DISRUPTION IS NOTHING new; in fact, human progress has always been driven by the advent of new technologies and processes which lower cost, increase convenience or improve product performance. Disruption in the market is usually driven by an innovation – a challenger company develops a new solution, initially with limited applications, a niche customer base and a relatively high cost structure compared to an incumbent business’s existing products. Over time, with technological advancements, either the cost structure or the technological capability of the innovation improves significantly. Eventually, what once appealed to a limited audience begins to draw in customers once loyal to the established business. These established companies often knew about the existence of the new innovation but either failed to realise the potential market size or adapt their business to take advantage of the technology.
Companies that are unwilling or unable to adapt their organisational structure to one better suited to respond to new innovation often find themselves the casualties of disruption. Take Xerox, for example. The printing solutions group actually invented the first personal computer (PC) in the 1970s with a graphic user interface and a mouse. However, it failed to commercialise its success because it did not have the retail sales knowledge to do so. Microsoft founder Bill Gates, however, grasped the promise of the technology for retail customers and developed an organisation well suited to serving this market. Xerox ultimately failed to commercialise its own invention.
The Great Atlantic & Pacific Tea Company, better known as A&P, was a chain of US grocery stores which operated very successfully from the 1920s onwards and earned above-market returns on investment for decades. A&P was a relatively small-format grocery store located in urban areas and charged lower prices than competing stores. It was able to earn high returns despite its low prices due to its cost efficiency. Several technological and social changes around the 1950s resulted in a dramatic shift to a new format, which resulted in A&P shrinking significantly.
The two key technological changes that disrupted A&P’s business model were the advent of affordable automobiles and the mass production of refrigerators. The former led to increased suburbanisation and the latter allowed people to make fewer but larger shopping trips. This favoured the supermarket format which began developing in suburbs. Supermarkets had large parking lots and stocked a greater variety and volume of product. Supermarkets drew customers from further afield than an A&P store could, resulting in a larger volume of sales than an A&P could support.
These volumes allowed the supermarkets to use their fixed cost infrastructure, such as their supply chains, much more efficiently than the A&P stores. Eventually they achieved a lower cost structure, allowing them to charge lower prices, take market share and then dominate for the next several decades.
Managed risk-taking is critical for businesses to thrive, especially when technology has accelerated the pace of change.
MODERN TECH THREATS
Key technologies leading to market disruption today are always-on connectivity, mobile devices, cloud computing, artificial intelligence (AI) and machine learning.
Always-on connectivity has increased product and service transparency to customers, with product and service prices and reviews easily accessible through using mobile devices on review sites like Booking.com – a share we own – or by asking your friends on social media.
As a result of this transparency, to win in business today, a company’s product or service has to be great; there must be some practical or emotional appeal. It is no longer good enough to control the distribution channel, because alternatives are often available at the click of a button rather than a drive away.
Cloud computing has lowered the cost to start up a new business. A smart entrepreneur can rent processing power and storage by the minute, prototype a new application (app) in days and then acquire customers globally via an app store.
MACHINE LEARNING AND ARTIFICIAL INTELLIGENCE
Machine learning and AI are probably less familiar to most than the other three technologies described above. Machine learning is a subset of the broader scientific concept of AI.
Normal PCs or servers perform relatively mechanical tasks at a much faster rate than humans are able to achieve. An app is simply a set of instructions that is broken down into smaller subinstructions, which are then executed in a linear manner.
AI, on the other hand, aims to imbue computers with interpretative capabilities. The popular technique of AI today, called machine learning, involves the setup of a computerised neural network. This network is then trained using masses of sample data, like images of cats, for example. Once the network is trained, it can be used to make inferences.
Results of a recent study in Nature Medicine journal showed that multimedia parent company Alphabet’s DeepMind AI system was able to diagnose eye diseases such as glaucoma from retinal scans at an error rate lower than that of eight different human retinal specialists. Alphabet is a holding in our portfolios.
How does one evaluate the investment potential of businesses in the face of these technological changes? Unfortunately, there is no easy answer; each business needs to be assessed on its own merits. There are several factors to consider in the process.
It is important to have a view on the impact, if any, of these technologies on the industry in which the business operates. For example, the mobile internet has driven mass adoption of social media, which has increased users’ time spent accessing various social media products. This has led to an increase in the inventory of advertising real estate (scrolling creates an endless stream which can be dotted with advertisements) and lowered digital advertising prices relative to traditional media. The development has been great for companies like Facebook and Alphabet, but very negative for traditional media (newspapers) and advertisers such as WPP. By understanding where we are in the shift from old to new media, we can get a sense of how much opportunity remains. While the best technology platforms still have many years of growth ahead due to these secular shifts, they are also investing significantly in future opportunities.
It is just as important to understand the competitive advantage or ‘moat’ a business has with respect to a technological change. It is not good enough for a disruptor to be better than traditional companies; for a business to thrive in the long term, it has to have something that makes it better than other companies using the new technology. Management with a long-term focus is a starting point. Jeff Bezos’s annual letter to shareholders has wonderful nuggets of wisdom.
He emphasises the importance of customer obsession and not focusing too much on process or bureaucracy at the expense of really understanding what would delight the customer. The best companies are aware of and embrace the big trends. In Amazon’s 2016 shareholder letter, Bezos says: “The outside world can push you into Day 2 if you won’t or can’t embrace powerful trends quickly. If you fight them, you’re probably fighting the future. Embrace them and you have a tailwind.”
These big trends are not that hard to spot (they get talked and written about a lot), but they can be strangely hard for large organisations to embrace. The importance of risk-taking was mentioned in another of Bezos’s annual letters: “In business, every once in a while, when you step up to the plate, you can score 1 000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”
TOP COMPANY PICKS
Three companies we believe will thrive over the long term despite the many disruptive trends mentioned above are Alphabet, Facebook and Vivendi.
In terms of equity positioning, we see value in Alphabet – it owns platforms such as Google, Google Maps, YouTube, Android, Gmail, Google Chrome and Google Play, which boast over a billion users each.
Alphabet’s current growth rates are multiple times higher than the market (3% to 5%) and GDP, with projected revenue growth of 22% in 2018 and 19% in 2019, while its net cash balance sheet is robust compared to the market as a whole.
When considering investment spending and undermonetised assets, Alphabet’s earnings are below normal, while its global platform and scale create tremendous optionality. We believe Alphabet has the talent, technologies, resources and intention to proactively defend its platforms and improve the reliability of their content.
Online social media company Facebook has one of the strongest network effects amongst consumer technology companies. It operates a two-sided network – not only does Facebook improve if more friends are on it, it also becomes more attractive to the other side of the network, the advertisers. The more advertisers that use the platform, the more Facebook is able to invest in improving its product quality. By re-investing in both new research and development, and employees and technological infrastructure, it is able to increase its moat.
People often forget that the company also owns Instagram and WhatsApp, both of which are undermonetised and benefit from similar network effects. Facebook recently signalled significant near-term spend to strengthen security, which we believe will only strengthen the company’s position many years from now. Facebook trades on a 23 times price to normalised earnings multiple, excluding cash, and should grow its revenue at least at a high-teens rate over the next five years. It converts over 100% of earnings to free cash flow, far in excess of the average company in the MSCI World Index.
Another top pick is French media conglomerate Vivendi, whose crown jewel asset is music publishing business Universal Music Group (UMG). Music industry revenues were decimated by piracy with the advent of the internet. The rise of unlimited music streaming, which has been enabled by fast, mobile internet has increased the value proposition of licensed music relative to both piracy and more unwieldy consumption forms like individual track downloads.
We believe the music industry is on the cusp of many years of significant growth as technology has increased the size of the addressable market. Paid streaming subscribers make up just about 8% of the overall smartphone installed base currently. UMG owns the rights to libraries of irreplaceable music and will be a significant beneficiary as the number of streaming music users explodes. At the current share price, you are not paying much for any of the other assets that Vivendi owns besides UMG.
Disruption has always been around. It creates risks but also opportunities. A strong secular driver in its early innings, an assessment of the business’s competitive advantage and a long-term-oriented culture that encourages measured risk-taking are features we believe set some businesses apart.
 In normalising earnings we have applied a lower than current margin, given expectations that Facebook will invest in security and privacy capabilities.