Disruption matters more than ever

Investors need to anticipate its effects

Disruption matters more than ever

We humans might do a lot of the same things we have always done; socialised, worked, sought novelty and entertainment. But the way in which we do so and the way in which companies deliver these goods and services to us has dramatically changed over recent years and decades.

It is almost quaint to now think about buying a newspaper, paying for it using coins from your kitty at home or sitting down to watch the same television program with your family in the evening.

But of course, change has always occurred. Motor cars replaced horses. Kodak films are no more. We have gone from records to cassette tapes to compact disks to digital music. People now send emails instead of writing letters and get much of their news and entertainment online instead of via magazines

What happened when these changes took place is that there was a fallout. Many enterprises went out of business. Kodak failed within three years of inventing the digital camera because the company sourced most of its earnings from selling camera films! Blockbuster video rental has gone out of business. Video killed the radio star is really a song about the historic introduction of disruptive technology!

The pace of change is accelerating

The rate of technological adoption and change is accelerating. This is unsurprising when it comes to technology which tends to improve at an exponential rate.

It took early technologies like electricity, the telephone and radio decades to reach 50 million users. The internet reached 50 million users within seven years, smart phones within four and Facebook reached its first 50 million users within 3.5 years and it now has more than two billion monthly users.

The point here is that as goods have become digitised, they can be taken up around the world rapidly. One reason is that the manufacturer doesn’t need to produce the product in factories, create a transport and distribution centre logistics model nor organise shipping to newly built and expensive-to-run stores to sell the product. 

These changes in technology and the mass adoption of computing technology lead to more rapid change. The uptake of smart phones has, as we all know, changed the way we go about our lives, be it listening to music, watching video, booking holidays and many other aspects of our lives in turn.

Industries facing disruption

It is instructive when analysing such examples of rapid change to think about what changes we might expect to see in future.

Take e-commerce. It is interesting to note that in the US, only 12% of retail sales ex-fuel are online (though this figure reached as high as 26% during the covid-19 pandemic), So although it might seem like old news to us, this trend and the disruptive implications still has a long way to run. While 70% to 80% of products such as personal computers and software occur online, for grocery and pharmacy products, online has been virtually non-existent to date, at 3% to 4% of sales.

Amazon has become the monster of retailing. After starting in bookselling, the company now covers all major categories – a retailer of everything for everyone.  The platform now generates US$325 billion in sales worldwide, including $219 billon in the US and is the second-largest retailer behind Wal-Mart, which has more than US$500 billion in sales worldwide.

But the difference is that Amazon doesn’t only sell items like a traditional retailer. What the company also does is provide a platform for third parties to sell their wares on Amazons site, and for half of these vendors Amazon provides ‘Fulfillment by Amazon’. This is the service whereby Amazon leverages its size and charges for use of its warehouse and logistics capability but at a price that is much lower and at faster speed than any small retailer could perform the same tasks.

Amazon has its Prime membership that one in three Americans has taken up. Prime gives its members free shipping and offers other services such as music and video. These Prime shoppers are highly valuable to Amazon because they are loyal, and they also spend considerably more once they get used to the convenience of the platform.

The other thing that is unique is that Amazon has built up trust in its customer base by giving them low prices, but they have also invested significantly in warehouses and logistics. The company has set a new standard with using robots in its warehouses and then giving its free shipping service a deadline of delivery within two days, a timeline competitors have struggled to match without boosting their costs - so you can see how difficult it is for large brick-and-mortar stores to compete with this. What our research is telling us is that for a while these retailers can keep muddling along, but once e-commerce penetration reaches and exceeds 30% of sales within a category, it gets more difficult for traditional retailers, without a proactive digital strategy to keep sales growth positive.

When I talk of fallout from disruption, we have already seen companies like Borders go out of business and the precipitous declines in sales and share prices of lots of well-known retailers in the US such as Macy’s, Bed Bath & Beyond and Sears, the fallen giants of US retailing. 

Given the goal of selling everything to everyone, Amazon is now pushing into other categories it hasn’t been in so far such as grocery following the 2017 acquisition of Wholefoods, and the steady trial and improvement of concepts such as Amazon Go convenience stores. Amazon is also proactive in rolling out private label items, be it Amazon-branded nappies or its active wear brands. Eventually Amazon might move to doing subscription grocery at scale for all of the staple items and it is possible that Amazon will accept a materially lower margin that what grocers claim today, though with dramatically larger scale. So while it is telling that Amazon is itself using brick-and-mortar retailing to broaden its reach, we can foresee material disruption risk for incumbent large brick-and-mortar retailers and for certain brand owners as well.

Another interesting example is in the advertising sector. What we have seen over the past decade is that print-based advertising has lost significant market share and this share has been taken up by the digital advertising platforms:  Google via its dominance in its search business and Facebook via its social-media platforms.

The huge advantage that these companies have from an advertiser’s point of view is that they get an incredibly high return on their investment in digital advertising because these companies can target the ads with such granularity. Advertisers know that via platforms they are reaching the people they want to target and that is in addition to the fact that this is where the eyeballs have moved. As fewer and fewer people read newspapers and magazines compared with viewing content online, it makes sense that this is where we have seen movement in advertising dollars.

A fascinating element of this shift, however, is that, to date, traditional advertising, including TV, has not overall lost material share. Traditional linear ad sales (linear TV, print, linear radio and out-of-home) amounted to $289b or 48.5% of total global advertising in 2020. It is our view that this number, and TV in particular, will decline as more video is moving to click and watch. The platforms include subscription channels such as Netflix but also to video content that has an advertising model that includes YouTube and Facebook video. Already, > 1 billion hours of content is watched on You-Tube each day, triple the amount of time spent watching regular TV, across > 2 billion monthly users who also upload > 500 hours of content every minute. Platforms are also bidding up the cost of content. The risks here for TV networks are rising costs and potentially falling revenues - particularly if major live sports end up on social-video channels.

Another area to watch is how machine learning backed by several large companies is enabling the development of driverless car technology.

Google’s Waymo is well ahead of the pack. Its fleet has driven more than three million miles on city streets, in addition to one billion miles in simulated settings annually. That is to say that progress is taking place rapidly.

While it’s easy to dismiss a driverless world as too far away, we counter that this could well happen sooner than people think and could have some interesting investment implications.

A car is the second-biggest household expense and on average it only gets used 5% of the time. Driverless-car technology and car sharing could reduce the number of cars by 85% and free up household income. It could take away the many deaths that are a result of drink driving. It has implications for jobs. Yes, for Uber drivers but also in industry. The 3.5 million truck drivers that transport goods in the US, for instance, could find their livelihoods under threat. We can also foresee the car insurance industry, the automakers and even parking real estate being disrupted by this shift over time.

What about businesses unaffected by technology?

Amid this talk of technology driven change, as investors it is also equally important to think about what constitutes business resilience as the world inevitably evolves. This is where the human element comes into play, where interaction with friends, desire for goods and experiences and self-expression and personal habits and comforts play a role in determining which businesses will likely withstand disruption. Equally the need for healthcare, and utilities such as transportation infrastructure and the internet are unlikely to change over time.

Navigating disruption in portfolio construction

Bringing this together, we would argue that rather than being a cliché, understanding disruption risk is more important than ever. We expect the pace of change driven by changing technology or changing consumer preferences will create a chasm between the winners and losers within and between industries. As such, forward-looking resilient portfolios account for:

  1. Technology winners – based on tangible, comprehensible trends and tailwinds such as the shift to cloud computing, digital payments, advertising such as Alibaba, Alphabet, Amazon, Facebook and Microsoft.
  2. Disruptive companies within traditional industries such as the use of robotics within surgery or in customer-relationship management such as Salesforce or Intuitive Surgical
  3. Resilient businesses – companies where we have conviction, they face a low risk of long-term disruption So here we have food, cosmetics, basic infrastructure, highly desirable clothing brands that people will still want to show to their friends or restaurants. Examples include Nestlé, Estée Lauder, Crown Castle International, Nike and Starbucks among others.
  4. Unique companies within otherwise threatened industries – this category would include insulated retailers such as Costco Wholesale and Home Depot.

Equally important is the avoidance of losers from disruption. Within this grouping, we include businesses where there is a wide distribution curve on future outcomes and where it is difficult to get conviction on their prospects, though they may appear to be tied to positive trends on the surface. This is where rigorous fundamental research and an in-depth understanding of company and industry fundamentals becomes key

The covid-19 pandemic of 2020 has in many cases dramatically accelerated these trends, be it within e-commerce, the distaste for handling cash aiding the digital payment networks, or the video conferencing and collaboration aiding cloud-based computing technologies. Equally, we have seen the human side come to the fore during this reset. Companies exposed to both forces are important pillars of future-focused investment portfolios today.

By investing our portfolios towards businesses with a resilience to disruption we are positioning our portfolio towards those businesses that are most likely to succeed. This should deliver better outcomes for our investors over the long term.


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