From ‘atoms’ to ‘bits’: COVID-19 as an accelerant for the digitisation of the economy
“Data is the new oil” and digital platforms are most likely to be the future investment winners as ‘bits’ increasingly replace ‘atoms’.
The last six months have been profoundly transformational, with the COVID-19 shock acting as an accelerant for the digitisation of the economy. This radical transition is especially advantageous for asset-light business models in the tech, health care and communications sectors.
This article, from GSFM’s investment partner Epoch Investment Partners, outlines its firm conviction that “data is the new oil” and, as such, digital platforms, with their economies of scale and low marginal costs, are most likely to be the future investment winners as ‘bits’ increasingly replace ‘atoms’.
For investors, the COVID-19 shock is best viewed as a forced experiment, compelling much of the economy into the digital sphere and offering an opportunity to assess what works and what doesn’t. The pandemic massively accelerated the adoption of remote activities, such as working from home and, while some telepresence activities will snap back after the pandemic, much of the transformation will be permanent or, at least, lead to hybrid models.
As a result, in coming years technology—always the great disruptor—is likely to play an even more central role in shaping the modern economy and driving equity market returns.
In terms of macro impact, the digitisation of the services sector is similar, in many respects, to the automation of manufacturing that occurred in the 1980s and 1990s. For a start, it will be profoundly disinflationary and lead to even more vexing difficulties in accurately measuring GDP. Moreover, tech disruption in services will be magnitudes larger than what occurred in the manufacturing sector, which itself was severe with long-lasting consequences for America’s political economy.
The manufacturing experience also suggests wage growth will lag productivity gains, lowering unit labour costs and pushing up profit shares.
The COVID-19 shock: turbocharging tech’s wallet share
While companies that rely exclusively on a physical footprint have struggled this year, digital businesses are thriving and gaining market share. Today, the digital economy represents about 38% of US GDP and has been growing at an impressive multiple relative to overall output (figure one). The COVID-19 shock is likely to widen the gap even further.
Companies that fail to implement a strategy for the digital age will surely flounder and ultimately disappear. Reflecting this, “What is your business strategy in the digital age?” has become one of Epoch’s favourite questions to ask when meeting with management teams.
Lower interest rates help buy time for “zombie” companies, but they can’t escape the headwinds posed by the accelerating substitution of technology for labour and physical assets. As companies seek to improve their profitability in a slow growth world, this means capital-light models will prevail in all industries.
Other critical factors supporting the digitisation of the modern economy include massive improvements in tech hardware and cloud computing, the ongoing rollout of 5G and exponential gains in AI efficiency. According to a recent study from Open-air, the cost to train AI is declining several orders of magnitude faster than the pace of Moore’s Law. Moreover, computing power is likely to keep improving as recent innovations in semiconductor design suggest Moore’s Law naysayers have been outmanoeuvred yet again.
Consequently, we believe this ‘fourth industrial revolution’ is still in the early innings and, if anything, is gaining steam.
Lockdown tech: working, studying, shopping and exercising from home
The current, rapid shift to working from home was enabled by two preconditions. First, tech hardware, residential broadband services and videoconferencing capabilities have improved tremendously over recent decades. Second, our economy now revolves around services, rather than manufacturing and construction, which is more conducive to working from home.
To illustrate the magnitude of this change, between 1960 and 2000 the share of employees working full-time from home never topped 3.5%. Since 2000, this has risen to 5.5%. This year, some surveys put that number at 16.6%. Other surveys have found that 75% of respondents would like to continue working remotely at least occasionally, while more than half want it to be their primary way of working after the crisis ends. A hybrid arrangement appears most likely to prevail, a trend that will boost the demand for a slew of tech products and services.
A second telepresence shift has resulted from the closure of schools. The physically close-knit nature of the classroom puts them not far behind cruise ships and assisted-living facilities as ideal theatres of contagion. Online learning has exhibited painfully slow growth over the last two decades, largely because of institutional barriers, and opposition from teachers and professors.
As NYU professor Scott Galloway points out, higher education is perhaps the only industry in the US that hasn’t faced pressure to cut costs. However, with COVID-19 only the most elite institutions with huge endowments and brand names may be able to resist change. Thus, the long-term outlook for education technology (EdTech) has undoubtedly been accelerated by COVID-19.
In fact, the market is forecasted to expand at a 15% CAGR over the next five years, especially impressive relative to an economy likely to exhibit sub-4% nominal growth. Still, as the pandemic subsides, a hybrid model is more likely than an outright shift to online learning, with traditional learning methods being increasingly complemented by online activities.
Shopping and exercising from home have received mountains of press, so we won’t provide a detailed discussion here. The only debate about e-commerce seems to be whether the pandemic has sped up the trend by two years or by five. Bolstered by the impact of COVID-19, global e-commerce sales are expected to expand at an impressive 10% CAGR over the next five years. And given that the overall e-commerce penetration rate is less than 15% globally, there remains plenty of runway for Amazon and its competitors to grow for years to come.
COVID-19 has accelerated telemedicine ‘by a decade’
Health care leaders across the ideological spectrum agree that COVID-19 has pushed the inevitable telemedicine revolution forward by a decade. Further, health care is being redesigned so that telehealth could represent around 25% of patient visits by 2025.
Consistent with this view, Global Market Insights expects a 19% CAGR from 2020 to 2026, which is more than five times projected nominal GDP growth. Other reasons to be optimistic about the health care sector include advances in molecular genetics and biotechnology that are poised to transform the world.
For example, the cost of DNA sequencing is declining at a rate faster than Moore’s Law and will soon cost less than $100. Moreover, one-third of the world’s data resides in the health care industry, which makes it ripe for disruption given advances in computing power, the cloud, AI and 5G.
All the big tech firms have serious initiatives in health care and, for each of the last six years, biotech has been the leading sector for IPOs (tech ranks #2). Health care is no longer punching below its weight when it comes to digital innovation and, in our view, this makes it one of the three most promising sectors. And that is even before considering the 140 teams of researchers that are racing to develop a safe and effective coronavirus vaccine, which will then be distributed to billions of people worldwide.
How expensive is tech after the pandemic’s super- charged returns?
To illustrate, the acceleration of the digitisation of the economy, six of the highest profile digital platforms now represent 24% of the S&P’s market value (up from 18% at the beginning of the year and 10% in 2015) and have accounted for roughly half of the S&P’s rise over the last five years (Figure 2).
The vertiginous ascent experienced by the digital platforms has led many investors and commentators to assert that the tech sector is dangerously expensive, no longer driven by fundamentals, and overdue for a sharp correction. However, considering the decline in bond yields, the sector appears to be fairly valued on a free cash flow (FCF) or earnings yield basis (Figure 3).
Most of the tech sector’s gains over the last year reflect strong revenue growth and lower bond yields, which is a vastly different backdrop than experienced in the late-1990s. Regardless, this still implies that future price appreciation will require both solid FCF growth and lower for longer bond yields. While we have high conviction about the latter, it is clear that sector valuations imbed aggressive earnings growth expectations, and this leaves little room for error.
There is certainly the possibility of a pullback in the short term, but we are confident the digitisation of the economy is still in early innings, so the best days likely remain ahead for the tech, health care and communications sectors. By the end of the decade, we expect the vast majority of the S&P’s market value will consist of digital platforms, although they could well be a different group than has led the market over the last decade.
Looking ahead – income strategies can thrive when bits replace atoms
The current environment is challenging for capital preservation strategies and capital growth strategies. Given today’s environment of slow to no growth with the risk of recession, the opportunity cost for a capital preservation strategy is high and a capital growth strategy is riskier in a no-growth environment. Income strategies may be the lifeline that sustains investors until organic growth picks up again or interest rates rise.
Income is highly desired today where the risk-free rate is near zero and the discount rate applied to growth investments are near all-time lows. One is paying a lot today for uncertain cash flow forecasts five to seven years hence. Income is the bridge between capital preservation and growth when dealing with financial goals such as retirement needs, education costs, mortgage deposits and repayments, possible effects from job losses and so on. Income is essential to every one of us.
What should investors look for in an income strategy? One desires certainty of income as much as possible, or put another way, the ‘assurance’ of an income stream. It should be well above that generated from the risk-free rate and it should have a growth rate attached to it. Furthermore, this income stream needs to be highly diversified such that no one security or asset class can undermine the goal.
Yield with a growth rate attached to that yield is best found today in equities. To assure the lowest risk, the source of that income must be diversified as much as possible and, importantly, the holdings need to be equal weighted as much as possible. Equal weighting is imperative to secure the highest possible certainty around the yield and its growth rate. Capitalisation weighting is not the way to go to because it allows individual securities to carry a ‘measure of weight influence’ that hurts rather than helps the probability of securing the desired yield stream with its accompanying growth rate.
Another important aspect of the income investment strategy is a focus on the sustainability of the dividend and potential capital risk of income generating stocks. Strategies that can deliver reliable income to investors are able to create portfolios that balance high current income through dividends with limiting capital loss risk. Loss of capital will eventually impair a portfolio’s income generation capability in the long run.
Even if we say we live in a world with new business models, where bits become more important than atoms, and growth is therefore more desirable, it remains important to solve the income need. It is also worth noting that these new business models are increasingly ‘capital light.’ Technology is being substituted for labour and physical assets, freeing up more cash that can be distributed to shareholders. In other words, payout ratios will likely rise. It is that ‘abundance of income’ characteristic that can then be blended with a capital preservation strategy and a capital growth strategy to deliver income and growth to investors in the current environment.
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