Series 1.3: DIGITAL REVOLUTION: LIKE THE INDUSTRIAL REVOLUTION, CREATING INTER-GENERATIONAL WEALTH
The first two industrial revolutions inflicted considerable pain and destabilisation erasing whole industries. The power boom in the late 18th century and then Edison’s electric light and Benz’s horseless vehicles in the 1800s, led to significant job losses. These though ultimately benefited everyone. The current revolution, the digital revolution, however could be far more divisive due to the “unpresidented” (author’s note: could not help myself) pace at which the change is evolving.
This is, and will, create significant risks not only for investors but many livelihoods.
This is, and will, create many livelihoods as well as provide opportunities for many astute investors.
The digital revolution is likely to create more economic change than ever before as its impact on every aspect of society, not just the working economy, is far more omnipresent. Between 1988 and 2003, computers became 43,000,000 times more effective through smaller processors and algorithms.
Problems once deemed impossible, are now held in the palm of our hands. Recently, one of Google’s AI innovations, AlphaGo, beat South Korea's Lee Se-dol, in a complex Chinese game called Go – a feat that had not been expected to be achieved for a very long time.
The pace of change is undeniable – but the key is to understand the remarkable pace of change, and more importantly understanding the likely impacts of this accelerated change, and then having a strategic plan of action. For the investment world for example, it is important to understand how companies can be very quickly disrupted, their share prices decimated and shareholder value eroded – this is already too fast for many investors to have time to react. The figure below shows the companies that have over the recent years joined the S&P500 index and the ones that have exited.
The pace at which these companies have entered the index means there has already been a significant growth in value while they remained unlisted. Back in the first technology investment boom in 1998/99, companies were listing at an average age of four years. Today the average is 11 years. Of the technology IPOs completed since 2002, 91% of the shareholder wealth created was pre-IPO, despite the better than market returns made by these companies post-IPO. Those that waited for the IPO simply missed out, as shown in the Figure below.
Who would have believed five years ago that today, Google and Apple would have a target to become the world’s largest automotive company? Or that the taxi and car rental industries could be so disrupted so quickly by the new “sharing economy”? While still a long way to go, this is now a very real possibility and a threat to some of the world’s oldest companies. And in response, these companies are investing in disrupters as witnessed in January 2016 when GM invested $500 million into car ride sharing upstart, Lyft. GM is hoping to offset some of the risk of disruption with this exposure to an unlisted disrupter.
The implications for today’s global corporates and therefore, for the investors, are impossible to estimate. The portfolio manager of 1950, 1980 or even 2000 didn’t have to deal with such risk management and allocation complexities.
But today’s portfolio manager, more than ever, does. And this is likely to get more and more complex as the pace of change accelerates.
We have seen what disruption has done to the likes of Kodak, Borders or Blockbuster Videos – these were specific industry innovations. What we may witness this time around is how the digital revolution could impact every industry indiscriminately: financial services, logistics, tourism, media and many more.
Companies facing disruption have two options for survival: compete and therefore lower margins by either investing in technology or fighting on price; or buy the disrupter. Either approach has more chance of lowering earnings per share than increasing them.
Investors have three choices:
Actively avoid industries that could be disrupted, or, actively invest in the disrupters, or invest in the index and ignore the digital economy’s impact.
The first and third are increasingly difficult - it is already estimated that 47% of US industry is at “severe risk” of disruption. That leaves investors with one practical option: invest in the disrupters. Most of the disruptors are unlisted and access can be complex and somewhat tricky.
Yale Endowment, widely recognised as the most successful portfolio manager of the past 20 years, has increased private shares exposure from 8% in 1985 (ie 92% of equities were listed); 50/50 by 2000, to 63% unlisted (just 37% listed) by 2016.
For investors, the implication of a slower world economy over such an extended time period combined with the digital technology revolution is that portfolio construction and allocation to equities needs to be reconsidered. There is an increasing trend amongst the leading US and European institutional investors to slowly reduce their exposure to listed markets and increasing their unlisted equities exposure just in the same way as Yale Endowment Fund above.
Both listed and unlisted equities are exposures to the ownership of the private sector of an economy; both are valued according to expected future earnings potential; and both are subject to the vagaries of the market’s risk appetite from time to time.
CONCLUSION:
- The digital revolution is upon us and is changing and accelerating at an unprecedented pace leading to significant change, challenges and opportunities;
- The pace of change is leading to significant disruption – the number of new companies in the S&P500 index (and the number of companies that exit every year) is telling;
- The key is to understand the remarkable pace of change, and more importantly understanding the likely impacts of this accelerated change and having a strategic plan of action;
- Significant wealth is still being created although 90 percent of the wealth is being created before a company is listed;
- There are significant opportunities as a result of this digital revolution – an allocation to unlisted assets is a critical element of any investors’ portfolio;
- but this needs proper investment guidance and advice.
Below, we cover the third most essential element of smart portfolios - criticality of high conviction investing.
SERIES 1.4
HIGH CONVICTION IS A MUST AS EQUITIES PRICES REMAIN HIGH DESPITE WEAK ECONOMIC OUTLOOK
World economies have fallen into trap with some concerning parallels to Japan’s lost decades. This gloomy opening sentence does not mean however that investors’ are best placed to lock their money away in cash (in fact that is probably the riskiest plan of all) - it actually means that investors have more opportunities to create wealth from what will invariably emerge as a massive shift in economic prosperity across the world.
The global central banks’ response to the GFC was to flood the world with cheap credit in the form of low interest rates, Quantitative Easing (QE) and easier lending standards. This was supposed to restart economic growth, but instead has created a toxic mix of excess industrial capacity, unsustainably high financial asset prices and record levels of debt, replicating the Japanese economy from the 1990s.
While excess capacity is keeping inflation low, it is also keeping employment down as demand for new investment is now even lower than in 2009 while demand for goods hasn’t recovered to pre-GFC levels.
Employment is the backbone of any economy. High employment means more money spent on goods and services in the economy leading to higher GDP growth, higher corporate earnings, share-markets, property markets and so on. This would all be good if employment remained high. We are seeing a global employment recession unfortunately especially amongst the youth and in manufacturing.
The demand for labour is down, covered up by the misleading “unemployment” statistical measure. The average person in the labour force is now working around 2% lesser hours than pre-GFC. While that might sound immaterial, it is the equivalent of everyone in the labour force working the same hours but unemployment being 2% higher across the world than currently reporting. The impact on the global economy is the same.
Even the US, despite its relative health, has seen long-term unemployment jump from 11% to 18% since 2007.
In Europe, long-term unemployment is now 50% (50% of unemployed have been out of work for more than 12 months).
Similarly youth unemployment across Europe is a dangerously high 21%, and much higher in Italy and Spain. And even for those with jobs, underemployment (workers not able to find as many hours as they need) is also at record levels.
So stimulus has at best been selectively successful - it has boosted investment to create jobs in the short term and arguably pulled the US economy out of its worst recession since the 1930s, but it created excess capacity and a more permanent and troubling employment issue for future years to face.
Unprecedented levels of debt, increasing risk and reducing future stimulus options
Worse still, not only was the stimulus relatively ineffective, it left global balance sheets with unprecedented levels of debt. The US, Europe and Japan added US$21 trillion to their federal liabilities since 2007. During that time, household, banking and business sectors reduced debt, but only by around US$3 trillion.
China’s government debt officially only rose by US$2 trillion, but their total debt to GDP ratio jumped from 120% to 250%, a total of $7 trillion, between 2007 and 2016. China accounted for 55% of the world’s household debt increase, 65% of the world’s total banking sector increase, and 64% for the corporate sector. As shown below, this means that 35% of total new credit globally in the past 9 years has been to Chinese borrowers, compared to their 15% share of world GDP.
Credit rating agency Fitch estimated that China pumped around US$3 trillion a year into its economy in the past 3 years, much of it via state-owned enterprises and local government borrowing. Then in 2016 as private sector investment growth slumped to zero, the government stepped in and funded a further US$0.9 trillion in public sector fixed asset investment.
This combination of low employment and high government and private sector indebtedness means that government and corporate balance sheets are now too stretched to provide further stimulus should it be needed. But without further stimulus of sorts, excess capacity will mean employment remains weak, and economic growth could be stuck in a pattern of low economic growth for years to come.
Conclusion is undeniable: The future belongs to high conviction investors
One could take a position from the above forecasts of economic mediocrity that the best place to put their money is in property and other real assets. And for some more conservative investors, that is probably true. But for those looking to continue to grow their wealth rather than purely defend it, there are some niches of the global economy that will create significant wealth in the coming years. These periods of inflection in the global economy have created history’s most wealthy family dynasties, and this time will be no different.
The key areas of opportunity are:
1. Digital business models that transform (link)
2. Agricultural assets from AgTech to farmland itself
3. Healthcare, particularly Aged Care solutions to capitalise on the western world’s baby boomer retirement and then shortly afterwards, China’s retirement bubble
4. Clean energy: now past the point of no return which will mean that oil producers will not constrain production but instead create a race to produce and sell as much as they can while oil is still relevant. Clean energy will rise to be the majority of global energy production shortly after the launch of electric cars, and oil’s demise will come shortly thereafter with the combined hit from autonomous vehicles and the sudden drop in passenger vehicle demand globally.
5. Chinese exporters (excluding the overleveraged over capacity steel and coal sectors). Years of a shift to globalisation have at the very least slowed dramatically, but there is a significant risk of a reversal of many of the trade agreements struck in recent decades. This isn’t just about Trump; it is also about the protectionist politics becoming very popular in Europe. Emerging Markets overall will be the loser from this move, but ironically China could benefit from these changes. Trump’s plan to kill off the TPP (Trans Pacific Partnership trade agreement) for example means that China is the largest player in the agreement, and as such gets to call the shots on issues such as tariffs and IP protection. The US has enjoyed leadership in every trade agreement since WWII but that might change now with much of the western world choosing to exit agreements or at least diminish their role.
We at Crossinvest, take a medium to long term view with respect to investments on behalf of our family of clients. While 2016 has invariably been a difficult year for many and is likely seen as the year that largely brought about the new “protectionist” order, we have adopted and adapted. Our smart portfolios are established for the medium to long term outlook and designed to withstand multiple shocks and tremors.
2017 will no doubt throw further challenges at multiple levels. We will continue to focus on ensuring our client portfolios have the right mix of allocation in these three essential elements of tomorrow’s smart investment portfolios:
1. Non-listed Real assets – infrastructure, agriculture, property and like;
2. Thematic based non-listed assets – PE, trade finance and like, and
3. High conviction traditional assets.
We will continue with our thought leadership series in January.
We wish you all a very happy, joyous and safe season and wish everyone an amazing 2017. Till then………
