Buying from the impatient

Notes on what we were buying while the market was busy buying semiconductors, what makes a software business hard to replace, and why buying the dip can lower risk.

We have been buying what other investors were selling. In our September dispatch, we described a market that had convinced itself a temporary fundamental change in the growth and margin structure of certain semiconductor companies — the result of a cyclical supply-demand imbalance — amounted to a permanent structural advantage. A second story was unfolding alongside it: fear that AI would disrupt enterprise software. That fear led to indiscriminate momentum selling, leaving software stock prices at levels that assume the disruption has already arrived and will strike every company alike.

Our research gives us a more discriminating view. The high-quality software companies we own deliver system-of-record and mission-critical solutions. That creates high switching costs and high client retention — a competitive advantage that is difficult to replicate. This quality test applies to every software company we own.

AI may lower the cost of writing code. But cheaper in-house code is nothing new; packaged software has always faced that competition. And replacing a system of record costs far more than writing the code. Not only must a new system be built, it must also be tested and integrated, and everyone from engineers to end users retrained. The risk and cost of errors are large. We believe decision makers would not take that risk to save a little money on coding. A replacement would have to be so much better that it is worth the disruption and risk of switching. Still, we monitor this competitive threat, in part by asking management teams directly: are you replacing software such as Workday, Salesforce or Autodesk? So far, the answer is no. We remain vigilant.

A tailwind mistaken for a threat

Autodesk shows what this misreading looks like up close. In the industries it serves, we see AI as a reason to buy more design software, not less. Construction faces labor shortages and tighter regulation; manufacturers are modernizing plants and diversifying supply chains. Both are spending on data and automation, which runs through the tools that design the projects. Those tools are Autodesk's, whose name is synonymous with CAD. A tool is only as good as the data and workflows beneath it, and Autodesk owns four decades of both. We estimate 20 million users treat the software as mission critical. It has spent more than $10 billion on research and development over the past decade, extending that moat. We expect it to keep adding consumption-based AI revenue on top of its subscriptions. None of that changed. The stock price did, widening the discount to our estimate of intrinsic value. We bought the dip, adding to our position, as we also did in Salesforce, Workday, and Microsoft. We believe AI is extending their competitive advantages and their addressable markets, not threatening them.

Volatility is not a problem; it’s an opportunity

Buying into a decline only makes sense if you know what the decline means. Volatility is inevitable and unpredictable. It is not, however, synonymous with risk. We define risk as a permanent loss of capital — a risk that can be reduced, rather than increased, when the share price of an unimpaired quality growth business declines. Distinguishing volatility from impairment means knowing the difference between temporary fundamentals and sustainable business quality. As such, volatility can create an opportunity to invest with a wider margin of safety. Buying the dip runs counter to the buy discipline of many growth equity managers. But to us, the risk of owning a great company is lower after its price has fallen, because buying at a significant discount to our estimate of intrinsic value can help mitigate downside risk while increasing the potential for upside appreciation. That distinction is central to our Loomis Sayles philosophy and process.

Leading versus following

The momentum trade has a structural problem: it follows market sentiment, handing the investment decision to the crowd. Buying the dip does the opposite. It requires a view of your own. We would rather lead — like the old hockey line about skating to where the puck is going rather than where it is. Because investing is about the future, our research is aimed at what margins and returns on capital look like ten years out, not next quarter or next year. For the companies we own, most of what we believe those businesses are worth comes from what they earn in those later years — the terminal value. That is the question almost no one is working on, and it is why patience and a long investment horizon are not preferences for us. Without them, there is no valuation argument to make.

What this can mean for you

Two investors can own the same business through the same decline and end up in different places. One decides she cannot wait any longer and sells. The more patient investor buys what was sold. And there it is: the wealth transfer. Selling low in fear and buying back higher when the narrative reverses does not generate alpha. It destroys capital — everything our patient, long-term, high-conviction process is designed to avoid. A margin of safety is an abstraction in a rising market. Nothing tests it. It becomes real only when prices fall, when it is hardest to act on. We do our research in advance; it is usually finished long before the price cooperates. Time arbitrage, in our language. That is the power of patience: a decline becomes an entry rather than an exit.

So here is what to expect from us: a selective, long-term, valuation-driven portfolio that will look different from the index — by design. There will be stretches when the crowd’s trade is working and ours has not - yet. That is not our process failing. That is how our process works: buying quality businesses with sustainable growth while they are marked down.

Keep this dispatch. Read it again once the cycle has turned and today’s fears have passed, and ask what the dip was worth. There is always someone who cannot wait. Our job is to be the one who can.

Until next month.
Loomis Sayles Growth Equity Strategies Team

The reference to specific securities, sectors, or markets within this material does not constitute investment advice, or a recommendation or an offer to buy or to sell any security, or an offer of services.