Gavin Baker - The One Thing That Matters Is Inflation

10/5/21, 9:07 AM Gavin Baker: «The One Thing That Matters Is Inflation»
INTERVIEW
«The One Thing That Matters Is Inflation»

Gavin Baker, founder of Atreides Management, sees
inflation setting the tone for financial markets. The
influential tech investor says what rising prices would
mean for the sector, what's next for the super-cycle in
the semiconductor industry, and why the record number of
new stock issues is creating attractive opportunities.
Christoph Gisiger
13.09.2021, 05.32 Uhr
Deutsche Version
Financial markets are heading into a pivotal phase. After a rapid

rise in inflation, the coming months will reveal whether this
trend is transitory or permanent after all. At the same time, the
Federal Reserve is signaling that it wants to start winding down
its gigantic stimulus program.
Gavin Baker thinks that inflation will become the key factor
determining the direction in financial markets. The founder and
CIO of Boston-based investment boutique Atreides
Management is one of the most esteemed investors in the tech
sector. Although he doesn't rule out the possibility that the
surge in inflation will level off next year, he is preparing for any
kind of scenario.
https://themarket.ch/interview/the-one-thing-that-matters-is-inflation-ld.4998 1/18
«We have been in a secular

bull market with receding
interest rates for decades,»
Mr. Baker says. High-
growth tech stocks, in
particular, have benefited
from this environment.
«That's why it's so
important to keep an eye
on inflation,» he argues. «I’m not smart enough to know
what’s going to happen, so I want to
be open-minded to any scenario»:
In this in-depth interview Gavin Baker.
with The Market/NZZ, the

investment veteran shares
his take on the outlook for the stock market and the
unprecedented shortages in the semiconductor industry. He also
explains how investors can take advantage of the boom in IPOs,
SPACs and direct listings.
Mr. Baker, once again, financial markets are laser-focused on the

next move of the Federal Reserve. How do you approach this
environment as a tech investor?
I don’t tend to focus very much on stimulus and the macro

environment in general. I think things like that are lost in
the sands of time. The Fed is going to do what it’s going to
do, maybe it will be a good decision, maybe it will be a bad
one. But the one thing that does matter is inflation, and
here’s a reminder of how humbling our job as investors is:
We saw these consecutive, massive CPI prints, and you
know what happened? Counterintuitively, the yield on the
long bond went straight down. This is why investing is the
greatest game ever invented, and we’re all lucky to be

involved in it.
What’s your investment strategy with respect to inflation?
I believe it's in the Bruce Kovner chapter of «Market

Wizards», one of the best books written about investing.
He says that he likes to picture himself as the boulder at
the top of a mountain. Based upon certain things, he
visualizes the path he’s going to take down the mountain: If
X happens, he’s going to go down this way, and if Y
happens, he’s going down a different path. So he’s keeping
an open mind and tries to imagine all the different
scenarios, depending on initial conditions and whichever
way the boulder starts to go.
Do you think there’s a real risk that inflation is here to stay?
Something I profoundly believe is that nobody repeats the

mistake of their parents. We all have nuanced opinions on
what our parents did wrong; in life, as parents or in
business. Whatever it is, nobody repeats those mistakes.
But all of our parents had parents, and that means that a lot
of times we’re repeating the mistakes of our grandparents.
What does this mean when it comes to the current

environment?
If you go back to 2010-11, the last time there was

significant quantitative easing, there were two remarkable
open letters to Fed Chairman Ben Bernanke in the «Wall
Street Journal», signed by the world’s greatest macro
investors and economists. Both said basically the same

thing: QE is a terrible risk, you’re going to unleash hyper-
inflation, and you have to stop. These op-eds were written
with a lot of conviction, and they were dead wrong. I think
because of that, almost no one is really pushing back on
what the Fed is doing today. At the same time, unlike in
2010-11, very few people in the United States Congress are
pushing back against stimulus programs, and today the
stimulus is a lot bigger. To me, that lack of real pushback is
concerning, just because inflation and deflation are the two
things that financial markets cannot abide.
Which way do you think this journey will go?
On balance, I think that a lot of this inflation will prove to

be transitory. It’s reasonably likely that you will have
negative CPI prints next year. Almost certainly, there is
going to be a massive supply response coming. But if it
starts to go wrong, it makes life very difficult for financial
markets. We have been in a secular bull market with
receding interest rates for decades. Obviously, we had huge
drawdowns along the way, financial crises and crashes, but
the market kept tugging, particularly over the last ten or
twelve years. So inflation is the one thing that’s important
to monitor. I’m not smart enough to know what’s going to
happen, so I want to be open-minded to any scenario. Like
Bruce Kovner said: If I’m that boulder on top of the
mountain, I want to know which way I’m going to go in
different scenarios.
How would tech stocks react if the current surge in inflation

isn’t transitory?
Everyone has looked at the 1970s and seen that technology

stocks did poorly. But back then, tech companies were low
return on capital, low return on equity companies. They
had many physical plants. Unsurprisingly, the best thinking
on inflation’s impact on the equity market comes from
Warren Buffett. He basically points out that the way
inflation crushes you is that it compresses RoE over time
by inflating your asset base. Hence, according to Buffett,
you want to own high ROIC, asset light companies with a
lot of revenue and profit per employee, particularly when
they have pricing power. And that describes a lot of the
technology industry today. That’s why tech might do better
in an inflationary scenario than many people believe. If you
are a company like Google or Facebook that sells digital
advertising and if you’re selling it at an auction, by
definition, you’re not really exposed to inflation. Your
prices will inflate with the economy by the magic of these
auctions.
Then again, the sector is rather richly valued. It’s also a fact that
investors use large-cap tech stocks as long-duration assets
instead of bonds. Aren’t these stocks at risk in an environment
with rising inflation and rising interest rates?
It’s actually pretty tough to argue that these mega-cap tech

stocks are expensive. A lot of the big tech companies are
pretty cheap. Here’s something I like to do with these
mega-cap tech companies: Let’s divide every number by
ten; the market cap, the shares outstanding, the revenue,
everything. And then, let’s pretend that stock is in another
sector like industrials and try to figure out where it would
trade. I can tell you the multiples would be way higher.
So far, investors remain

quite optimistic. The S&P
500 and the Nasdaq 100 are
up close to 20% year-to-
date, hovering around their
all-time highs.
Averages can be quite

misleading. If a river
«It’s actually pretty tough to argue
is on average three
that these mega-cap tech stocks
feet deep, that sounds are expensive. A lot of the big tech
easy to cross, but not companies are pretty cheap.»
if at the deepest point

it’s a hundred feet
deep. While the averages and the indices have been very
placid, there is crazy turbulence underneath with violent
rotations. It’s not uncommon that on a day when the
market is up or down 1%, one group of stocks is up 3 to 5%,
and another group is down 3 to 5%. Sometimes it’s sectors,
sometimes it’s subsectors, or thematic like work from home
or re-opening, or cyclical versus defensive. I think that is
the market sorting through all these crosscurrents: The
stimulus fading, another infrastructure bill on the horizon,
and the fact that the Fed at some point is going to taper.
Among the best performers this year are again some

semiconductor stocks. What’s your take on the recent
developments in the chip industry?
First of all, there is a difference in the semiconductor

industry between a capacity cycle and an inventory cycle.
In the 1980s and 1990s, we saw capacity cycles, and the
reason for that was that most semiconductor companies
had their own fabs. So when you had upgraded every line
in that fab and there wasn’t a new process technology
available, the only way you could expand capacity was to
bring on a new fab. What’s more, most semiconductor
companies back then would all bring on new fabs at the
exact same time. So even though semiconductor demand
was growing very consistently, you had these crazy boom-
bust cycles where you would go from crazy undersupply to
crazy oversupply. That’s why it was such a cyclical industry
in the past.
How about today?
Mostly because of TSMC and the shift to outsourcing

semiconductor fabrication, those capacity cycles have gone
away. TSMC supplying such a huge increment of the
world’s semiconductors means that at any point in time, it
has loads of fabs and production lines it can bring on so
that supply very smoothly matches demand. That’s why it’s
been twenty plus years since we’ve seen a true capacity
cycle in the semiconductor industry, outside of the memory
sector. However, over the last twenty years there have been
lots of inventory cycles.
How is an inventory cycle different from a capacity cycle?
It’s similar to all these equations in macroeconomics, like

savings must equal investment, investment must equal
savings etc. The equation that explains the modern
semiconductor industry is the fact that customer buffer
inventories equal semiconductor lead times. So if you’re a
purchasing manager at a company like Ford, you generally
have a pretty quiet job; you just have to buy stuff and make
sure it’s there to run the factories. But what you really don’t
want to happen is what actually happened: Ford’s plants
got shut down because they couldn’t get semiconductors.
That’s a disaster, and that’s how you lose your job as a
purchasing manager.
What does this mean for the present state of the semiconductor
industry?
Purchasing managers all around the world want to avoid

that problem by holding buffer inventory equal to lead
time. That means, if a semiconductor company is quoting
you a lead time of two weeks to get a part, you want to
have two weeks of inventory. Thus, when the lead time
grows to three weeks, you build inventory for three weeks.
Critically, as long as customers are building inventories,
what the semiconductor companies are seeing is not true
end demand. They’re seeing stronger demand because the
customers are ordering to meet their demand plus to build
inventories. That’s what you have seen in the
semiconductor industry over the last year.
You’ve started your career in the investment industry as a

semiconductor analyst in the late 1990s and you know the sector
very well. What do you think is going to happen next?
Everybody thinks this time it’s different, but it’s never

different. As lead times are increasing, I promise customer
buffer inventories are increasing. If you’re a giant internet
company, to provide services you need a lot of CPUs, GPUs
and memory. You don’t want to run out of those processors
and have the company’s growth curtailed. So you’re
building inventory everywhere. If you’re a big handset
company, you’re building

inventory. Everybody is
building inventory, and
there is also something
called double ordering.
That means if you’re a
handset company, you’re
placing an order with more
than one semiconductor
«Everybody thinks this time it’s company for what you
different, but it’s never different.» need because you’re not
sure you are going to get it.
The semiconductor
companies are always thinking it’s not happening. But it’s
happening.
So how is this going to play out?
Semiconductor companies are straining to meet this

demand that’s actually growing stronger and faster than
true end demand. And then something happens. Who
knows what it is? Maybe it’s the crypto currency market
rolling over. Maybe it’s a big smartphone company coming
out with a device that’s not as cool as it usually is. Maybe
it’s the Delta variant slowing down economic growth. But
all of a sudden, lead times go down one tick, say from
twenty weeks to nineteen weeks. So of course, customers
reduce their inventories. All of a sudden, demand flips from
above natural to below natural, and then it spirals the same
way down as it went up. That’s why you have these wild
inventory cycle driven swings in end demand. It’s pretty
clear that if we have not already seen the peak of this
inventory cycle, we’re very close. But once we’ve gone
through that, the open question is if we’re in a true capacity

cycle.
What do you think?
That’s what we talked about in our last interview:

Semiconductors are cyclical and economically sensitive, but
long-term they grow faster than GDP. Now, artificial
intelligence is going to raise the semiconductor intensity of
global GDP. In other words, if in the past the
semiconductor industry grew at 1.5x global GDP, now it’s
going to grow 2x to 3x because AI, by its very nature,
consumes so much more semiconductor content than
software written by humans. Therefore, it may be possible
that the world is structurally short of capacity, and we’re in
a capacity cycle, driven by the confluence of AI and all
these other trends: the electrification of cars, autonomous
vehicles, crypto mining. All these mega trends will be
driving semiconductor demand, but they’re all dwarfed by
AI. Yet, we’re only going to be able to make that judgement
once we’re on the other side of the current inventory cycle.
Semiconductors have become a hot topic in geopolitics, and

leading manufacturers like TSMC, Samsung and Intel have
announced massive investments to build new fabs, betting on
government subsidies. Is this a smart move?
For their sake, I better be right about AI driving

semiconductor demand. Because if I’m not right and all
these fabs come online, it’s going to be a train wreck. Also,
better be careful what you wish for. There is too much of a
good thing, and government subsidies tend to distort
supply and demand. I’m a huge believer that we should
have fabs in the United States and Europe. We need leading

edge semiconductors, it’s a geopolitical imperative. The
same is true for pharmaceuticals and batteries: Every tank,
every armored personnel carrier, every Humvee, every
airplane needs batteries, too. You need a domestic supply
chain for those three things. They're the oil of the 21st
century. But if we have all these subsidies, and demand
isn’t structurally higher, it’s going to be very painful for the
semiconductor industry.
Which companies are attractively positioned against this

backdrop?
Companies in the semiconductor capital equipment area:

These are the arms dealers, and they have massively
consolidated. What’s interesting about a lot of these
companies is that they become structurally better
businesses and thus evolve into really great stocks. They
have almost done what the aircraft engine companies did
in the past. The big inside in GE twenty years ago was:
«Who cares making money on the engine? We’re going to
make a lot of money on servicing that engine.»
Semiconductor equipment machinery, whether it’s
lithography or edge deposition, is really complicated. It’s
like aircraft engines. So they realized: «Wow, we can do the
same thing! We can have recurring revenue!» Consequently,
they have become more stable businesses.
Where else do you think there could be opportunities?
Going back to my earlier point that AI requires a lot more

processing and memory than software by humans,
processor and memory companies are interesting areas
over the next three to five years. But don’t get confused,
they are probably all going to go down in an inventory
cycle.
What are the areas in the tech sector where you would advise
caution?
EV SPACs are the most ludicrous group of stocks I have

ever seen. They are not the way to go for investors. These
are absurd companies, and they’re going to get – for the
most part – crushed between the dominant electrical
vehicle incumbent and the OEMs, whether it’s BMW,
Daimler, GM or Ford.
In general, the market for new issues is booming. What’s your

approach in this space?
Here’s my
recommendation
where to research and
spend time: Between
all the new IPOs,
direct listings and
SPACs, the system has
been overwhelmed. «There are a lot of inefficiencies in
the market for new issues, and it’s a
The world’s largest
great area for anyone who is an
asset managers don’t investor to go do work in.»
have enough analysts
to keep up with all of
the new companies that are going public. Neither do hedge
funds, ECM teams at investment banks and the research
teams on the sell side. Hence, there are going to be a lot of
exciting investment opportunities on the long side and on
the short side in that cohort of companies. Some of them

are going to go to zero, and some are going to be incredible
stocks. There are a lot of inefficiencies in the market for
new issues, and it’s a great area for anyone who is an
investor to go do work in.
But aren't many of these companies already richly priced when

they go public?
Two observations: One, Amazon went public at $1 billion,

Facebook at $40 billion. But they both created a lot of
value. If you go public at twenty, thirty or forty billion, it
doesn’t mean you can’t create a lot of equity value,
particularly in these «winner takes it all» tech markets with
increasing returns to scale.
And what’s your second observation with respect to new issues?
Ignore them until they have been in the market for six
months. Everybody pays all this attention to these
announcements of IPOs, direct listings and SPACs, but it’s
just sound and fury. You only get your first real market
price when the lockup expires. So if a company goes public
via an IPO and you’re interested, do some work, but
recognize you’re generally not going to get a true market
price until six to nine months after it’s gone public. Just put
it on your calendar for six months after the date of the IPO,
and then begin considering it.
Tech is probably the most disruptive industry in the world. How

do you stay on top of your game as an investor when it comes to
new market trends and the emergence of new technologies?
There’s a saying: If you don’t know who the patsy is at the

poker table, it’s you. So I try to only invest in companies
where I believe I’m in the top 1% of investor knowledge.
The reason for that is actually not that I think being in the
top 1% of investor knowledge will help me get stocks right.
I’m just here to tell you it doesn’t. There are stocks where
I’m way up into the top 1% of investor knowledge, and I
still lose vast amounts of money. I’m still wrong half the
time. Investing is really hard, it’s humbling, and the game
within the game is always changing.
So what’s your advantage when you’re better informed about a

company than most investors?
Good investing is all about finding a philosophy that fits

your temperament and emotional make-up such that you
can make high-quality rational decisions when you are
wrong. Put differently, if I own a stock and wake up and it’s
down 25% because of a risk I hadn’t considered, the odds
that I make a low-quality decision are pretty high. That’s
why I try to avoid these situations. Generally, if the stock is
down a lot and I’m losing money, it’s because of a risk I
considered. I know how to react to it and I’m going to make
a high-quality decision. Sometimes that decision is to buy
more, sometimes it’s selling everything, and sometimes it’s
selling a little. It’s different every time, but I’m much more
likely to make a high-quality decision. And, I’ve concluded
that to remain in the top 1% of investor knowledge in the
stocks and sectors that are important to me, I need to be in
at least the top 20% of crypto currency knowledge. That’s
because cryptocurrencies and blockchain are going to have
a big impact on software, on the internet, on payments and
on the back offices of so many companies.
Gavin Baker
Gavin Baker is one of the most profound investors in

the tech sector. He started his career at Fidelity
Investments in the late 1990s as a semiconductor
analyst. In the course of his career, he rose to
become one of the stars of the Boston based money
manager. In total, Mr. Baker worked at Fidelity
Investments for eighteen years, most recently as
the portfolio manager for the $17-billion Fidelity
OTC Fund. During his eight-year tenure, the fund
outperformed 100% of its Morningstar peers,
compounded at roughly 19.3% annually net of fees
and won six Lipper Awards. He helped spearhead
Fidelity’s venture capital investing and was a board
observer at Nutanix, 23andME, Jet.com, AppNexus,
Dataminr and Roku, among others. In January 2019,
Mr. Baker founded Atreides Management. The firm
brings the long-term perspective of a private equity
investor to high growth technology and consumer
companies and invests across public and private
markets. At the end of June 2021, it managed
assets of approximately $3.7 billion. Gavin Baker
earned an AB in economics and history from
Dartmouth College. He regularly shares his insights
into technology on his personal blog and on Twitter.
He’s an ardent fan of video games and science-
fiction. It’s no coincidence that he named his firm
after the house of Atreides, the powerful dynasty in

the science-fiction saga «Dune».
All opinions expressed by Gavin Baker in this article are solely his own
opinions and do not necessarily reflect the opinion of Atreides
Management. This article is for informational purposes only and
should not be relied upon as a basis for investment decisions.
INTERVIEW
«Semiconductors Are the Closest Thing to Magic In the

Modern World»
Gavin Baker, founder and Chief Investment Officer of
Atreides Management, spots exciting perspectives for
investments in the chip sector. He anticipates a surge in
demand due to the rise of artificial intelligence and
explains why Taiwan could become geopolitically even more
important than the oil rich countries of the Middle East
in the 1970s.
Christoph Gisiger 24.09.2020
INTERVIEW
«Anybody Who's Buying and Selling Stocks Thinks They're

Smart»
Richard Thaler, Nobel laureate and Professor of Behavioral
Science and Economics at the University of Chicago, talks
about the new stock market boom, irrational price
movements in stocks like GameStop, and the most common
psychological traps in investing. A conversation with the
pioneer of behavioral finance.
Christoph Gisiger 27.07.2021
INTERVIEW
Russell Napier: «We Are Entering a Time of Financial

Repression»
Market strategist Russell Napier talks about why he sees
structurally rising inflation coming, why central banks
are impotent – and what that means for investors.
Mark Dittli 14.07.2021
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10/5/21, 9:07 AM Gavin Baker: «The One Thing That Matters Is Inflation»

«The One Thing That Matters Is Inflation»

Financial markets are heading into a pivotal phase. After a rapid

«We have been in a secular

with The Market/NZZ, the

Mr. Baker, once again, financial markets are laser-focused on the

I don’t tend to focus very much on stimulus and the macro

greatest game ever invented, and we’re all lucky to be

What’s your investment strategy with respect to inflation?

I believe it's in the Bruce Kovner chapter of «Market

Do you think there’s a real risk that inflation is here to stay?

Something I profoundly believe is that nobody repeats the

What does this mean when it comes to the current

If you go back to 2010-11, the last time there was

investors and economists. Both said basically the same

Which way do you think this journey will go?

On balance, I think that a lot of this inflation will prove to

How would tech stocks react if the current surge in inflation

Everyone has looked at the 1970s and seen that technology

It’s actually pretty tough to argue that these mega-cap tech

So far, investors remain

Averages can be quite

if at the deepest point

Among the best performers this year are again some

First of all, there is a difference in the semiconductor

How about today?

Mostly because of TSMC and the shift to outsourcing

How is an inventory cycle different from a capacity cycle?

It’s similar to all these equations in macroeconomics, like

Purchasing managers all around the world want to avoid

You’ve started your career in the investment industry as a

Everybody thinks this time it’s different, but it’s never

company, you’re building

So how is this going to play out?

Semiconductor companies are straining to meet this

through that, the open question is if we’re in a true capacity

What do you think?

That’s what we talked about in our last interview:

Semiconductors have become a hot topic in geopolitics, and

For their sake, I better be right about AI driving

have fabs in the United States and Europe. We need leading

Which companies are attractively positioned against this

Companies in the semiconductor capital equipment area:

Where else do you think there could be opportunities?

Going back to my earlier point that AI requires a lot more

EV SPACs are the most ludicrous group of stocks I have

In general, the market for new issues is booming. What’s your

the short side in that cohort of companies. Some of them

But aren't many of these companies already richly priced when

Two observations: One, Amazon went public at $1 billion,

And what’s your second observation with respect to new issues?

Tech is probably the most disruptive industry in the world. How

There’s a saying: If you don’t know who the patsy is at the

So what’s your advantage when you’re better informed about a

Good investing is all about finding a philosophy that fits

Gavin Baker is one of the most profound investors in

after the house of Atreides, the powerful dynasty in

«Semiconductors Are the Closest Thing to Magic In the