May 02, 2019
How We Got Here
It is normal for people to focus on day-to-day activities as we all like to keep busy with work, family, and recreation. Rarely is there time to just sit back and think about the big picture. Constant media flow of news and opinion about current events reflecting rapid change in our political economy can make it difficult to focus on the big picture and see important secular trends that are transforming our world. Sometimes it is helpful to look back at long-term historical evolution in order to identify these trends.
The title of this essay comes from a wonderful, highly readable book by Alan Kessler entitled "How We Got Here". It goes back through history to look at the technological changes that have brought us to this point. From this I think we can draw important insights for investing in the new economy. What follows is an update to past blog posts where I have touched on this subject: "A New Era of Investing", "Harry Potter and the Productivity Paradox", and "The World Is Changing…..Are You Ready?".
Over the long scope of human history (the very big picture), there have been three major economic eras. First, there was agriculture. Next came the industrial revolution. And today we are entering a new era based on knowledge and ideas, collectively called ‘data'. Data can be collected, stored, transmitted around the world, and analysed at ever increasing speeds. This new economy has been given many names: knowledge economy, data economy, digital economy, internet economy, etc. It is important to recognize just how fundamental are the changes occurring now as we move from the previous economic era to the new one. You can get some idea by looking at the way the industrial revolution completely transfigured the world that was based on agriculture. In the agricultural economy, ownership of land was what mattered. Feudalism was based on the monarch owning the land and parcelling it out to various nobles to buy their loyalty and military support. Land was the basis of wealth and the end product was food.
The industrial revolution introduced mass manufacture of a great many material things and enabled rapid long-distance transportation of people and freight. Wealth came from the ownership of factories and machines (the means of production, as Karl Marx pointed out at the time in Das Kapital). When the steam engine took hold in the 18th century, railways became the internet of that era and coal was the commodity to own. But by the early 20th century, development of the internal combustion engine made the world revolve around oil, almost to the present day. Post WWII, the automobile was the symbol of economic growth and what was good for General Motors and U.S. Steel was good for America.
So, in the agricultural era, you needed to own land and produce food in order to be wealthy. In the industrial era, you invested your capital in factories and equipment that manufactured ‘things' people wanted to buy – like cars. Alternatively, you could simply own the commodity that the economy ran on, which was oil. But what do you do today in the digital economy? Epoch Investment Partners calls the transition from the industrial age to this digital one, "atoms to bits" ("bits" obviously meaning data).
The new economy is very different from the one that existed prior to the internet. Instead of food or material goods, the data economy provides services and media content for consumers, and produces automation equipment and software for industry. Standard models for economic forecasting and corporate valuation no longer work very well. As I have written before, it is hard to measure productivity and evaluate the impact of capital spending since, as Epoch points out, dominant corporations in the digital economy are "capital light". Scott Barlow wrote about this recently in the Globe & Mail citing research from Credit Suisse that suggests P/E multiples are no longer the best guide to stock valuation compared to free cash flow and return of capital.
So what do we do to identify solid investments in this time of rapid technological change? I have suggested in past essays that we should try to identify businesses with a future (BWAF) where we have a high degree of certainty that the company will still be around and growing five years from now. At the same time, it is just as important to avoid companies not adopting new technology that may lead to market share erosion.
I believe there is another important insight we can take from the economy's evolution through history described above. In the agricultural era, the key commodity was land. It was not that important what plants or animals you produced so long as you owned a productive piece of land. In the industrial age of manufacturing, you might not do very well if you invested in the wrong auto company in the 1920s since very few survived, but all the cars and trucks ran on oil. So, if you bought that key commodity, you did not need to worry about which new car model would succeed in the marketplace.
If we draw the analogy to today's digital economy, the obvious key commodity is data but it is hard to find a discreet investment in data. Certainly Amazon, Facebook, and Google (Alphabet) are leaders in collecting data, but they do a lot of other things as well. I think there is an alternative to investing in data, which is to focus on another essential commodity in the digital age: semiconductors. No matter which smart phone succeeds, they all contain chips from the same manufacturers. So we can invest in the chips that go into all devices that collect, transmit, store, and process data. Further, we can invest in the businesses that make the equipment used to manufacture semiconductors. Semiconductors are the "oil" of today's economy.
There are at least three other sectors that have similar attributes to semiconductors in the emerging digital economy in that they produce niche equipment or services for a broad spectrum of businesses implementing digital technology, supplying customers that may be in competition with each other. First, there are software and IT consulting companies that help enterprises and governments adapt to doing business over the internet, and to AI, automation, the Cloud, the Internet of Things, etc. Software is essentially ideas in a digital format. Then there are companies supplying networking equipment and infrastructure to telcos and cable companies for building out the new 5G network that will be truly revolutionary. Finally, there are a number of businesses making specialized scientific instruments used in biotech and healthcare to implement new technologies. For manufacturers and other industrials, these companies also provide test, measurement, monitoring, and other automation equipment.
The degree of change is breath-taking. An investor can be at a loss as to what to do. Big blue chip names from the past do not necessarily work anymore. You might want to just give up and buy the whole stock market through an inexpensive passive index ETF. That way, you would own the winners - but you would also have exposure to all of the losers being impacted by technology. There may be a better way. If you would like to learn more, please call me to arrange an appointment.
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