Sector Focus: Global Technology
Over the last decade, investors in global technology companies have enjoyed a period of outsized returns, with the IT sector far outperforming the broader benchmark. This was not an unjustified outcome: after the financial crisis of 2008/2009, no other group of businesses has grown profits and cash flows to nearly the same extent. However, some of the conditions that allowed for this paradigm are changing, and investors would be well served to understand these shifts and how it might impact future returns.
Arguably, it all started with the iPhone. When Steve Jobs walked onstage at the Moscone Convention Centre stage on 9 January 2007 to tell the world that Apple was going to release a “widescreen iPod with touch controls, a revolutionary mobile phone, and a breakthrough internet communicator” as one device, few would have anticipated the world-changing impact the smartphone would have a scant decade later. And yet, the iPhone did change the world: not because it was Apple selling it, but because it introduced a new paradigm in the computing landscape.
Prior to the iPhone, smartphones were Blackberry devices: they were somewhat clunky, had a small screen and a difficult-to-use keyboard. The iPhone created the paradigm of the consumer-friendly mobile device, with a much more intuitive touch interface, and a big(ger) colour screen that became a keyboard when you needed to input text, but would also show you pictures of your loved ones from edgeto-edge when you did not.
As with all hardware innovation, commoditization followed. Soon, competitors were creating their own smartphones. While the iPhone was the market leader in technology and usability, it was also priced as such. Competitors struggled initially to create a device with the same level of quality, but they did create devices with largely the same functionality at lower, more affordable price points. As time moved forward, these ‘good enough’ alternatives came to rival SCALING These days, any Silicon Valley veteran will tell you that the most important driver of profitability is achieving ‘scale’ – and rightly so. Some of the zanier business models of the dot-com bubble all of a sudden look far more sustainable when you have the ability to reach billions of potential users. This is best illustrated by looking at Netflix. The idea to stream video content for payment is not new, dating back to the 1990s. However, the telecommunications infrastructure required to do so combined with the cost of the hardware the consumer would have to purchase to actually watch the content was prohibitively expensive, limiting the audience to very wealthy (and tech savvy) consumers. (and even exceed in some measures) the iPhone in terms of features and user-friendliness – and because they were still selling at lower price points, enabled a far wider audience of consumers to purchase a smartphone.
With apologies to Jane Austen, it is a truth universally acknowledged that a consumer in possession of a smartphone must be in want of a large quantity of affordable mobile data. Mobile network operators saw the smartphone revolution happen before their eyes and invested heavily in capacity to cater for this seemingly endless demand. This naturally led to price competition, meaning that data costs steadily decreased on a per megabyte basis in virtually all markets around the world for the last decade.
The combination of the Apple-pioneered user-friendly touch interface, affordable (and powerful) smartphones and cheap mobile internet created a technology paradigm best likened to the Cambrian explosion – when single-celled organisms became complex animals, and led to the rapid growth and diversification of the biosphere on Earth. In the same way, these three technologies all maturing at the same time enabled new business models that could reach vastly more consumers than ever before thought possible, and allowed internet-based commerce to flourish. It is fair to say that Amazon, Facebook, Uber, Google, Netflix and many others besides would not exist without the ecosystem enabled by these three technologies.
These days, any Silicon Valley veteran will tell you that the most important driver of profitability is achieving ‘scale’ – and rightly so. Some of the zanier business models of the dot-com bubble all of a sudden look far more sustainable when you have the ability to reach billions of potential users. This is best illustrated by looking at Netflix. The idea to stream video content for payment is not new, dating back to the 1990s. However, the telecommunications infrastructure required to do so combined with the cost of the hardware the consumer would have to purchase to actually watch the content was prohibitively expensive, limiting the audience to very wealthy (and tech savvy) consumers.
However, with the mass-market adoption of the smartphone, Netflix now has a potential audience in the billions – and asking somewhere in the vicinity of $10 per month to stream more content than you can shake a stick at is far more palatable than a nearly $10,000 hardware set-up in the 1990s, simply because more people can afford to part with $10 a month to satisfy their need for inhome entertainment. It is because Netflix can address an audience of billions – to scale, in Silicon Valley parlance – that the model becomes sustainable (though in the case of Netflix, not profitable, due to all the debt they have had to take on to achieve scale).
Similarly, Uber – connecting otherwise idle vehicles with people needing a ride – only works in a world with ubiquitous smartphone penetration and cheap data. Google had a decent business model by providing search results on desktop, but with the addition of mobile search queries, has a much bigger addressable market, because looking something up online whilst waiting in a queue at the convenience store always trumps remembering to look it up later when you get home to your computer. Facebook can glean far more information from a mobile user for the exact same reason – users are more likely to share information on their social feeds in the moment than do it later at home.
The underlying and enabling technology finally became affordable and widespread enough to enable nearly societywide ‘scale’ – hence the explosion of new businesses to take advantage of the opportunities enabled by this paradigm over the last decade, and hence the rapid growth in profits for said businesses.
Of course, no new technology magically solves all of society’s ills. In fact, it frequently creates a slew of new problems. This has been true all the way since the Industrial Revolution and continues to be the case today.
Amazon has undoubtedly bought a wider array of selection and lower prices to a vast number of consumers but has entirely disrupted the traditional retail sector in the process. From a society-wide perspective, a more efficient allocation of resources would seem to be a good economic outcome, but tens of thousands of retail employees have been laid off as a result. (To be fair, Amazon has also created many thousands of jobs, but less so than they have arguably disrupted).
Google and Facebook have decimated the traditional newspaper and advertising industries – first by moving news consumption online, and secondly by upending the traditional advertising market. In the process, these businesses have arguably built an unrivalled electronic surveillance system to track their users’ behaviour online and in the real world for commercial gain. This has implications for privacy and creates ample opportunity for bad actors to abuse these systems to spread misinformation.
Tencent built a video-gaming empire that is the envy of all and combined it with a robust social network, but has created a system that frequently sees users spend an extraordinary amount of time and money on the platform, to the detriment of life away from the screen – forcing the Chinese government to put caps in place on screen time for teens or young users.
Whilst general artificial intelligence is still likely more than a decade away, AI will be able to perform repetitive tasks previously in the domain of ‘knowledge workers’ at a level of speed and efficiency that will render many professional occupations if not obsolete, then in real need of reskilling.
The above is not meant as your typical ‘technology is destroying our way of life’ fearmongering. The point is that the tremendous technological advances of the last decade has also created genuine displacement, disillusionment, fear and resentment, in addition to an enormous amount of wealth.
Society and policymakers are only now beginning to grapple with the implications of these changes, and we think the likelihood of some form of regulatory intervention in the years ahead is the first change in the bigger tech landscape investors should be wary of. Depending on the type of intervention – say, attempting to break some of the large tech companies into smaller components – it may have significant negative implications for the profitability of these companies. If a tech company expands it margins and grows its profits as it scales, forcing it to shrink its user base will likely have the opposite effect.
DIMINISHING RETURNS ON INNOVATION
The second big change that will affect the technology landscape is simply the fact that we are at the very latter stages of the adoption curve for many of these technologies. Most consumers now have a smartphone and some data. New innovations in hardware – which usually enables a paradigm shift – has slowed. This is not because companies are not investing, but because innovating is difficult. Truly revolutionary innovation regularly requires other technologies to mature first before the next big leap forward can be made.
The more marginal rate of innovation is again illustrated with the iPhone. The difference between the original iPhone released in 2007, and the iPhone 4 released in 2010 is huge, with the latter having a clear technological superiority. The iPhone 7, again, was much better than the iPhone 4, but by that point the industry had settled on the form factor and standard features of a smartphone. The iPhone 7 was certainly still a better-than-most smartphone, but no longer light years ahead of the competition. The iPhone X – released in 2017 – yet again had a faster processor, a better camera and an innovative facial recognition-based security feature, but users could probably get by with the cheaper iPhone 8 released alongside it. This culminated with the announcement by Apple in January 2019 of a substantial sales shortfall.
Per management, this was because of a disappointment in sales of the new iPhone XS in China, fuelled by economic uncertainty and a slowing economy. However, to merely write it off as a cyclical slowdown misses a bigger point: Apple has not materially grown iPhone volumes in three years. In fact, revenue growth was almost entirely driven by putting up the price of the iPhone. It likely indicated the strength of the Apple brand, but was a strategy with limited runway, as technology always commoditizes and sees price decreases over time – Apple going the other way was attempting to defy gravity, with predictable results.
Against a backdrop of declining global smartphone shipments – down from the 2016 peak in both 2017 and 2018 – it is safe to say the smartphone market is mature. This has implications for other technology businesses as well, as it logically implies the ‘scaling’ problem has to some extent been addressed: most people who want a smartphone and can afford one likely owns one by now. As such, growth from this point will revert to the more traditional battle of prices, features and consumer utility, whereas the last decade had the secular tide of massive smartphone adoption rolling out that lifted all boats.
To be clear, the above analysis does not mean we can never have another technology ‘super-cycle’ like we had over the last decade – there are several promising areas of investment that could lead to the next wave of technological innovation. Virtual and augmented reality wearables both hold promise, but likely need further innovation in battery miniaturization to be ready for wide-spread adoption. AI will absolutely have many applications in business, but the initial roll-out will be slow, and will likely be met with much social opposition in the absence of re-skilling initiatives for workers affected by it. The point, however, is that we are likely a few years away from such a moment.
THE ROAD AHEAD
At Melville Douglas, we like technology stocks for their ability to grow earnings, and to do so at exceptionally high returns on capital. For the reasons outlined above, we think the last decade has been an extraordinary one in terms of growth, enabled by the simultaneous maturity of three foundational technologies that enabled innovation that literally changed the world – but we also think the foundation upon which this extraordinary period was built is slowly being eroded.
This latter fact does not mean we won’t own technology stocks – merely that it requires being clear-eyed on the investment rationale for owning any particular technology stock. Just ‘buying the FAANGs’ is unlikely to create outperformance going forward – stock selection will be paramount. This is particularly true where the cost of capital is increasing as the Fed hikes rates: more speculative ventures that could successfully be funded at near 0% interest rates may not make sense when those rates are much higher.
Broadly speaking, the IT sector is an ecosystem with four players: component-manufacturers, hardwaremanufacturers, software developers and service providers. This is an over-simplification, but it works well enough to explain the interlinkages between each. Each player may be seen as a layer on a stack, with component-manufacturers at the bottom and service providers at the top.
The component manufacturers create and supply the basic silicon and equipment used by hardware manufacturers to create ‘finished’ goods, such as laptops, smartphones or networking equipment. The software developers live a layer above the hardware players, building the tools that make the hardware perform their pre-assigned task, or the programmes used by consumers and business on the hardware they own. Finally, the services players live yet a layer higher, combining solutions of all three layers below them and selling them to consumers or businesses.
Component and hardware manufacturing are capital intensive business models with a high risk of commoditization, and when volumes decline, profits tend to plummet sharply. Given where we are in the technology cycle right now, we would be very reticent to take excessive exposure here. We prefer the software and services layer, where companies such as Microsoft sell critical tools and infrastructure on a service basis to large businesses, or where Tencent and Alphabet enjoy the benefits of strong lock-in due to the very powerful network effect of their services models. Amazon likely has the most exciting growth path of all the tech stocks we look at, but we are cautious on the valuation, and would only recommend adding when we think there is enough margin of safety.
Visa and MasterCard are names we still prefer, and whilst seen as ‘technology’ companies, operates to a much different set of underlying drivers – the transition towards a cashless economy. In this instance, we are still very much constructive on the investment outlook for these two names.
Technology companies have enjoyed outsized returns for the last decade as three foundational technologies – user-friendly touchscreens, cheap smartphones and affordable, high-speed mobile data – all matured at the same time, leading to an explosion of opportunity for new business models. These technologies have matured as adoption has increased, and together with a higher likelihood of regulation, means the path for investors going forward will have to be more considered, as there will likely be fewer winners until the next big tech super-cycle