The Primary Trends I’m Investing In Next Year

In 2003, Enron, WorldCom, and Conseco underwent the three largest bankruptcy proceedings in business history. Enron and WorldCom were brought down by accounting fraud (like the entire crypto industry); Conseco also had accounting fraud but additionally, the business sucked (again, crypto). The consensus of the market was that these assets were dead in the water. 

David Tepper disagreed. The hedge fund manager purchased distressed debt from all three companies. When the companies emerged from bankruptcy, like a phoenix that dabbled in white-collar crime, his fund was up 148%—making him a billionaire.

In celebration of this ballsy trade, a former employee gifted him a pair of brass testicles. New York magazine described them as “cartoonishly huge and grotesquely veiny.” Beneath the metallic cojones a plaque was inscribed with the words “THE MOST VALUABLE SET OF ALL TIME.”

To generate outsized returns, you have to be comfortable with most people thinking you are an idiot. Prices on the assets you’re investing in will be lower and, if you’re right, the returns will be that much higher. It does, however, require a strong sense of confidence to employ this strategy. You have to be willing to be wrong, publicly, and perhaps for many years.

In the spirit of Tepper’s burnished balls, I’m forecasting what I think matters for investing in 2023. (I did this last year, and it was a popular article.) Next week we’ll examine whether my forecasts from last year were accurate.

None of this is investing advice. There is a difference between trends that matter for stocks and whether a stock is a good buy. Issues like portfolio construction and pricing matters. I’ll discuss some examples, but please do not use me as your personal Wolf of Wall Street. This is a newsletter, not Warren Buffet’s advice column.

The hardware paradigm shifts

Two forms of financial arbitrage have driven the last 20 years of the technology sector. The first was software’s superior cash flow and margin profile slowly taking over more and more economic activity. The second was outsourcing low-margin labor and hardware costs to China. Businesses like Flextronics, Selectron, Foxconn, and Pegasus built multi-billion-dollar enterprises around the idea of plucking low-skill labor from the U.S. and transporting it to China.

In the early years of this transition, most of the outsourcing value came from labor arbitrage and tax advantages the local government was willing to give. However, as the ecosystem has developed, the value has moved far beyond mere low-skilled labor optimization. Instead, China has a robust system of suppliers, engineers, raw materials, rare earth elements, and shipping ports dedicated to manufacturing electronics. This developed into a mutually beneficial system of design in the U.S. and manufacture in China. Everyone wins—except American laborers.

However, as Chinese manufacturing skill has concentrated, so has the associated risk. Today it isn’t possible to do high-precision, high-scale electronics manufacturing anywhere else. I’ve heard anecdotes of firms being able to hire 40,000 laborers in China in the course of three days, all of whom could work on goods as complex as iPhones. You can’t get that anywhere else in the world.

This is changing—fast. China’s zero COVID policy has made work slower and more expensive than ever. It has sparked some of the most sustained political protests in years. Additional weakness in the real estate market plus an enduring economic depression mean that China isn’t the economic haven it once was. Add in the fact that, the country is committing mass genocide against an entire ethnic population, and China doesn’t look like the safe bet it once did. Apple has already made plans to move some production to India and Vietnam. Nike has tried to outsource away from China many times but mostly failed. As a result, China is facing a less performant manufacturing operation.

It will take many years to fully disentangle manufacturing from China (if it’s even possible to do so). In the meantime, I would expect that many firms will see an increase in cost of goods sold (COGS). If the scariest downside manifests itself, with China invading Taiwan, sparking World War III, there would likely be an almost complete collapse of the electronics manufacturing supply chain. The biggest risk is politically driven threats. I don’t frequently cover macro-economic factors in this publication, but the macro threat cascading through the rest of the economy is real. If I’m right, expect increases to Apple’s cost structures and other consumer electronic companies. Similarly, expect executives to examine their relationship with China to see if they can decrease their reliance. Manufacturers with specializations in India or other low-cost regions of Southeast Asia will stand to benefit. 

Disclosure: I worked at Flextronics Corporate Strategy Group.

Vertical SaaS accelerates

I’ve previously defined our current period in software as the “ASS period” (After Salesforce’s Success). You take a manual workflow on a spreadsheet, automate it, stick that automated workflow onto the cloud, and profit. That simplicity feels like it’s coming to an end. Microsoft’s distribution advantages, coupled with so many of the easy opportunities already being snatched up, have made it far more difficult to build a billion-dollar horizontal software company than it was five years ago.