May 01, 2018
A New Era of Investing
I have written before about how the world is changing due to the adoption of new technologies. Recently, I attended a presentation on this same theme by one of the legends of Wall Street, Bill Priest of Epoch Investment Partners. The basis of the presentation is provided in their January 2018 newsletter entitled When “Bits” Meet “Atoms”: Implications of the Second Machine Age for Corporate Profitability and Traditional Business Models. This can be downloaded from Epoch’s website and I highly recommend reading it. Here, I will summarize the most important points for investors.
First, the pace of change is accelerating. This is because the application of new technological discoveries takes time to have material economic impacts. Epoch makes the important point that the industrial age was basically driven by one emergent technology, the steam engine. But what we are seeing happening today - in what Epoch calls the “Digital Age” - is the convergence of a number of new technologies beginning around 2007. The resulting synergistic effects are producing economic change at a rate that is exponential rather than linear. “The world has never seen disruption at this pace and breadth before.” And, to quote John Mauldin, “There is going to be more creative destruction in the next decade or two than in all of the last century.”
Next, it is important to understand that not everyone will win from these changes and it is necessary to identify and avoid those businesses that will be negatively impacted. “Disruptive innovation naturally produces more laggards than winners, but that is especially true during periods of exponential progress…” Also, “disruptive innovation is affecting every sector of the economy, and not just tech.” Epoch provides examples like the 80% decline in household spending on long distance telephone services from $77 billion in 2000 to $16 billion in 2013, and the 70% decline in newspaper advertising revenues in the ten years between 2006 and 2016.
There are critical differences in the nature of the Digital Age compared to the Industrial one that preceded it, changes which have made legacy financial models and macroeconomic measures inadequate to fully explain the new economy. One result is that “productivity growth in the economy is understated”, which is a theme I have written about previously.
More important, however, is the failure of standard analytical methods to adequately assess and value leading companies that are based on intellectual property, software development, and branded consumer networks on the internet. In short, such businesses expense R&D and other costs that create long-term value but, since these costs are expensed rather than capitalized like new plant and equipment, they do not appear on the balance sheet. At the same time, these development expenses reduce reported earnings. Therefore both assets and earnings end up being understated when using standard valuation metrics.
Baruch Lev, Professor of Accounting and Finance at the Stern School of Business, NYU, writes about “…the archaic, detached from reality accounting rules” of GAAP (generally accepted accounting principles). “Internally-generated intangible investments – R&D, brands, human resources, organizational capital – are immediately expensed, following GAAP rules, despite the obvious fact that in modern economies these investments are the most important and consequential long-term value-drivers of business enterprises.”
Epoch makes the key observation that bits, unlike atoms, can be copied, re-used, and easily transferred. While the up-front cost to build a network may be high, the incremental cost to add a new customer after the network has been established is miniscule. Profitability - taken as return on investment - enjoys a double positive impact because profit margins rise as “tech replaces workers” while the amount of investment needed to grow revenues is reduced “if a company substitutes technology for assets”. Epoch calls this the “asset light” business model. “Any firm not pursuing an “asset light” model faces obsolescence, as rivals will compete its business away.”
The result in many sectors is concentration in a few large companies with dominant market shares by virtue of being the early adaptors of new technologies. Google, Amazon, and Facebook are some obvious examples. Business models like these having become established in the marketplace, “wide digital moats are keeping potential competitors at bay”.
I believe what this means for investors going forward is that stock selection will become much more important and the passive approach to investing that has become so popular in recent years will no longer be adequate for achieving required returns on invested capital. This will be especially true if the long term secular bull market in the U.S. finally experiences a normal correction that historically has been in the range of 16%-18%. That would shift the market’s focus to identifying who are the winners versus losers when transformational technology results in rapid economic change.
To quote Eric Parnell of Gerring Capital Partners: “..if any future period of darkness were to befall the U.S. stock market, it would put the end to the current age of indexing and a departure of the near-exclusive focus on the U. S. stock market that has resumed during the artificially inflated years of the post-crisis period. In its place would be the dawn of a new age of active management including the ability for specialized managers to once again add value through their own unique strategies and processes.”
If you would like to assess the suitability of your portfolio for this new era of investing, call me to arrange an appointment.
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