Global themes in a tech driven world

23 Oct 2018

From GSFM

Disruptive innovation will affect all economic sectors, not just information technology.

In a recent series of presentations to advisers in Australia, industry veteran Epoch’s CEO and co-CIO Bill Priest, discussed the new world order, in which bits replace atoms, tech is the new macro and companies need to evolve to stay relevant.

Global businesses have arguably entered a period of unprecedented innovation and disruption, one where platform technologies, network economics and winner-takes-all markets favour global champions. The accelerated pace of technology means disruptive innovation is affecting every sector of the economy; there will be more laggards than winners, and investors need to be wary of value traps, as many seemingly cheap companies struggle in the face of change.

The digital age

The second machine age – or digital age – commenced with the shift from mechanical and analogue electronic technology to digital electronics in the late 1950s.

In 1965, Gordon Moore, who later founded Intel, theorised an exponential relationship between integrated circuit complexity and time, in which circuits would double in performance roughly every 18 months. Although the impact of the digital age was difficult to see for the first few decades, as even exponential growth from a small base is not visible for a long time, Epoch believes technological innovation reached an inflection point around 2007 with the emergence of a raft of technology companies and innovations, illustrated in figure one.

Today’s tech companies benefit from broad developments such as faster processing power, cheaper and better data storage and improving network bandwidth and transmission capacity. They also benefit from lighter and longer-lasting batteries for devices and advances in artificial intelligence and machine learning.

Since progress in the digital age is exponential rather than linear, the business world has never seen disruption at this speed and scale before: witness the dramatic transformation in industries such as newspaper, film, music, telecommunications, retail, transportation, and accommodation.

In 2006, the US’s 2,400 newspapers generated almost $50 billion of advertising revenues. However, within a decade these revenues had declined by 70% and are expected to continue declining by 15% per year over the next five years. On the other hand, internet ad revenues have been growing by 20% per year, with Google and Facebook being the biggest beneficiaries of that growth (their digital ad revenues are up tenfold since 2001).

Case study one: The retail sector feels the pointy end of disruptive innovation

Developments in the retail sector provide a good case study regarding the implications of technology for employment and wages. E-commerce has been around for a while, but its impact has been most profound since August 1998 when Amazon announced plans to move beyond books, with the intent to ‘sell everything to everybody’.

In recent years, online retail sales have been growing by a solid 15% per year, which is roughly four times the growth rate for traditional brick-and-mortar retailers. Despite faster sales growth, the share of retail employees who work for internet retailers has barely budged. This is reflected in a much lower employment-to-sales ratio, a trend which shows no signs of reversing.

To the contrary, by dramatically reducing transaction costs, e-commerce has captured 65% of all retail sales growth over the past two years (with Amazon alone capturing 60-70% of that). This process will likely continue to put downward pressure on both wages and employment in the retail sector.

Bits versus atoms

The exponential growth of processing power, as aptly expressed by Moore’s Law, has helped drive the digitisation of information. This data is composed of ‘bits’ rather than ‘atoms.’

Bits represent the digital age whereas atoms represented the first machine age. The key differentiating point is that data in the form of bits can be copied freely, perfectly and instantaneously. As such, they are usable over and over again, unlike goods constructed from atoms.

The old saying, “you cannot have your cake and eat it, too,” speaks to the world of atoms. Economists use the term ‘rivalrous’ consumption to describe such goods. On the other hand, a ‘bit’ of information is ‘non-rivalrous’; it can be consumed or reused over and over again.

This and other related properties of the digital age have important implications for the structure of the economy and traditional business models. This includes higher margins and profits for the relatively small number of dominant firms.

If a company determines that it does not need the same level of assets to run its business as it did in the past because technology has replaced the need for atoms (people and fixed assets), it can remove equity from the business through cash dividends, share buybacks, or debt pay downs.

This follows from the observed trend toward asset light business models. The ‘atoms’ of human beings and fixed tangible assets are being replaced by ‘bits’ of technology and intangible assets. This effect is appearing in almost every company Epoch examines as each endeavours to become more efficient in its use of labour and assets. Any firm not pursuing an ‘asset light’ model faces obsolescence, as rivals will compete its business away.

Case study two: the music industry moves from physical to digital

The global music industry has been forced to dramatically change its economic model over the last decade or so. Worldwide sales of recorded music declined by roughly 50% from US$24 billion in 1999 to just over US$12 billion in 2014, with a massive transition from physical to digital (see figure two).

In 2014, the global music industry generated roughly equal amounts of revenue from digital channels as from physical formats such as CDs. However, Epoch estimates digital sales will be five times that of physical sales by 2021 – ‘bits’ crush ‘atoms’ yet again.

Free, perfect and instantaneous are the hallmarks of digital disruptive strategies. Once digitised, information goods can be freely copied, with the digital copies being perfect duplicates of the original. The internet makes their distribution almost instantaneous.

With cloud computing, AI and machine learning, more data translates to a smarter, more effective platform. Traditional goods and services are at a huge disadvantage since they do not possess these qualities.

A digital platform can be characterised by near zero marginal cost of access, duplication, and distribution. Common digital platforms include Amazon, Netflix, Google’s search engine, Facebook, the iPhone’s app store, Spotify, Uber, and Airbnb. They all feature business models with high fixed costs and low marginal costs, which are the key attributes of natural monopolies.

Importantly, lower does not mean zero. No company, even in the digital age, is able to scale its business meaningfully without incurring some additional expenses. For example, Amazon needs to build more warehouses and Netflix needs to produce more content.

Network effects are an essential element in the digital age, and Facebook is the most frequently cited example of network effects today. The value of a network rises exponentially relative to its number of active members. For example, the more people that use Facebook, the greater its value to both its users and advertisers.

Indirect network effects can also be powerful. For example, an increase in the number of iPhone users encourages more app developers to invest in the platform.

In addition, digital platforms are able to continuously mine and analyse customer data to create much smarter platforms (for example, Amazon content recommendations). It has become increasingly popular for tech companies to offer complementary goods on their platforms (for example, AirBnB selling local experiences), a tactic called bundling.

Is e-commerce a bubble?

Although Epoch believes the e-commerce index as a whole does appear stretched, there are two key points to consider.

Firstly, cheap changes everything. Digital technologies are much more powerful than their predecessors, because the inherent scalability massively lowers firms’ marginal costs. The result is a seminal business model that is capable of producing an impressive win-win, with both companies and consumers becoming vastly better off.

Secondly, cynics risk tarring all e-commerce companies with the same brush, while Epoch believes many companies in the sector possess sound and promising business models. To accurately distinguish between the likely winners and losers, it is crucial to analyse each company based on its ability to produce free cash flow on a sustainable basis and on management’s skills in capital allocation, including investing today for future value creation.

These principles are as relevant to e-commerce companies as they are to firms in more traditional sectors such as consumer staples or industrials.

There have been (at least) seven clearly identifiable bubbles over the last forty years or so, as illustrated in figure three. The first bubble was gold, which peaked in 1980 at about 5x its initial price. The most recent candidate is e-commerce, which is up over 8x since mid-2010. Although not convinced it’s a bubble, Epoch admits it shares a lot of the characteristics of one.

Bubbles always involve a dislocative event that promises to upend the existing order. This produces outsized gains for a number of years, and typically generates clever explanations for why traditional valuation metrics are inaccurate, inappropriate and irrelevant. This was certainly true of the Nikkei bubble in the late-1980s (Japan Inc. was going to take over the world, so a PER of 80x was totally reasonable) and tech’s massive gains a decade later.

The current hype about two-sided platforms, big data and ‘blitzscaling’, featuring a growth over-profits mentality, certainly raises the possibility that e-commerce might be yet another bubble waiting to be popped.

The digital age has undoubtedly turbo-charged the process of creative destruction, which is now occurring more swiftly and tumultuously than ever before. However, it has always been the case in tech that titans rise and then, often quite suddenly, titans fall.

Some of the notable examples of this process include: Atari in the late-70s to early-80s (marked the beginning of the PC, created a new American art form and, at its peak, was the fastest growing company in US history, and then ‘poof’ it pretty much disappeared), America Online (king of the dial-up internet era), Netscape in the late-90s (was dominant from 1995–1998, but lost to Microsoft in the “browser wars”), and Myspace a decade ago (it was the world’s #1 social networking site from 2005–2008, but was then overtaken by Facebook).

Technology has a long history of producing disruptive companies that appear dominant and unstoppable one year, only to find themselves abruptly and acutely on the ropes as they in turn are disrupted.

For a more quantitative perspective, Epoch estimates companies that are in the top 10 at one moment in time had a 60% chance of remaining in the top group five years later, a 45% chance after a decade, and only 35% after 15 years had passed.

The companies currently at the top of the list (see figure four) look entrenched and difficult to dislodge, but they always do, and the historical record suggests we should expect the rankings to change quite substantially between now and 2023 or 2028.

Looking at the next tier of companies, those ranked 11th to 25th, only 55% of them remained in the top 25 five years later, a figure that dropped to 30% after a decade. On the other hand, for these second-tier companies there is only a 15% chance of moving into the top ten after a decade has passed. This suggests they are in a very competitive and dynamic space, with a much higher probability of moving out then of moving up.

At first, it might seem quite remarkable how many companies come from out of nowhere to make it into the top ten. Such companies in the 2000s included eBay, Cisco and Google, while more recent entrants have included Facebook, Amazon, Alibaba and Tencent. However, statistically, the numbers are not so encouraging. On average only 15% of companies in the top 10 weren’t even in the top 25 list five years earlier, a number that rises to 30% if the lookback is increased to ten years.

Disruptive innovation will affect all economic sectors, not just information technology. As a result, Epoch believes it’s increasingly important to favour companies with a demonstrated ability to produce free cash flow and allocate that cash flow wisely between return of capital options and reinvestment or acquisition opportunities.

Companies that possess superior managements with competent capital allocation policies possess the attributes most likely to be even more important going forward, as management is tasked with creating value by marshalling talent and technologies during a period of unprecedented innovation and disruption.

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