AI or, Artificial Intelligence, is the topic du jour across much of the U.S. entire economy, especially within the tech sector—and deservedly so. We believe that the advent of AI will likely prove to be a moment of profound shifts in how we interact with and extract value from technology. In this sense, it resembles earlier paradigm shifts, such as cloud computing, mobile phones, networking, etc. However, an unintended—and in our view interesting—component to all of this is the distortion that AI is creating around the tech sector. AI is not only monopolizing the mind share of the sector but is also nearly the only game in town right now that is driving economic growth within Information Technology.
Indeed, it is easy to look at the performance of the Magnificent 7—the cohort of mega-cap stocks consisting of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—and assume that all tech stocks are in a broad and robust bull market. In reality, however, many pockets of weakness currently exist in the sector beyond the companies tied specifically to AI, regardless of cap size. Whether it is technology spending being delayed due to macro concerns, higher interest rates, political uncertainty, continued supply chain normalization in certain areas of the market, or uncertainty around how AI will alter the tech landscape over the long term, we are seeing cyclical trough-like fundamentals (or at least softness) across much of the tech sector. This has resulted in considerable volatility, which is creating many interesting opportunities for our small-cap quality value approach within tech.
Within our Strategy's benchmark, the Russell 2000 Value Index, the tech sector has oscillated dramatically between lagging through the early months of 2024 to having a massive leadership run from late spring through much of the summer only to fall back to last place in the waning days of the season. While frustrating in the near term, we think the sector's schizoid behavior has been creating tremendous opportunities in both directions.
A perfect case in point can be seen from one of our holdings, Coherent (COHR, Financial). At its core, Coherent is a materials engineering specialist, developing many of the foundational technologies that go into multiple different secular growth markets across the technology, industrials, consumer, and medical markets. The company has exposure to trends like autonomous driving, electric vehicles (“EVs”), and laser tool penetration for both industrial and medical applications, to name just a few. For some time now, nearly all of Coherent's markets have been at cyclical bottoms—with one exception. Coherent has a strong market position within the optical networking space—that is, in the technology that sends light waves down optical fiber for communications. And while the vast majority of this market is still dealing with bloated inventory from the hyperactive growth of the COVID era, AI is now driving a massive upward shift in demand for optical networking for data centers.
This perfectly encapsulates what we see broadly across the tech sector: strength from AI spend and weakness everywhere else. Coherent's stock enjoyed a dynamic run through mid-July based on its strength in AI, as well as the market's enthusiasm around the hiring of a new CEO in early June who has demonstrated an ability throughout his storied career to create considerable shareholder value. Our long-term optimism for Coherent has only strengthened during the period in which we have owned its shares. In particular, we feel that the market will be surprised by the company's inherent earnings power as its non-AI markets move back to growth phases. However, we dramatically reduced our position size after its stock price ran up as we felt that the market was pricing in too much near-term strength, so we took advantage of upside volatility while waiting for the longer-term story to play out.
We are also seeing promising opportunities within tech companies that are in extended trough cycle phases, with Kulicke & Soffa (KLIC, Financial) being a great example. “KLIC” has a majority share in ball bonder equipment, which is used in the back-end packaging portion of the semiconductor manufacturing process. It is a core holding due to its high-quality business model, solid strategic execution, and strong management team. KLIC also boasts great financials and return-on-invested-capital characteristics, as well as a net cash balance sheet. The ball bonder market is now entering its tenth consecutive quarter of a cyclical downturn, though the historical average for a ball bonder downturn has run closer to six quarters. We think that the stock's weakness has given us a timely opportunity to increase our position at an attractively low valuation for several reasons: First, Kulicke & Soffa has a track record of emerging from previous cyclical downturns as a stronger and more profitable company. We see no reason that the next cyclical rebound will be different. Second, we think its balance sheet strength provides exceptional downside protection as we wait for the down cycle to end. Third, we think any attempt to time the next cycle upturn is a fool's errand, especially as this stock tends to rapidly discount efforts of this kind that those investors are likely to miss most of the returns if they aren't positioned from the very beginning. Fourth, we think the company has several promising ventures to move beyond ball bonding into other types of advanced packaging—which we view as free call options given that we don't think we are paying for that upside expansion at today's stock prices.
Another highly interesting opportunity within the IT sector is Hackett Group (HCKT, Financial), which is an IT services and consulting firm. Our initial thesis held that Hackett has a tremendous opportunity to monetize a differentiated data asset it has been building over decades due to its distinctive vantage point in the technology ecosystem. So, while we recognize that Generative AI has the potential to broadly disrupt consulting companies, we also think that this Generative AI-driven market shift is creating an even greater opportunity for the company to lean into its data asset. Broadly speaking, we think the winners in Generative AI will largely be predicated on access to unique data assets because the technology will allow companies to extract the value that has always been inherent in the data but is hard to tap into in any meaningful way. Hackett is feverishly pivoting its strategy to lean into a new Generative AI tool called AI XPLR, which we think has the chance to significantly boost Hackett's growth and profitability profile.
Mr. Hintz's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
