave New World.” This was released earlier this year as part of an ongoing series of papers created by JPMorgan’s Strategic Investment Advisory Group.
The goal of this group is to focus on long-term issues that impact investors, not over a new cycle or even a couple of quarters but rather over long horizons.
And the subject of “Brave New World” which is a series of innovation trends impacting firms and the economy is emblematic of what the Strategic Investment Advisory Group is trying to achieve.
So I’ll begin with a few high-level thoughts on the importance of innovation both to the economy and to portfolios.
First, innovation drives growth. There is a clear linear relationship between the country’s openness to innovation and its level of GDP per capita.
What’s perhaps most interesting about this data is that the outliers are truly the exception that proved the rule. Countries that have achieved high GDP per capita without innovation are limited to oil states and there are some countries who have achieved high levels of innovation without a particularly high level of GDP per capita such as India and China where the populations are simply so large that they can’t achieve the numerical progress.
But for the rest of the countries in the global economy, the linear relationship is very clear. And so the value of innovation in terms of generating higher GDP per capita, improved living standards and the wealth and development that comes with it is critical.
Second, innovation requires a long-term view. The presence of patient, risk-taking capital is essential to drive innovation. And we can observe this in a variety of places. We can look at patent’s activity and the willingness of legal systems to support innovators.
We can look at venture capital both the size of the venture capital marketplace and the returns that it generates for investors as a statement of confidence in the economy’s ability to allow innovations to succeed.
And finally we can look at the performance of new public companies as a statement that they are able to grow and achieve scale and continue to innovate along the way which is a bridge to the third point.
Innovation is not just about startups. Maximizing the value of innovation to our society requires both new firms that spearhead innovation and large firms that can exploit those innovations at scale.
And finally, the fourth point, the cycles of the economy create both volatility and opportunity. Having confidence in our long-term view allows us to allocate capital to innovators when it is needed most -- when it is scarce and when it offers us the best long-term returns.
Now the markets are certainly going through a rough patch at the moment. But this is a perfect time for this conversation because it is our confidence in these long-term trends that allows us to allocate money where it is needed most and where it will serve the highest and best purpose both to the innovators and the economy and ultimately to our investors.
So with that, I’m going to turn it over to Felise for a deeper dive into these trends.
Felise Agranoff: Thanks, Jared.
Now the key focus of our Brave New World paper, as Jared mentioned, is to highlight our differentiated research on long-term paradigm shifts in innovation.
And the key innovation topics that we discussed in our paper include genetics and medicine, the metaverse, automation, fintech and cybersecurity.
And the reason we chose to focus on these big themes is as growth investors, we make the most money over the long term whom we identify large secular shifts that have the potential to create an opportunity for big winners and big losers which is a great opportunity for us as stock pickers.
Now we also do work on these paradigm shifts for decades. But the key is to make sure that we correctly identify the winners and most importantly get the entry timing right as growth is inflecting and the profit models are becoming increasingly clear.
Now as we allude to the Brave New World highlighted themes, there are areas within the paper such as the metaverse and fintech that are quite early and it’s so unclear to us who many of the winners will ultimately be.
However, there are other highlighted innovation themes such as genetics, automation and cybersecurity that are more exciting to us from a near-term investment standpoint and will be the focus of today’s podcast.
So with that, now let’s dig into the themes in more detail. We’ll start with genetics where I’m joined by my colleague, Dr. Matthew Cohen.
Matt, it seems like the importance of genetics and medicine has grown significantly over the past few years and is set to inflect further over the next few years. How did we get here and what will drive future growth?
Dr. Matthew Cohen: Thanks, Felise.
In what is certainly one of the most significant scientific advances in human history between 1990 and 2003, a global consortium of scientists completed the Human Genome Project which mapped the blueprint for human life including all 20,300 genes of a human genome.
This astonishing accomplishment has led to a sea change in our understanding of what makes human cells function or makes them malfunction and has transformed our approach to diagnosis and treatment of human disease from genetic-based inborn illnesses to cancers and has even impacted our approach towards disease monitoring and prevention.
Looking forward, while we are still in the early phases of this journey of discovery, the stage has certainly been set for a future that will be increasingly reliant on genetic information as a lynchpin for medical care.
Along those lines, the advent of increasingly more sophisticated genetic analysis and genetic editing tools, which are used to manipulate DNA, promised to advance the science even further and should lead to the development of an entirely new generation of innovative patient selective and highly impactful precision diagnostics and therapeutics.
Felise Agranoff: That’s certainly quite exciting. Diagnostics seems like one of the most exciting areas from an investment standpoint. Why is this the case? And how do we think about the potential winners in the public markets across portfolios?
Dr. Matthew Cohen: When people discuss the impact of advances in genetics on the field of medicine, new genetics research-derived medicines such as targeted oncology drugs most often grab the spotlight because of their obvious impact in treating previously untreatable diseases or significantly improving patient outcomes versus traditionally-developed medicines.
While the impact of these genetic-based medicines is certainly incredibly important, the role of genetics and diagnostics, which often goes unheralded, promises to have as big an impact on the patient experience and on outcomes. And why is that the case?
Well, like therapeutics, new precision clinical diagnostics leverage the same genetic knowledge analysis processing technologies that are used in the research lab.
In a straightforward example, doctors can now take tissue or blood samples from cancer patients and rapidly look for specific mutations or changes that are driving an individual’s disease.
Today for many diseases, therapies can then be tailored to focus on specific genetic mutations and the patient can then be followed up with further testing to monitor for treatment effectiveness or for progression of disease.
The ability to analyze free-floating DNA or cells of interest in blood -- a technique called liquid biopsy -- provides a key biomarker for diagnosis, therapy selection and monitoring of a patient’s disease course. And as a key area of focus across our portfolios and includes innovative companies such as Natera, Exact Sciences, Personalis and Twist Bioscience.
Felise Agranoff: That’s great. Thanks, Matt.
And how do you think about the impact of genetics combined with artificial intelligence on drug development? How do we think about the potential winners and losers?
Dr. Matthew Cohen: Historically the biopharmaceutical industry has spent billions of dollars each year conducting largely analog, labor-intensive R&D on the hopes of bringing a handful of meaningful therapeutics through clinical trials through the regulatory agencies and into the hands of doctors treating patients.
After years of R&D market by immensely low efficiency like many other industries, today is biopharmaceutical industry is increasingly turning to new modalities such as genetic and AI-assisted research tools to provide a higher hit rate for drug pipeline throughput while also lowering cost potentially by as much as 75% versus historical models of R&D spend.
Of note, while many biopharmaceutical companies are spearheading these new efforts internally, the expertise required to fully benefit from the shift towards genetics and AI is highly specialized. And so many companies are outsourcing to biotechnology innovators like Twist Bioscience and Relay Therapeutics or more nontraditional healthcare players such as Google to keep pace with this exciting trend.
Felise Agranoff: Great. Thanks, Matt. That’s really fascinating and really seems like genetics has the potential to really inflect over the next few years.
So now I’d like to bring Eric Ghernati into the conversation. And he’s going to touch on both automation as well as cybersecurity.
And so, Eric, if we want to start with automation, with accelerating labor cost inflation today, it feels like the case for automation has never been more clear. How do you think about the enablers of an acceleration in automation from a technology perspective?
Eric Ghernati: Thanks, Felise.
So our research indicates that China will need to deploy 4 million robots by 2030 up from 200,000 units currently to compensate for manufacturing labor shrinkage.
China will be the main manufacturing hub for electric car batteries where labor conditions can be hazardous. So you will need to deploy robots there as well.
We expect we will see a similar, if not a more dramatic, inflection in the US and Europe because it isn’t just the shrinking manufacturing labor force that’s impacting these regions but also the spike in labor inflation. That includes wages and the cost of labor safety for manufacturing plants and e-commerce warehouses.
And we think the technology that will enable the big inflection of next generation robotics and automation is here. We classified these under three buckets: Artificial intelligence software which allows robots to learn any track as close to human as possible; low-cost, high-performance compute to train artificial intelligence software that will power robots; and computer vision which is the technology that allows robots to see and react at near-human level and it is also trained by artificial intelligence software.
All of these technologies are quite mature. They keep getting better at an exponential rate each year. So in the future many technologies will produce robotic use cases at parity with what a human can accomplish today.
Felise Agranoff: It’s definitely quite encouraging. What do we see that gives us confidence that computer vision is improving to the point where we expect much wider adoption?
Eric Ghernati: Our confidence comes from observing the maturity of self-driving cars which is by far the most complex application for computer vision. We’re also seeing a major increase in the use of computer vision in e-commerce warehouses like those from Amazon where computer vision is now powering even autonomous forklifts and are replacing humans at an increasing rate.
We have seen exponential improvements in the training of their large, complex artificial intelligence software which is essential to improving the accuracy of computer vision sensors.
And this will give more comforts in adoption of robots for broader new use cases. Besides e-commerce warehouse, which we think deployments of robots will increase, the main other new use cases we are watching for is robotaxis.
Waymo, for example, as of last month is offering robotaxi drive testing for employees in San Francisco as successful pilots in Arizona.
We’re also bullish on the prospects of collaborative robots or, as they call them, cobots. And these are robots that work alongside humans. That market is growing 30% to 40% and cobots are quite popular these days.
Felise Agranoff: Great. Thanks, Eric.
Now how are we looking to play the inflection automation across portfolios today?
Eric Ghernati: So we are playing the inflection more broadly through owning artificial intelligence and data center-exposed companies such as Google and Amazon and major arms dealers like NVIDIA whose silicon and software are essential to the progress of the entire ecosystem and Erista whose networking hardware and software are critical here as well.
Few players in our portfolios include NVIDIA and Teradyne which not only provide tools to test silicon but also as robotics business that as we mentioned is growing 30% to 40% and has number one market share globally in collaborative robots.
Felise Agranoff: Great. Thank you so much, Eric. I think that’s really helpful on automation.
So why don’t we shift gears to cybersecurity? Now clearly there’s been an increase in cyber attacks in an increasingly digital world. How do you think about which parts of the market we need to see further acceleration in cyber spend?
Eric Ghernati: So to put this in context, the global cybersecurity market is estimated to be $100 billion and is going to grow between 15% to 20% annually because of growing cyber attacks.
Prior to 2018, 10% of cybersecurity budgets were towards protecting cloud because cloud penetration up until that point was low for most large enterprises and governments that controlled the bulk of the cybersecurity budgets.
Our research indicated that the percentage of cybersecurity budgets allocated to the cloud will move from under 20% currently to 50% by 2025 in a market that is growing 15% to 20%, which means cloud security which is a 10-billion market today, will become close to 60 billion to 80 billion by 2025.
And we are seeing a big increase in spending towards the protection of enterprise traffic passing through public Internet either through employees or general business transactions. Other areas garnering a larger percentage of cyber spend include the protection of any identity in the cloud and securing applications being deployed in the cloud and providing constant alerts, analytics and proxy remediation and response against attacks that happen in the cloud.
We are also seeing all governments stepping up their spending on cybersecurity to protect critical infrastructure.
Felise Agranoff: Wow. So there’s so many cybersecurity companies out there. How do we think about which companies are best positioned and most underappreciated today?
Eric Ghernati: Yes. So there are a lot of cybersecurity companies out there and the cybersecurity market has been quite dynamic for many years. So our approach has been to look for the best-of-breed companies that best protects against the latest attack vectors but also we have been looking for companies that offer full suite solutions, a holistic menu of sorts because most companies would rather deal with few vendors versus thousands of point solutions out there.
And clearly the best positioned companies in the future will be the ones with best-of-breed suites for protecting cloud and offering proactive and instance response and remediation, analytics around potential vulnerabilities, ability to analyze traffic for malware on the fly and covers most surface areas possible when it comes to cybersecurity including identities not just for PCs and servers but also virtual machines and cloud traffic as well.
So some of the more underappreciated names we own currently include Palo Alto Networks which offers a best-of-breed firewall as well as unique solutions for cloud protection.
We also own Okta which is best positioned player in cloud identity; CrowdStrike which is not only an endpoint protection company but increasingly a cloud cybersecurity company that protects servers and cloud workloads.
Another name that could be interesting is Confluence who’s a recent IPO. The company has real-time data streaming technology that is being used more and more for real-time security analytics.
Elastic, which is also a holding in our growth portfolio, has been a key player in security not just for searching but also storing and analyzing large amount of security traffic.
Felise Agranoff: Got it. And so it definitely sounds like we’re really bullish on the fundamentals for cybersecurity. But in a world where growth stocks have been under pressure, how are we thinking about valuations for these cybersecurity companies that you speak of?
Eric Ghernati: There is a bifurcation right now in valuation for security companies with newer names that are growing fast at, say, 30% to 40% trading out of 50% premium to companies such as Palo Alto Networks which is growing revenues in the mid to high 20s while generating 30% free cash flow margin.
And we think that the growing importance of large best-of-breed suite providers such as Palo Alto Networks not just to corporations but also governments will lead to that gap closing further.
Felise Agranoff: Thank you, Eric. It really does sound like automation and cybersecurity are at the early phases of inflection in growth like genetics. So thank you both, Eric and Matt, for covering both the trends in technology and healthcare in great detail.
Now I can turn it back to Jared for some concluding remarks.
Jared Gross: Thank you, Felise and Eric and Matt. Great discussion and a lot of really interesting specific opportunities out there that we like which is great to hear about.
I guess I’ll just make one last point as it relates to innovation from a high level which is simply this: That innovation for all of the benefits that it bestows it doesn’t come without cost as well. It is inevitably the case that legacy firms will be disrupted by some of these trends and many will see their business prospects falter, if not be eliminated entirely.
Also many innovators are themselves unable to successfully exploit their own advances and these companies, you know, won’t succeed over the long horizon. It doesn’t mean that their innovations won’t be taken up by others but we have to be mindful as investors that there is a downside to some of this as well.
And from an investment standpoint, this is further reinforcement of the value of active management and that we are able to weed out legacy firms that may be on the wrong side of history and perhaps within the cohort of innovators find those who have the greatest chances of success.
And so when we think about the ways in which investors can gain exposure to innovation in their portfolios, it’s a combination of both early stage venture and growth equity in the private markets but also a very robust opportunity set in the public markets in growth sectors and growth portfolios.
And so we don’t want to be dissuaded from seeking to get ahead of these trends. It’s always a healthy reminder that we want to diversify our bets and the ways that we take on risks in our portfolios but long term being on the right side of innovation is unequivocally a positive both for our society and for our investments.
And so with that, I want to say thank you to the team for joining us today. This has been a great conversation. And we’re going to sign off now. Thanks very much.
Thank you for joining us today on JPMorgan’s Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcast and on our Web site. Thank you.
Recorded on April 26, 2022.
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