COVID-19 has acted as an accelerant for the digitisation of the economy.
The following article is an excerpt from a white paper written by two investment experts from Epoch Investment Partners: William W. Priest, CFA — Executive Chairman, Co-CIO and Portfolio Manager Kevin Hebner, PhD — Managing Director, Global Investment Strategist. This is the second part of a series examining the impacts of COVID-19 and how this profoundly transformational experience has acted as an accelerant for the digitisation of the economy. The first part can be found here.
The radical transition that’s occurred over the past nine or so months is especially advantageous for asset-light business models in the tech, health care, and communications sectors, but is also likely to turbo-charge a range of industries, such as edtech, telehealth, e-commerce and e-fitness. While all companies will be acutely affected, the biggest winners are platforms, with their economies of scale and low marginal costs.
As the success of the big tech firms has demonstrated, ‘data is the new oil’, with comparative advantage increasingly defined by the ability to aggregate content and consumers. With ‘bits’ rapidly replacing ‘atoms’, we expect digital platforms to represent the vast majority of equity market capitalisation by the end of the decade.
Consequently, 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.
The COVID boost
Even before the pandemic, the digital economy was growing more than four times as quickly as the rest of the economy (figure one). With the lockdown-induced boost, this growth differential is likely to increase even further.
While the digitisation of the modern economy has been turbo-charged by the pandemic, that is not the only catalyst. Other critical factors include massive improvements in tech hardware, cloud computing[1] the ongoing rollout of 5G, and exponential gains in artificial intelligence (AI) efficiency. According to a study published by OpenAI in May 2020, the cost to train AI is declining several orders of magnitude faster than the pace of Moore’s Law[2]. While the gains in AI efficacy are truly spectacular, computing power keeps improving thanks to recent innovations in semiconductor design.
This is important as one of the biggest beneficiaries of the pandemic is the semiconductor industry, given these devices are the key enabler of the connected world. Consequently, we believe the digitisation of the economy, featuring the substitution of ‘bits’ for ‘atoms’, is still in the early innings and is gaining steam.
Tech guru Benedict Evans stresses that tech was very small until recently, with the number of global computer users having quadrupled since Facebook was launched in 2004 (representing a 10% CAGR), with no signs yet of slowing down. Moreover, in a world in which ‘data is the new oil’, global internet traffic continues to grow at a 20%+ pace (figure two).
Working from home post pandemic
Regarding the structure of work post- pandemic, recent survey results suggest the anticipated share of working days at home is set to triple—rising to 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 permanently change the labour market edifice and, among other things, boost the demand for a slew of tech products and services.
This year’s rapid shift to working from home (WFH) was enabled by two preconditions. First, tech hardware, residential broadband, cloud services, collaborative software, and videoconferencing capabilities have improved tremendously over recent years. Second, our economy now revolves around services, rather than manufacturing. This has allowed a majority of US companies to engage in what amounts to a national experiment in remote-work capabilities.
Economists are franticly collecting data to make sense of this year’s experiment and, so far, the evidence on productivity appears mixed. Regardless, it is clear that the nature of work has changed profoundly. For a start, many employees have swapped fixed 9-to-5 hours for fragmented schedules, with working hours becoming more flexible, night-time email traffic soaring, the weekday-weekend divide all but disappearing, and business travel plummeting.
A July 2020 study from Harvard Business School covered a large set of companies and found that, compared to pre-pandemic levels, the number of meetings per person rose by 13%, while the average length of meetings declined by 20%. It also found that the length of the average workday increased by 8% (50 minutes).
Regarding business travel, a July survey by the Atlanta Fed found that firms anticipate slashing their annual travel expenditures by 30% when concerns over the virus subside. Such a large, broad-based reduction in travel spending not only suggests a sluggish and potentially drawn-out recovery for the travel, accommodation, and transportation industries, but also indicates that firms are counting on a shift from face- to-face meetings to lower-cost virtual meetings. Survey respondents held 16% of their external meetings by video conference pre-COVID but expect this to rise over three-fold, to 50% post-COVID.
E-commerce and creative destruction: still in early innings
It was just over 25 years ago that Amazon sold its first book and started a retail revolution. While e-commerce has grown tremendously since then, the average global penetration rate is not yet even 15%, suggesting we are still in early innings. The much higher share in China also implies plenty of runway remains (figure 3). While no one denies that the pandemic bolstered virtual shopping, there is much debate as to whether we have leaped ahead by two, three or five years.
There is also some controversy regarding how much of this ramp-up will remain in place once the pandemic recedes. We believe much of the new activity will stick, with a recent survey by McKinsey indicating that during the crisis 75% of consumers tried a new shopping behaviour, such as a different website or delivery app, with over 73% intending to continue using it post-crisis.
The digital economics favouring e-commerce platforms are extremely powerful and becoming even more so. As a result, we believe its share will rise for all categories, from food and beverage, with its 4% penetration rate in the US, to books and music which currently has a chunky 63% (figure 4). While health and personal care had only a 13% e-commerce share pre-COVID, this proportion is set to rise dramatically.
Bolstered by the impact of COVID-19, global e-commerce sales are expected to expand at an impressive 17% in 2020, and by a 10% CAGR over the next five years.
This is not the first time that an outbreak has provided a tailwind for online activity. The SARS outbreak in Hong Kong/China, which was especially dangerous from November 2002 to July 2003, proved to be a vital watershed moment for Chinese e-commerce. Duncan Clark, the author of Alibaba: The House That Jack Ma Built, asserts that SARS represented the turning point when the internet emerged as a truly mass medium in China: “Crucially for Alibaba, SARS convinced millions of people, afraid to go outside, to try shopping on- line instead.” It was not by coincidence that Alibaba’s tremendously successful e-commerce website, Taobao, was launched in May 2003.
The process of creative destruction necessarily has its downside, and, in this case, it is the ongoing retail apocalypse. UBS predicts that 100,000 brick-and- mortar US retail stores will close by 2025, continuing a trend that started before the pandemic and has accelerated amid COVID-related shutdowns. Even so, post-COVID we expect brick and mortar stores to hold a large, albeit declining share. Similar to WFH, we project a hybrid model to remain in place for the next decade or so.
Accelerated automation: robots neither catch nor spread viruses
In a recent survey by Ernst & Young, 41% of executives said they expect to accelerate automation because of the pandemic. Due to concerns over vulnerable supply chains and the potential for infection of human workers, COVID-19 has incentivised companies to implement labour-saving technologies where they can. And once automated, those jobs will not be coming back.
Given that there are ten times as many service sector jobs as there are in manufacturing, there is every reason to believe that tech disruption in services will be magnitudes larger than what has occurred in the manufacturing sector over recent decades. That experience strongly suggests wage growth will lag productivity gains, lowering unit labour costs and pushing up profit shares.
A study published last month by the Bank of Canada, “COVID-19 and Implications for Automation” emphasised that the pandemic is likely to accelerate the automation of jobs, as employers invest in technology to safeguard against current and potential future pandemics.
Their analysis demonstrated that among the occupations with a high joint risk of viral transmission and automation potential are: medical assistants, dental hygienists, correctional officers, pharmacy technicians, and retail salespeople. Unsurprisingly, the occupations with the highest viral transmission risk tend to be in the services sector.
In addition to COVID-19, there are four reasons why the installed base of industrial robots is expected to double from 2019 to 2025 (figure five). First, they are becoming more flexible and autonomous by virtue of improvements in AI. Robots are also becoming cheaper, with the Boston Consulting Group projecting prices to decline by 6% annually (in quality-adjusted terms), which is clearly disinflationary and will act to hold down wages for a number of occupations. Next, the robotics industry is looking to copy the successful SaaS model.
A major challenge to the spread of industrial robots, especially for small and medium enterprises, has been their high initial cost. With a RaaS model, customers essentially subscribe to industrial robots as they might a cloud service like AWS. Finally, e-commerce has received a huge boost from COVID-19 and is leading in the deployment of mobile robotics, although most of these systems require external infrastructure like barcodes and magnetic tape to move around.
Investment conclusions: COVID-19 as an accelerant for the virtual economy…
The last nine months have been profoundly transformational, with the COVID shock acting as an accelerant for the digitisation and virtualisation of the economy. Once the pandemic subsides, some activities will snap back to their pre-COVID levels. However, much of the digital acceleration will be permanent. For most activities, hybrid models will prove most resilient and successful.
The digitisation of the economy is still in the early innings and is gathering momentum. Given this, we believe asset-light business models in the tech, health care, and communications sectors are most likely to be the future investment winners.
With an increasing proportion of activities moving from ‘bricks and mortar’ to the virtual world, we expect digital platforms to represent the vast majority of equity market capitalisation by the end of the decade.
From a macro perspective, this implies an asset-light economy in which technology is being substituted for capital and labour. This points to improved free cash flow margins and higher ROE—in fact, all three components of ROE should rise. Additionally, platforms feature low marginal costs and increasing returns to scale. This creates winner- takes-all markets which favour global champions.
Further, digitisation, like automation and globalisation, is profoundly disinflationary, which implies ‘lower for even longer’ interest rates. This is especially beneficial for long- duration equities such as tech.
Understanding how companies will adapt their business models is central to assessing their ability to produce free cash flow on a sustainable basis. Capital allocation processes will also be influenced, as capital-light business models, combined with solid revenue growth and higher free cash flow margins, allow many companies to increase dividends and buybacks, keeping overall payout ratios well above historical norms.
…and emphasises the importance of dividends
The saying “profits are a matter of opinion, but dividends are a matter of fact” encapsulate the reason that dividend paying companies tend to hold up well during volatile times. Profits are calculations based on a range of real and estimated data and have been known to be overstated; dividends are tangible, paid from corporate earnings.
As such, dividend paying stocks generally provide investors with tangible returns on a regular basis, irrespective of market conditions. As well as being a sign of good corporate health, dividends can help to mitigate losses when a company’s share price falls.
Apart from the obvious income benefit for investors, in the long term, stocks that pay a consistent dividend tend to outperform those that either cut or cancel announced dividends or don’t pay any at all, as illustrated in figure six. In fact, from May 1994 to September 2020, companies in the MSCI World Index that paid stable dividends returned 6.5% on an annualised basis; those that consistently grew their dividends over this period did better, returning 9.6% per annum.
Companies that did not pay a dividend had an annualised return of 6.5%, while those that cut their dividends delivered nearly half of the return provided by the dividend growers, at 4.9%. Importantly, the consistent dividend payers achieved better returns with lower volatility.
Epoch has always favoured companies that possess superior managements with effective capital allocation policies, believing they are the most probable winners. These attributes are 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.
Add to that, the focus on companies paying out high levels of dividends has delivered an ‘unintended consequence’ to investors; the stocks Epoch owns tend to experience less volatility than the market. Because the total return that these companies generate over time is more ‘front loaded’ than that of the average company, there is less uncertainty around it, and the price movements over time reflect that lower uncertainty. At a time when uncertainty abounds, some level of certainty is welcomed by investors.
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