Management Commentary: July 2023
Dear Investors,
We began this past quarter emerging from a minor banking crisis that threatened to spread across the broader financial system. Quick action by the Fed helped to contain the fallout, but this served as a reminder of what unintended consequences can emerge from a rapid increase in interest rates over a short period of time. What we have not seen, however, is a meaningful slowdown in economic activity or weakness in the labor markets. This will likely keep the Fed poised to raise rates further, although likely at a more gradual pace. As for the equity markets, this recent turmoil resulted in growth investors moving even further towards the perceived safety of larger-cap companies that would likely have fewer potential liquidity issues as well as less sensitivity to an economic slowdown. On a relative basis, smaller companies have had a difficult time keeping up, even though valuations are not nearly as stretched, and we now find ourselves in one of the narrowest market rallies in over twenty years. We believe that as concerns continue to recede in the banking system, and investors get more clarity on how the economy is faring, it is likely that the smaller cap stocks we tend to favor will catch up to the major indexes in the second half of the year, and the funds’ positioning will start to bear more fruit.
One recent bright spot specific to the technology sector is the growing awareness of Artificial Intelligence (AI) technology. While advanced AI has been around for more than a decade, it has mainly been used by companies internally to help analyze data. With generative AI now available for consumer use, it is showing the world exactly how powerful and profound the technology could eventually become. ChatGPT, the most well-known of the large language models (LLM) driving the latest iteration of generative AI, reached over 100 million user accounts in two months, a remarkable feat that took TikTok 9 months and the Web itself 7 years to reach. The long-term societal and business disruptions likely to emerge from the development of generative AI are vast, incredibly complex, and nearly impossible to predict. Not surprisingly, the early leaders in AI engines have been some of the largest technology companies in the world, but the ripple effect caused by the need for more computing power, speed and storage should accelerate corporate spending in a broader way that will benefit many new tech platforms as well, including some of the Fund’s larger holdings. With significant motivation for companies to meet customer expectations, and keep up with competitors, we believe this will lead to outsized returns for those companies that are integral to this more rapid AI evolution. We are still on the hunt for additional names that might benefit from this trend but will remain vigilant about not confusing substance with hype, a nontrivial task given the justified interest and excitement in AI.
Jacob Internet Fund
The Jacob Internet Fund added two new positions in the quarter, Confluent and Zhihu. Confluent is a leading data software provider that helps companies move from legacy batch processing systems to modern real-time data streaming. In a world where many companies are challenged to manage on-premise infrastructure along with multi-cloud deployments, older architectures are increasingly incapable of handling these demands. The founders of Confluent had previously created Kafka, which pioneered the open-source standard now used by over 80% of the Fortune 100. As is typical for large open-source deployments, security and scalability quickly become issues that typically need to be addressed by a more robust commercial solution. Confluent fits nicely into that role, and with less than 4% penetration among current Kafka users, should benefit as the demands of AI data generation make more efficient processing vital to their business’s future needs.
Zhihu is a leading social media sites in China, with more than 100 million people using its question-and-answer service every month. Often compared to Quora here in the U.S., Zhihu has expanded its business model beyond advertising to offer up paid subscriptions, vocational training, and e-commerce. The company has also been aggressively incorporating AI technologies into its service and recently announced an initiative with the Chinese start-up Model Best to create an LLM called Luca, using its huge database of questions and answers as one of the primary sources of data for the model. Like many public Chinese Internet companies today, Zhihu trades at an incredibly low valuation due to investor concerns about the country’s economy and its increasingly tense relationship with the U.S. While these are valid concerns, we believe the upside potential more than compensates for the risks involved.
Jacob Small Cap Growth Fund
The Jacob Small Cap Growth Fund also added the same two new positions in the quarter, Confluent and Zhihu.
Jacob Discovery Fund
The Jacob Discovery Fund added two new positions in the quarter, Scynexis and Zhihu. Scynexis’s main compound, ibrexafungerp, was the first antifungal with a new mechanism of action to be approved by the FDA in more than 20 years. Unfortunately, the company and its drug – approved to fight vaginal yeast infections under the brand name Brexafemme – struggled mightily to compete with the available generic options, which are much cheaper and often good enough. A second approval of Brexafemme late last year for recurrent yeast infections should help expand the market, but the big news is a recent development deal the company signed with GSK that could be worth almost $600 million in milestone payments. The British pharma giant should do a much better job at selling Brexafemme, and ibrexa is also in Phase III trials for the treatment of the deadly invasive candidiasis (IC) infection. If successful in that indication, ibrexa could be a $1 billion-plus drug within a few years. Scynexis will earn a mid-teen percentage of sales in royalties from GSK if that happens while still retaining all rights to other antifungal compounds in its pipeline. Antifungal resistance is a major emerging worldwide health threat, and new medicines like the ones Scynexis is developing are critically important.
Jacob Forward ETF
The Jacob Forward ETF added two new positions in the quarter, Confluent and Zhihu.
Ryan Jacob
Portfolio Manager
Jacob Internet Fund
Jacob Small Cap Growth Fund
Jacob Forward ETF
Darren Chervitz
Portfolio Manager
Jacob Discovery Fund
Jacob Internet Fund, Small Cap Growth Fund and Discovery Fund Risk Disclosures:
Mutual fund investing involves risk. Principal loss is possible. There are specific risks inherent in investing in the Internet area, particularly with respect to smaller capitalized companies and the high volatility of internet stocks. All three funds may invest in foreign securities, which involve greater volatility and political, economic and currency risks, and differences in accounting methods. These risks are greater in emerging markets. All three funds also invest in smaller companies, which involve additional risks, such as limited liquidity and greater volatility.
The Internet Fund may invest in fixed income and convertible securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The market value of convertible securities tends to decline as interest rates increase and, conversely, to increase as interest rates decline. In addition, convertible securities generally offer lower interest or dividend yields than non-convertible securities of similar quality.
Investments in micro capitalization companies may involve greater risks, as these companies tend to have limited product lines, markets and financial or managerial resources. Micro cap stocks often also have a more limited trading market, such that the Adviser may not be able to sell stocks at an optimal time or price. In addition, less frequently-traded securities may be subject to more abrupt price movements than securities of larger capitalized companies.
Jacob Forward ETF Risk Disclosure:
Investing involves risk; Principal loss is possible. Please see the prospectus for the risks associated with investing in the Fund.
Click here for a link to the Jacob Forward ETF prospectus.
Click here to view the Jacob Funds prospectus.
The information provided herein represents the opinion of Jacob Mutual Funds and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Click here to view the holdings for the Jacob Internet Fund, as of May 31, 2023.
Click here to view the holdings for the Jacob Small Cap Growth Fund, as of May 31, 2023.
Click here to view the holdings for the Jacob Discovery Fund, as of May 31, 2023.
Click here to view the current holdings for the Jacob Forward ETF.
Please note that these fund holdings are subject to change and should not be considered a recommendation to buy or sell any security.
Earnings growth is not representative of the Fund’s future performance.
The Jacob Funds are distributed by Quasar Distributors, LLC.