MYCONSULTANTNEWSLETTER

AUGUST 2018

1MYCONSULTANT Newsletter August 2018

DIGITAL WORLD – JANA 2018 US RESEARCH TOUR

In June, John Coombe and David Surridge from JANA attended a research trip with some of our clients through the United States. The tour travelled through Dallas, Des Moines, New York, Boston, Washington D.C., Denver and Los Angeles, and provided our clients with the opportunity to meet with portfolio managers, researchers and political analysts covering listed equities, private equity and debt, real estate, listed property, infrastructure and renewables, fixed interest, agriculture, hedge funds, retirement solutions and geopolitics.

David Surridge – Senior ConsultantDavid is a Senior Consultant, joining JANA in June 2016.

Prior to joining JANA, David was a Senior Investment Strategist at the New Zealand Superannuation Fund covering credit markets, alternative beta strategies, infrastructure and alternative energy, and arbitrage strategies.

Before joining NZ Superannuation Fund, David was a Portfolio Manager at Dimensional Fund Advisors in Sydney.

David holds an MBA from the Macquarie Graduate School of Management, an Honors degree in Applied Mathematics and a B.Sc. in Physics from the University of Auckland.

1. Changing Demographics – themillennial generation are nearly aslarge as the baby boomers and will be thefirst generation to have only seen mobilecomputing. In countries like China wherethey don’t have a legacy banking system,mobile payments have increasedexponentially and in 2017 made up 40%of all payments (refer to Chart 1). So,businesses need a well thought out andintegrated mobile strategy and presence.

2. Digitisation and the battle to controlinformation on the consumer. Digitalmodels are built to encourage moreexpenditure by making it an enjoyableexperience and the more businesses knowabout their customers, the more targetedthe individual experience can be. Forexample, legacy retail businesses were builtto capture a margin from consumers,whereas digital models are built to delightand capture more spend from customersand this is turning the merchandisingmodel on its head.

3. Deflationary forces through thetransformation of the consumptionof goods and services has meant thatbusinesses that were earning supernormalprofits have seen margins reducesignificantly and perceived barriers to entryvanish.

The tour provided many investment insights; however, with technology, disruption and artificial intelligence having wide-ranging investment implications, we thought it was timely to focus this article on the move to a digital economy and the resultant disruption that is happening across all industries. In particular we focus upon what investment managers need to consider to avoid investing in companies or industry sectors that are suffering a permanent dislocation.

“What use could this company make of an electrical toy?”

William Orton, president, Western Union Telegraph Company in 1876, said this after being offered the chance to buy the patent for the telephone. Clearly disruption isn’t new, so what’s changed?

Whilst technological advancements are giving people more access to information, disruption today isn’t just about technology, there are more forces at play that are compelling companies to change their business model and the way they use technology to interact with customers. It is compelling investors to question the longevity of companies, such as:

$47 TRILLION

$283bn

Forecast 2020/21

$9 TRILLION

$112bn

2011 2016

CHINA USA

$15bn

$8.3bn

Chart 1: When it comes to mobile payments, China dwarfs the USA

Homeless in China go Cashless

Source: Social News Daily Source: iResearch (China), Forrester (U.S.)

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eCommerce Sales Est. Brick & Mortar Sales eCommerce Share

Sales lost to eCommerce Brick & Mortar eCommerce Share

Until recently, Walmart margins had been consistent for over 40 years but in the past two years they have steadily declined in every quarter to their lowest level. Internet sales are becoming more concentrated in a few players in a way that physical stores never did (Chart 6). Distribution of goods and services has been commoditised, but content has not. While retail sales continue to grow, eCommerce is taking all the growth, but it is still a small portion of total sales, as can be seen in Charts 7 and 8.

Chart 7: eCommerce Market Share

Source: U.S. Commerce Department Retail Trade Report

Chart 8: US Shopping Mall Tenant Sales (2017 = 100)

The key message from managers is that it is vitally important to work out whether, through disruption, there is going to be a temporary or permanent change in company earnings. If we consider Microsoft as an example in Chart 2, it was suffering the effects of an outdated business model and was clearly in the disruptee category only five years ago.

Chart 2: The Revival of Microsoft

However, fast-forward to today, the Office operating system is still as strong as it has ever been, they have pivoted towards the cloud and are now selling products in a subscription model similar to Netflix and Amazon Prime. Nevertheless, managers need to be aware that sometimes the market is right when pricing these companies, as shown in the demise of Blockbuster in Chart 3, which saw its business model upended through consumers moving away from DVDs into subscription-based services such as Netflix.

Chart 3: The Demise of Blockbuster

The Exponential Growth of eCommerceWhilst eCommerce has been around for 25 years, customers’ willingness to transact online and the proliferation of mobile payments has meant that companies with a strong digital presence have been able go global more quickly now than ever before. Amazon makes about 40% of all retail sales on eCommerce platforms (Chart 4) whilst, at its height, Walmart had only a 10% share of all retail sales (Chart 5) and the rise of Amazon has cut its profit considerably.

Sources: Consensus Economics, QIC Economics & Research, SICS, U.S. Census Bu-reau, CoStar, Green Street Advisors

Source: Janus Henderson

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As shown in Chart 9, whilst retail sales have been growing at below average rates, there have been clear winners and losers in the capture of those sales and in most markets. There are always a handful of companies that will do better than competitors, in this example ASOS and Amazon, so it’s important that investors remember that market growth is not necessarily a requirement for company growth.

Chart 9: Disruptors Can Drive Well Above-Average Growth

Source: FactSet and Sands Capital

The shift in online spending has also resulted in significant disruption in the advertising world, and advertising revenue from print has declined year-on-year since 2008, with the big winners being Google and, more recently, Facebook, Chart 10 demonstrates this. Online travel bookings are also changing the way consumers interact with traditional travel agencies, as can be seen in Chart 11.

Chart 10: Global Advertising Revenue

Source: Magna Global as of June 2017, Projected 2017-2021

Chart 11: Growth In Online Travel Penetration

Source: Statista, estimates as at December 2017

The Introduction of vCommercevCommerce, or voice commerce, is the future of eCommerce. For instance, grocery lists don’t change very much from week to week, so customers can simply say to the voice box, “Alexa do my shopping,” and it’s done. It’s growing so fast that 26% of US adults now live in a home with a speaker but so far only 17% have bought things with it so purchase penetration is still very low.

Research suggests that groceries are the second most likely thing to be bought via vCommerce (42% of people using vCommerce had purchased groceries, which is 15x higher than the current digital penetration rate for households purchasing groceries online). So, with the purchase of Whole Foods and its integration into Prime, Amazon are looking to bundle more into Prime (like groceries) and make it a necessity to have.

The introduction of vCommerce means that there will be a shift of the point of sale from stores to kitchens, including data capture from stores to digital. For the unestablished brands, it is likely to make it harder to gain traction in a marketplace where purchases by vCommerce are completed without consumer knowledge of new brands coming to the market.

The Rise of the Machines - Artificial Intelligence (AI)The big competitions in the last century were the race for the atomic bomb and the space race. Now it is the race for technology and artificial intelligence and the only “two horses in the race” are the US and China. China’s strategic goal is to become the world leader in AI by 2030.

When AI will exceed human performance

Language translators: 6 years

Truck drivers: 9 years

Pop musicians: 10 years

Retail workers: 13 years

Best-selling novelists: 35 years

Surgeons: 35 years

All human tasks: 45 years

Source: Future of Humanity Institute at Oxford University – As of 2016

Whilst the major effect of globalisation has been to lift overall living standards, with the share of the working population living in poverty continually falling, this has also led to rising inequality and disenfranchisement of the middle class in developed countries. Artificial intelligence is likely to make this worse with the speed at which it is replacing human jobs.

However, investors should be wary of fund managers’ use of artificial intelligence. What AI can do today is speed, ostensibly, the ability to process massive amounts of data quickly. What AI can’t do is recognise a pattern in a complex system over multiple time horizons, for instance, in a complex system two items may be highly correlated, but at present AI is unable to recognise whether that correlation makes sense.

Amazon ($B)

ASOS ($B)

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ConclusionOverwhelmingly, the research trip highlighted that the speed of change is accelerating with the increase in digitisation and disruption across all markets. From an investment perspective, there are a number of key messages that must underpin investment decision making. The barriers to entry into markets are being eroded and, more than ever, companies have the capacity to go global and grow more quickly. Regardless of an investment manager’s style, managers must be aware that disruption is sometimes permanent. Hence value managers need to be careful in assessing companies as being “cheap”, as permanent disruption may indicate that their value is depressed for good reason.

Similarly, growth managers need to be wary in extrapolating earnings in the future in an environment where competitive advantage can be illusory as disruption quickly erodes that advantage. Finally, it is clear that there are real opportunities in the market if investors can identify companies with the ability to use digitisation to capture large increases in market share very quickly, as Amazon has illustrated with respect to e-commerce sales.

Disclaimer: This material is not for circulation to retail investorsThis information is provided by JANA Investment Advisers Pty Ltd (ABN 97 006 717 568, AFSL 230693) (“JANA IA”), Level 6, 255 George St, Sydney 2000. This document may not be copied or redistributed without the prior consent of JANA IA. This document is intended for use only by persons who are ‘wholesale clients’ within the meaning of the Corporations Act. The information is directed to and prepared for Australian residents only. Returns are not guaranteed and actual returns may vary from the returns discussed in this communication. Securities mentioned in this article may no longer be recommended by JANA IA. Any service or investment referred to in this communication is not a deposit with or liability of, and is not guaranteed by, JANA IA.

While due care has been taken in the preparation of this document, no warranty is given as to the accuracy of the information. Except where under statute liability cannot be excluded, no liability (whether arising in negligence or otherwise) is accepted by JANA IA for any error or omission or for any loss caused to any person acting on the information contained in this document. A137246-0717

What are the Risks and Opportunities?Technology today is enabling businesses to go global more quickly than ever before, so disruption of companies and industries can be sudden and permanent. The risks for managers are that more than ever they need to be able to quickly identify changes in consumer behaviour and be able to understand who the winners and losers will be – some companies and industries will never recover, think no further than Blackberry or print advertising.

Saturation, obsolescence, regulation – these are the things managers should be interested in over the medium term. The big tech companies, the current winners, will probably continue to win in the medium term but growth may slow due to saturation.

Managers need to be cognisant that disruption may be permanent, and this will impact the decisions of both value and growth managers, i.e. value mangers need to understand whether the relative cheapnessis temporary or cyclical and growth managers need to make sure theyaren’t overpaying for future earnings at a time when business modelscan quickly become outdated.

Real estate managers need to consider how changing consumer behaviour will continue to impact shopping malls, infrastructure managers need to factor in autonomous vehicles, and so on across all asset classes.

The rise of eCommerce has seen the growth in retail sales consigned almost exclusively to online sales, so whilst the industry continues to grow, the way consumers are spending their dollars is changing rapidly. The opportunity for companies to capture a share of the growth is substantial, with eCommerce removing the barriers to entry to compete with large bricks-and-mortar retailers.

vCommerce is the next battleground for consumers’ wallets and companies like Google and Amazon are already leading the way in being able to monetise the technology.

Artificial intelligence is likely to increase disenfranchisement as the automation of an increasing number of jobs becomes a reality. What that means for investors is uncertain, and while managers are embracing the use of AI and big data, they need to understand the limitations which can lead to poor outcomes for investors.