Gavin Baker - The Cyclone Under the Surface - [Invest Like the Best, EP. 260]

Here is the translated investment research note, adhering to all specified rules.

At a Glance

Guest Gavin Baker is the Managing Partner and CIO of Atreides Management, focusing on growth equity investments in consumer and technology. The main theme of this episode is dissecting the causes and opportunities of the "underwater collapse" in growth stocks in early 2022. Gavin Baker's core judgment is that the valuations of many small and mid-cap growth stocks have returned to or fallen below 2018 levels, while their fundamentals are far superior to that period. This creates highly attractive investment opportunities, but investors must distinguish between the different situations of the three sub-sectors: software, internet, and semiconductors.

Thematic Sections

1. Inflation is the Only Key Variable, But "Good Inflation" Must Be Distinguished from "Bad Inflation"

Gavin Baker believes inflation is the only important macro variable for the current market, but the market's interpretation of inflation is too general and needs to be broken down.

• Supply-Side Inflation ("Good Inflation") : Driven by supply chain bottlenecks and commodity shortages, such as port congestion and chip shortages. Baker is very optimistic about this, believing that capitalism's supply response is extremely strong. He cites an example: "Amazon has spent more money on CapEx in the last two years than they did in the preceding 20 years. " TSMC's 2022 capital expenditure will be several times that of 2019. At the same time, the economy is slowing (the Atlanta Fed's GDPNow model fell from 10% in November to 5% in December), and consumer spending is shifting from goods to services. With increasing supply meeting slowing demand, he believes this part of inflation will fade quickly.
• Wage Inflation ("Bad Inflation") : This is the real risk. Job openings have exceeded the number of unemployed for the first time, which is unprecedented. Baker attributes this to massive fiscal stimulus, debt relief (student loans, rent moratoriums), and early retirement of older workers. Citing Buffett's theory, he points out that even if companies can pass on costs, inflation inflates the asset base, depresses ROE/ROIC, and thus lowers long-term stock returns. "If wage inflation is here to stay, I think it means very bad things for the market. It’s just that simple."

2. Tech Sector Divided into Three: Software is Most Stable, Internet Under Pressure, Semiconductors Face Cyclical Headwinds

Baker emphasizes that tech stocks cannot be viewed monolithically; the fundamentals and outlook for the three sub-sectors—software, internet, and semiconductors—are vastly different.

• Software: The Most Favored Sector. Software is the "consumer staple of tech," showing the most fundamental resilience during an economic slowdown. Baker is particularly bullish on infrastructure software (e.g., companies built on top of cloud infrastructure), believing its moat is deeper than application software. He warns that large cloud vendors (like AWS) have a "nature" to encroach on the application layer, and CIOs also prefer to build applications on the cloud themselves. Therefore, he prefers application software companies serving SMBs, as they cannot build their own. Additionally, he mentions cybersecurity, where the involvement of AI makes scale a significant advantage, breaking the industry's ceiling.
• Internet: Facing "Post-COVID Aftereffects." E-commerce and advertising internet companies are highly sensitive to GDP and are undergoing a normalization after the demand pull-forward caused by the pandemic. Baker warns that upcoming earnings reports for many small and mid-cap internet companies could be disappointing. "COVID took them to a place that was way above trend. And now that’s normalizing and that’s painful." An exception is search advertising, which benefits from the recovery in service consumption.
• Semiconductors: Cautious Short-Term, Structural Growth Long-Term. The industry has become highly consolidated into monopoly/duopoly structures. Long-term demand is structurally shifting higher due to AI and vehicle electrification (growth rate increasing from 1.5-2x GDP to 3x GDP). However, it currently faces a massive inventory cycle, coupled with an economic slowdown and massive capacity expansion. Baker is very cautious about the short-term outlook. "I’m probably as cautious as I’ve been on semiconductors in a long time right now."

3. Public-Private Valuation Disconnect: Liquidity Premium Has Become an "Illiquidity Premium"

Baker points out a significant disconnect between current private market valuations and public markets, with the root cause being LPs' pursuit of "smooth returns."

• Mechanism: Because private assets are not marked to market, their book returns show low volatility, making their Sharpe ratios appear higher, creating an "illiquidity premium." This leads to a continuous flow of capital into private markets.
• Endgame: Public market valuations are the ultimate "reality check." Baker believes that if the public market weakness persists for 6-9 months, private valuations will inevitably cool down. "Public multiples are the ultimate reality."
• Impact on VC Landscape: Baker predicts the future VC market will bifurcate into four types of participants: angel investors, truly value-adding seed-to-Series B specialist funds, operational growth funds, and large multi-stage crossover funds. He argues that to compete with crossover funds, all large institutions will eventually have to become crossover investors, as their "never sell" commitment is highly attractive to founders.

4. Growth Stocks Have Become Opportunistic, But Focus on Free Cash Flow

Despite the uncertain macro environment, Baker believes many small and mid-cap growth stocks currently offer significant investment value.

• Valuation Anchor: The valuation multiples of many software and internet companies have returned to 2018 levels, even though interest rates (10-year Treasury at 3%) were much higher then, and company fundamentals (growth rates, profit margins) are far superior now.
• Key Screening Criteria: The market has begun to differentiate based on free cash flow. Baker emphasizes a strong preference for companies that can generate positive free cash flow in 2023, with a free cash flow yield of 2%-4%, rather than those still burning cash. "I do have a big bias towards the ones that generate free cash flow."
• Self-Awareness: Baker admits he always buys "too early" and jokingly calls himself "addicted to the 52-week low list." He reminds listeners that his judgment might be premature but believes these companies will show decent relative performance over a 12-18 month horizon.

Position Moves

Position	Guest's Stance	Key Data
Amazon	Example of supply response	CapEx in the last two years ($87B) exceeded the total of the preceding 20 years ($62B).
Taiwan Semi	Example of supply response	CapEx in 2021 and 2022 will exceed the total of the preceding 5 years.
Microsoft	Bullish on its metaverse asset portfolio	Owns HoloLens, Windows gaming platform, Minecraft, Bethesda, Activision Blizzard.
Activision Blizzard	Mentioned as Microsoft acquisition target	Being acquired by Microsoft.
Zoom	Extreme case of "post-COVID aftereffects"	Stock price significantly down from highs.
Peloton	Extreme case of "post-COVID aftereffects"	Stock price significantly down from highs.
Google (Alphabet)	Mentioned as market leader	One of the few stocks driving the Nasdaq in 2021.
Microsoft	Mentioned as market leader	One of the few stocks driving the Nasdaq in 2021.
NVIDIA	Mentioned as market leader	One of the few stocks driving the Nasdaq in 2021.
Tesla	Mentioned as market leader	One of the few stocks driving the Nasdaq in 2021.
Netflix	Example of "leveraged royalty on global GDP"	Viewed as a leveraged royalty on global GDP and consumer leisure time.
Roblox	Current form of "metaverse"	Viewed as a cartoon-style, child-oriented metaverse.
Fortnite (Epic Games)	Current form of "metaverse"	Viewed as a cartoon-style, child-oriented metaverse.
World of Warcraft (Activision Blizzard)	Current form of "metaverse"	Viewed as a fantasy-style metaverse.
Destiny (Bungie)	Current form of "sci-fi metaverse"	Baker himself spends a lot of time in it.
Salesforce	Representative of application software	Its CEO's "scorpion and elephant" fable about AWS was cited.
Twilio	Representative of infrastructure software	Mentioned as an infrastructure software company.
DataDog	Representative of infrastructure software	Mentioned as an infrastructure software company.
Stripe	Representative of infrastructure software	Mentioned as an infrastructure software company.

Judgments Worth Remembering

1. Gavin Baker believes that the valuation compression in growth stocks is largely complete, with multiples for many companies back to 2018 levels, but their fundamentals are far superior. Support: The 10-year Treasury yield was 3% in 2018, and the market was in the middle of a rate hike cycle; currently, many companies are growing faster with higher margins, yet trade at lower multiples.

2. Baker argues that the market's discussion of inflation is too general and must distinguish between "supply-side inflation" and "wage inflation." Support: Supply-side inflation is likely to fade due to capitalism's strong supply response (e.g., massive CapEx from Amazon, TSMC) and an economic slowdown; wage inflation is the real threat to the stock market as it erodes long-term returns by depressing ROE.

3. Baker warns that the fundamental situations for software and internet companies are vastly different, and investors should not lump them together. Support: Software companies have no "post-COVID aftereffects," their fundamentals are stable, making them the "consumer staples of tech"; internet companies (e-commerce, advertising) are undergoing a painful normalization after pandemic demand pull-forward, and their earnings may disappoint.

4. Baker asserts that the "illiquidity premium" in private markets is the root of the public-private valuation disconnect, but public market valuations are the ultimate "reality check." Support: LPs' pursuit of smooth returns makes non-mark-to-market private assets appear to have higher Sharpe ratios. However, if public market weakness persists for 6-9 months, private valuations will inevitably follow suit and cool down.

5. Baker proposes that future VC will bifurcate into four types: angels, truly value-adding early-stage specialist funds, operational growth funds, and large multi-stage crossover funds. Support: Crossover funds, with their "never sell" commitment and IRR-oriented (rather than MOIC-oriented) strategy, hold immense appeal for founders, forcing all large institutions to eventually become crossover investors.

6. Baker believes AI fundamentally changes the competitive landscape of the cybersecurity industry, turning scale from a disadvantage into an advantage. Support: In the past, success attracted targeted optimization by attackers, limiting company size. Now, with AI-driven security companies, models learn from more data; the larger the scale, the stronger the defense, breaking the industry's ceiling.

7. Baker points out that the market has begun to differentiate growth stocks based on free cash flow, which is a positive signal. Support: In the past, all high-multiple stocks rose and fell together, but now companies with a 2%-4% free cash flow yield are showing relative resilience, while those still burning cash continue to face pressure.

8. Baker believes the key to judging whether someone can be a good public market investor is to see if they can remain rational when they are wrong. Support: Public market investors make mistakes far more frequently than private investors, and even good investors often have a win rate below 50%. The ability to face mistakes calmly and make rational decisions is a core quality.