I’ve been wanting to write a post on a more big picture topic for a while. Macroeconomics has come to the fore in investors’ minds, with recent volatility prompted by concerns about inflation and interest rates. As a professional economist (though not macroeconomist), I do feel a sort of duty to be able to say something about the macroeconomic situation. However, after a few attempts at starting a post, I’ve discovered that I don’t have anything very illuminating to add. Trying to predict the economy as a whole is complicated and feels too much like guesswork. My view is fairly straightforward: I’m fairly optimistic at the moment because, having thought about the obvious concerns, I don’t yet see good reason not to be.
So instead of macroeconomics, I’m writing about another more interesting and useful big picture topic – horizon scanning.
Horizon scanning is a process for detecting early signs of opportunities and threats. In an investing context, it involves taking a big step back and looking at what’s going to happen to the economy as a whole. And I don’t mean inflation, interest rates and stuff like that. I mean more fundamentally how markets, businesses and consumer demand will evolve over the coming years. This big picture speculation is necessarily quite vague and doesn’t help very directly with individual investment decisions. However, it is useful for identifying growth ‘themes’ – one part of the investment jigsaw puzzle needed to increase one’s chances of outperforming.
The role of technology
The evolution of markets, businesses and consumer demand is driven primarily by innovation and the adoption of new technology. One way of approaching horizon scanning is to first try to understand how this process is currently playing out and then extrapolate into the future.
Looking back over the past few years, one particular technology really stands out as having transformed both corporate profits and people’s lives – the internet.
The internet has enabled centralised digital information that connects people and businesses to each other, enabling vastly easier, faster and better decisions and transactions. It has been and continues to be the global platform for an ever increasing proportion of economic value creation. Its importance has grown dramatically over the last ten years. Most of the largest businesses in the world are now directly related to the internet, including Google, Facebook, Apple, Amazon, Microsoft and Alibaba.
Many newer technologies have been emerging over the past few years: big data, machine learning, blockchain and AI. All build on the internet and I think are worth getting excited about in the long run. However, there are more immediate priorities. People have a tendency to get excited about new technologies too soon. This point is captured well in the ‘Gartner hype cycle’. The stock market was getting very excited about the transformative power of the internet 20 years ago in the dot.com boom. It was right to get excited, though was ahead of its time. We are in the ‘real life’ dot.com boom now…
The internet and more broadly the wider sphere of ICT (information and communications technology) is the main ‘theme’ behind my investing strategy. I think we are still only near the beginning of seeing how the internet and other related ICT technologies will transform markets.
There are other areas, but to me this seems the most obvious and important sector to consider for growth opportunities. Even if you are not going to directly invest in information technology, I think by far the most important question for any truly long term investor is whether their investments are likely to be beneficiaries rather than victims of digital technology. I’m not alone in thinking this. Nick Train has been making similar points for a while (as an aside I recommend you read the monthly reports of the Lindsell Train funds if you haven’t already – lots of useful ideas in there).
What are the opportunities and threats?
Platforms, networks and the importance of convenience
The internet has created the opportunity for a whole class of consumer facing businesses to emerge: online platforms and networks. These make it far easier for people to connect to and transact with information, businesses and other people. Pretty much all consumer markets are susceptible to disruption by online platform competition.
An attractive feature of online platforms is that they are capital light. This means they can be hugely profitable and growth can be very quick while requiring little investment. They can achieve and sustain this profitability in part because once they have sufficient scale, network effects mean they become to a large extent insulated from competition. I’ve written about this before in this post.
Network effects arise when the value to its users of a platform increases when there are more users. They arise because of the convenience of being able to connect with many other businesses or consumers in one place. The success of online platforms demonstrates just how important convenience is. A huge amount of value has been created online by making transactions more convenient and there is a huge amount of additional value yet to be created.
All of these features I believe make online platforms attractive investments. I have a number of them on my watchlist. However, there are downsides. While network effects can provide protection from competition for the largest, most successful platforms, they also mean scale becomes critical and this can result in an extreme ‘winner takes all’ competitive dynamic. Even successful platforms are susceptible to new rivals providing greater convenience with better technology or just a better idea. The importance of convenience and scale means that there are benefits to platforms converging to provide multiple services in a single place. Amazon’s strategy seems to be to take this to its logical extreme – a single platform for everything positioned as conveniently to the customer as possible.
Retail and professional services – death of the middlemen?
The flipside of the success of online platforms is the businesses they disrupt. There is a whole class of businesses that are either losing from this already or most likely will be soon. Basically, any sort of professional service that relied on connecting customers to information or to the right supplier will be disrupted by the internet: traditional intermediaries, certain knowledge based professional services and various types of business that have previously relied on excessive search costs to exploit their customers.
There are various industries either already into the process of being disrupted or likely to be in the next few years. Here are a few examples:
- Retail: the disruption of the high street by online is well documented and has been happening for some time. Online commerce has the unbeatable combination of being both cheaper and more convenient. ‘Bricks and mortar’ may not die out entirely but there is still a long way still to go before it is even overtaken by online. I anticipate this process will accelerate and a lot of physical retailers will go bust over the coming years. I would recommend avoiding the sector like the plague. There are a few exceptions: for example, retail in situations where online is not an alternative (e.g. in airports) or where it has exclusivity over the products sold (e.g. a brand).
- Estate agency: this has traditionally been a fairly profitable business with decent economics. Buying a house is a complex transaction and professional assistance of various kinds (conveyance, mortgage broking, estate agency) is generally invaluable. However, I don’t think the traditional model of estate agency is likely to last. There seems to be too much to be gained from combining services and achieving scale in a one stop only portal, and undercutting the vastly inefficient fees charged by estate agency. Purplebricks seems to be driving things in the right direction.
- Funerals: a classic example of an industry that historically relied on exploiting consumers through opaque pricing, that is now being disrupted by online competition. The impact on Dignity, historically a highly profitable business, has been severe.
- Advertising: has been completely transformed by the superiority of online advertising, which can be targeted much more effectively than traditional media. This is very bad for the traditional advertising media giants who have been circumvented as customers go direct to Google and Facebook.
- Legal services and education are two big knowledge-based sectors ripe for digital disruption. There is likely to be increasing competition from online business models in the longer term, though this is more of an opportunity rather than threat for investors, who historically would have found it very difficult to invest in these sectors anyway.
The success of consumer facing platforms has been more notable so far, but I think there is an even richer vein of opportunity in ICT business to business markets. The potential for ICT to add value to how businesses organise themselves and execute their strategies just seems enormous and continually growing. I say this partly from my own work experience, observation of how IT businesses have been developing, and simply intuition. Businesses are complex and use a lot of information: there is a lot to be gained by using it better. There are a huge range of activities where ICT can massively help businesses: HR and payroll, marketing, digital media, design, database management and a host of different IT for more specialised applications.
In addition to there being huge growth potential for these sorts of businesses, they often have several attractive characteristics for an investor. They can be very capital light and profitable, as they can sell many products at low incremental cost once developed. They often have repeat business and can use subscription models for more certain revenues. It is often difficult for business customers to switch between IT systems, creating a competitive advantage for the incumbent supplier. It’s not surprising that this is one of the largest categories of businesses on my watchlist.
Technological immunity – consumer staples
Over time, consumer staples has been one of the best and most consistently performing sectors in the stock market, if not the best. Part of the reason for this is that demand for consumer staples is defensive, consumers need them regardless of how well the economy is doing, and part of the reason is that they are relatively immune to technological change – how much innovation can be done to clothes, cleaning products or food?
The underlying picture may be a bit more complex. Many consumer staples are commodity like and sold in competitive markets, and the internet has affected how they are sold. I think the key to identify investments that will be successful in the future is intellectual property. While the distribution and marketing, even of consumer staples, is being reshaped by the internet, strong intellectual property over the underlying product or content can provide a sustainable source of growth immune from technological disruption.
Most commonly this intellectual property comes in the form of a brand. Successful brands are easy to identify and it seems fairly straightforward to successfully invest in them. Fashion and drinks brands in particular have generally made good long term investments. I don’t see any reason why this wouldn’t continue. I’m a bit more wary of the owners of large portfolios of household product brands, like Unilever and Reckitt Benckiser. These have been very good investments in the past, but I think the strength of brands for more commodity like products may be eroded over time.
A final sector worth a mention is digital entertainment content, including videos and computer games. This sector is growing extremely fast and the businesses within it are differentiated in the intellectual property they hold. It seems a great sector to invest in.
Healthcare – the ultimate defensive growth sector?
I think healthcare warrants a special mention as a defensive growth market. Spending on healthcare has been steadily growing as a proportion of GDP for decades and this trend is set to continue for the foreseeable future. There are strong underlying economic drivers for this. Fundamentally, the demand for better, longer-lasting health is near limitless and takes precedence over most other needs, while improvements in technology mean what can be supplied is always growing (and at greater cost).
Healthcare companies often benefit from technological or physical competitive advantages and from sticky less price sensitive customers. There are rich pickings for investors who can identify healthcare companies in the right niches as these companies may have decades of defensive growth ahead of them.