blog 22.2.17

Looking for love in all the wrong places

The second stage of disruption – by Alex Pollak, CEO & CIO of Loftus Peak.

The ups and downs of reporting season can sometimes mask disruptive changes. Disentangling what is cyclical and what is structural is not always easy at the time it is happening. Telstra, for example, has just reported its first ever mobile revenue drop, citing strong competition. Telstra’s mobile revenue declined 8.7% to $5 billion compared to the first half of FY16, contributing to the 14% drop in Telstra’s first half net profit.

Westpac is a little better, but its adjusted EPS is still lower than it was in FY14. The oil price, on which a chunk of the resources industry depends, had halved over the past two years before the recent rally. Same for the gas price. The Australian dollar has come down from parity with the USD in 2013, so global buying power for Australians has declined. The S&P 500 index is up 23% in the past two years, but back out the performance of Apple, Amazon, Facebook, Alphabet, Alibaba and the like, and that growth is significantly lower. General Motors is flat relative to 10 years ago. Ford is not appreciably higher. Exxon, the world’s biggest oil company, has gone nowhere. Oracle is flat. Walmart has been on the slide – it is off 15% from two years ago.

What we have here isn’t necessarily a cyclical low in the fortunes of some of these companies, thus marking a buying opportunity. In fact, the economy, relatively speaking, is not bad. The “Trump bump” has put some life into extractive industries like coal, or the global banks, but the long term decline in the value of these businesses, because of disruption, is clear for all to see. Bank of America ten years ago was US$50, today it is around US$25.

We have seen the value of companies in industries like media and telcos collapse for existing players (like the New York Times, Fairfax and Telstra). That value has been massively transferred into disruptors like Google and Facebook. But this marks only the first phase of the disruptive change, in which companies that at their core are already digital, are damaged. “Already digital” means that the product or service is fundamentally consumed as information – music, movies, news and phone calls – and so lend themselves naturally to a shift on-line.

That is where it started. But now we are seeing disruption impact businesses whose products are physical goods and services – i.e. where the product isn’t digital. For example, when a consumer buys from Uber, it is a physical ride that is being purchased. US customers buying from Amazon don’t buy technology, they buy soap and nappies, for example. Sure, Uber uses technology, but that isn’t what the customer gets. Uber injects knowledge into a network that allows unused transport capacity to be unlocked (like Airbnb and hotels) to the detriment of existing taxi companies. Alibaba and Amazon use connectivity to re-cut the retail transaction, effectively removing the necessity for high street retailers to be in shopping malls, in favour of a direct-to-customer distribution centre. The saving is distributed to shareholders and customers.

What does this mean? GICS sector classifications, shown above for the MSCI World Index, is the way most fund managers construct portfolios. For example, Industrials, Financials, Materials and Utilities account for nearly 40% of a typical global equity portfolio. Consumer Discretionary is a further 12% and Consumer Staples adds another 10%. But it is what is inside that counts. Autos and components are a significant part of Consumer Discretionary, as are media and retail. A major component of Industrials is transport – road, rail, marine, airlines, transportation infrastructure – and building products.

Virtually all the auto makers have electric and self-driving models in the works. But, the more successful they are with these, the more the potential for write-offs in their internal combustion engine business – which is the main part of the business. Banking disruption has started, but has not hit the mainstream – yet.

But fund managers typically invest looking to the existing make-up of the global economy, through the GICS sectors, which are composed of the companies in those industries. So the fund manager will have investments in oil, automakers, energy and transport, at a time when those sectors are heading for massive disruption. In essence, the fund manager is investing by looking backwards.

This is a poor long term strategy, and one which has already begun to cause drag in portfolios that are underweight “technology” shares, because they form a small part of the index, at the expense of other sectors that are large now but are de-weighting as disruption takes hold. We are at a particular point in economic history where disruptive companies are moving into industries that were previously considered inviolable, companies which could not be damaged because demand for the underlying physical good was thought to stretch out to the horizon and the company’s “economic moat” could not be crossed.

In fact, the demand may still be there, but the way it is delivered, because of technological change, is affecting virtually all industries. That’s why it pays to invest in disruptive companies, preferably sooner rather than later.

The Loftus Peak Global Change Model Portfolio is a Separately Managed Account available through the Mason Stevens Investment and Administration Service.

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