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Dual duel

Second Quarter 2017

Download PDFCapital Investment Services Second Quarter 2017 Perspective - Dual duel

A U.S. President (Andrew Jackson) once did it. Another almost did so (Abe Lincoln). A Vice President (Aaron Burr) and a Secretary of the Treasury (Alexander Hamilton) did it, and it cost the latter his life. (Hamilton’s son also did it and suffered the same grave outcome). Legislators did it as well (Henry Clay, James Westcott among others). So did a Supreme Court Judge.

And it wasn’t just members of the three branches of government that did it. Heck, even economists got in on the action. Joseph Schumpeter—whose term, creative destruction, remains one of the best descriptions of the process of economic progress—did it.

A new duel in groceries as Amazon buys Whole Foods?

cartoon discussing the implications of amazon acquiring whole foods

The “it” is duels, of course. Thankfully, some cultural norms change over time and dueling is no longer an acceptable method of preserving honor and settling disputes among individuals. However, duels—in the form of business competition—are both natural to free and competitive economies and essential to grow them.

To see why, let’s return to Schumpeter for a moment. As we’ve noted on prior occasions, among his main contributions to the field of economics were insights into the process of innovation. He recognized that competition drives the innovation process through entrepreneurial discovery. A market-based economy provides a trial-and-error venue for this discovery process. The judge and jury are consumers. Profits flow to those innovations that most please consumers. Losses (or profits that are insufficient) are a signal that an innovation is not catching on with consumers.

Profits attract competition like ants to a picnic. In a healthy economy, businesses relentlessly try to win consumer affection by ‘raising the bar’ and making the features of a new product or service more appealing and affordable.

While marketplace acceptance of innovation reflects the creative aspect of the process, Schumpeter also fully acknowledged the destruction aspects as well. He recognized that innovative new products or services shake up and displace the previously existing economic order. Yet, despite the pain inflicted on the displaced—even as some of whom never adapt or recover—overall economic well-being is lifted by this process. New products and services with superior functions meet an expanding consumer audience and the new abundance that results lifts the general standard of living.

Viewing today’s world through a relevant lens

We believe Schumpeter’s creative destruction provides a ‘lens’ through which we can view and make sense of today’s economy and investment scene. Consider for example, some of the creative destruction duels blowing across today’s economy:

a table comparing incumbent products and services with newer offerings based on technological advancements

Many of these duels have been raging for several years now. But, as is the case in digital shopping, many appear to be reaching significant tipping points.

Hardly a day goes by without a story about a mall closing, or how Sears or other formally iconic retailers are circling the business drain. The innovative digital forces have gathered sufficient mass such that they are no longer merely potential threats to existing ways of doing business.

The creative destruction duel tipping point goes well beyond retail. Innovation has also mightily disrupted the physical world of oil and natural gas. New technology-enabled drilling methods have significantly reduced the cost of extracting shale oil and gas reserves. The supply side of the market has been significantly altered and expanded by this development.

The status–quo incumbents are experiencing ‘game changing’ repercussions. OPEC is learning that they no longer are the world’s oil price setter.

Meanwhile, lower energy prices provide significant support for consumer purchasing power. We, by the way, continue to expect energy prices to remain restrained under the weight of these trends.

Idea companies—software continues to eat the world

The emerging digital world is having a profound impact on the business world, and with significant investment implications. A few years back, tech innovator and investor Marc Andreessen made the case that the very embodiment of idea companies—software enterprises—will dominate, or in his words “eat the world” in the near future.

…we are in the middle of a dramatic and broad technological and economic shift in which software companies are poised to take over large swathes of the economy.

–Marc Andreessen

Andreessen’s idea only seems to be gaining momentum. Consider these comments from GE:

“If you woke up as an industrial company today, you will wake up as a software and analytics company tomorrow.” That doesn’t mean that you’ll be selling software; it means that software will be an important part of whatever you’re making.

In their book, What To Do When Machines Do Everything,1 business analysts Malcolm Frank, Paul Roehig and Ben Pring offer additional insight along these same lines:

“Each industrial revolution was catalyzed by a new raw (physical) material: coal, steel, oil, electricity. This time around, data is the primary raw material.”

“And unlike coal or oil, which are ‘zero-sum,’ data and insight actually increase in value the more you use them. After all, adding one drop of oil to another simply yields two drops. However, combining one piece of data from a business operation with another from a customer or a business partner could yield huge benefits.”

Profits are increasingly shifting from heavy industry to idea-intensive sectors that revolve around R&D, brands, software and algorithms.

–McKinsey Global Institute

From an investment perspective, ‘idea-based’ businesses—rather than capital intensive entities—have some of the strongest, absolute and relative earnings growth, highest profit margins and free cash flow generation abilities. Businesses with these profiles continue to comprise our equity investments.

Dual Duel

Our earlier duels list suggests we are in a period where innovation is being showered on the economy. Yet measured productivity growth is sluggish. How can one reconcile this?

Measurement issues are probably part of the answer. How does economic growth measurement (from which productivity growth is imputed) account for a free map app that replaced physical maps that one had to purchase?

But there have been several deep-dive productivity studies that offer what is likely a bigger part of the solution to the productivity puzzle. A study by economists Michael Mandel and Bret Swanson,2 for example, concludes that a ‘dual economy’ exists when it comes to productivity trends of recent years.

They note that digital industries (technology, communications, media, software, finance and professional services) and physical industries (health care, transportation, education, manufacturing, retail) have very different technology spending patterns and productivity trends.

The digital companies are experiencing significantly higher productivity growth, and are also significantly bigger technology spenders. Chart 1 and Chart 2 below summarize these points.

Chart 1

an image comparing the growth of the digital economy vs. the physical economy over the past 15 years

Chart 2

an image showing how physical industry continues to employ the majority of Americans yet spends very little on technology

This is in stark contrast to the slow spending and productivity trends exhibited in the physical industries. And while digital industries are gaining on them in terms of economic importance, as Chart 2 suggests, the physical industries remain the big kahuna when it comes to overall economic activity. Sluggish productivity growth here is a key reason why economy-wide-measured productivity growth has been soft.

Another study by two economists, Mathew Tracey and Joachim Fels,3 make very similar ‘dual’ productivity observations. But why have the physical industries, tech spending, and productivity lagged?

Mandel and Swanson note that the physical industries are generally heavily regulated. This makes them less nimble and slower to adopt new business practices. Slower growth in these physical industries also may dampen appetites for new reinvestment initiatives.

Other economists4 contend policies adopted in the wake of the 2008 Financial Panic—particularly the prolonged period of ultra-low interest rates—have allowed loss-making, low-productivity ‘Zombie’ firms to survive on low-cost credit. These companies are operating in survival mode, and are not increasing investments in their businesses and represent a drag on productivity growth.

We think a more comprehensive explanation lies in the creative destruction duel underway between established physical business model firms and the digital industries.

Financial writer Robert Samuelson explains:5

“We’re in the midst of a massive reallocation of economic resources—workers, firms and capital investment—but this (transition period) weakens productivity growth because we have to have two (dual) systems to do one job.

Companies have to support old as well as the new technology. People no longer buy everything in stores, but stores are still necessary.

Still, the loss of sales makes brick-and-mortar stores less productive, and their loss of productivity offsets some or all of the gains from digital technologies.

This is, I think, the basic explanation of what’s happening at Macy’s and Sears. They have to invest in the new technology, even as the value of the old technology erodes. The effect is compounded because they’ve been slow to shut marginal stores. There’s always the hope that these stores will bounce back and avoid large losses.”

Meanwhile, the creative destruction dual duels being waged appear to be escalating. Amazon, for instance, revealed its intention to buy Whole Foods a few weeks back. On the announcement, the stock prices of nearly every other retailer—food, clothing, pharmacy, auto parts—all declined notably, as new fears of disruption to the status quo emerged.

“Endless shelf” food duel and increased urgency

Another salient example can be found in a recent Wall Street Journal article, “So Long, Hamburger Helper: America’s Venerable Food Brands Are Struggling.”6

Excerpts from the article follow in italics:

Many big brands didn’t move fast enough to remove artificial ingredients and haven’t been able to shed the negative perception of processed food, said several food executives and others close to the industry.

“Back then (1990’s)”, said food historian Andrew Smith, “they (big brands) could advertise and promote their way out of a problem. They ignored the concerns (about processed foods), and they stopped experimenting because they could buy aisles in the grocery store.”

“A lot of what’s crept into big companies is internal focus, bureaucracy, PowerPoint presentations—the antithesis of agility,” said Sean Connolly, chief executive of Conagra Brands Inc., maker of Hunt’s ketchup, Peter Pan peanut butter and Chef Boyardee.

“In the good old days, the retail shelf was an important barrier to entry,” said Nestlé’s CEO Mark Schneider in June. Today, the “endless shelf” of the internet means smaller companies can easily enter the market, he said. “Size alone does not protect you from the winds of change.”

Instead of “winds of change”, Schumpeter used the phrase gales of creative destruction. However phrased, a new sense of urgency by businesses has set in. Failure to adapt brings increased risk that a business will become the next Eastman Kodak, Blockbuster, Sears or “zombie” company.

New tools to compete

These duels should continue to represent a solid backdrop for many of our portfolio companies. Within our investments, many companies we own provide today’s technology ‘tools’ that enable other firms to become more productive as the physical and digital business worlds meld. The tools include such things as cloud computing, internet of things, software simulation, big data analysis, AI, quantum computing and digital payment capabilities.

It would be extremely arrogant to think that humans today are any smarter than Aristotle or Shakespeare or Steve Wozniak. But our tools are.

–Frank, Roehrig and Pring

Any one tool may help companies compete. In combination, they can potentially be very powerful and enable firms to build entirely new services, products and business platforms with which to duel.

As “agents of change” on the creative side of the innovation process, we believe many of our companies possess the potential to further compound their earnings power as the dual duel rages on.

Investment opportunities beckon…

Appendix 1: Have the duels created a bubble?

With software company shares and technology stocks in general doing well this year, another duel of sorts has arisen. This one is between stock traders. With the turn-of-the-century ‘tech stock wreck’ in mind, some argue that another tech bubble is upon us and a bust is imminent. On the other side of the duel are those that counter that, while tech stocks are perhaps not ‘cheap’, their current valuations are nowhere near the nose-bleed levels of a bubble.

The following table contrasts current stock valuations of the top five tech stocks with those during the turn-of-the-century bubble.

a table comparing price-earnings ratios, cash holdings, book value, and free cash flow averages for tech companies in 2000 vs. 2017 image comparing the growth of the digital economy vs. the physical economy over the past 15 years

What’s our view on the bubble duel theories?

While a stock price ‘correction’ can happen at any time, it does not appear that the present situation represents a precarious bubble situation. Corrections will be overcome if the underlying fundamentals remain favorable. And some stocks—tech or otherwise—will indeed prove to be dangerously overvalued…if their earnings power proves disappointing.

But, as always, stock valuation remains much more akin to ‘art’ than ‘science’. As growth-at-a-reasonable-price investors, we believe one must judge each stock by estimating a company’s prospective earnings power in light of the expectations implied by its stock valuation.

We constantly make this valuation assessment within our portfolio of companies and with prospective investment candidates. We often trim investment position sizes as valuations expand. We liquidate entire investment positions if valuations become stretched to the point where the risk/reward of a holding is no longer worthwhile in our estimation.

Unlike conditions prevailing at the turn of the century (massive stock valuations and recession), we think the earnings fundamentals underlying many idea-companies (of which tech is a part) remain solid.

We suspect, however, more of this trimming/selling activity within our portfolios will occur in the future.


Appendix 2: Creative destruction employment angst

The ever-present fear is that innovation will “kill” jobs and insufficient employment growth will occur. History strongly suggests otherwise. As previously referenced business analysts Frank, Roehrig and Pring note:

“Most look at (innovations like) automation and technology solely as job destroyers, but every major technological shift through history has led to job creation.”

People have worried about ‘new machines’ and their effect on the human condition for centuries. Only the machines have changed; the concerns remain the same.

–Frank, Roehrig and Pring

They note:

“When the steam engine enabled mechanization during the second Industrial Revolution, experts openly worried that the ‘substitution of machinery for human labor’ might render the population’ redundant.”

As assembly lines made mass production possible, the economist John Maynard Keynes famously warned about widespread unemployment: “due to our discovery of means of economizing the use of labor outrunning the pace at which we can find new uses for labor.”

They make the point that rather than net job loss from new technologies, what actually unfolds is job transformation. The routine (often dull and physically challenging) aspects of work often become automated, but jobs become enhanced by newly created demands.

The three authors also note:

“The more technology enhances us, the more it creates the opportunity for a human touch. When the computer does what it does well, it allows humans to focus more on what we do well: being empathetic, building relationships and making sense of complex situations.”

Perhaps you’ve seen the movie Hidden Figures. This picture shows one of the main characters—a human ‘calculator’—whose computations supported NASA in its early decades. The calculator function was disrupted by computers. But the displaced human calculators became engineers, programmers, database administrators, and IT technicians. Yet, early on, most of the newly-created jobs were inconceivable.

Frank, Roehig and Pring emphasize that’s usually the case:

“We often focus on the impact of a technology on the world as we currently know it.”

“But humans simply have trouble forecasting the world of the future. We’re quite happy to be (rightfully) proud of our current moments. We believe we’re at the zenith of development (technically, socially, etc.). We seem hardwired to think of ourselves as being at the apex, but in reality we’re really just at the highest camp (so far) on the side of an infinitely high mountain. We just can’t envision how things will be years down the road.”

The Mandel/Swenson productivity study referenced earlier provided some evidence to support the net job formation study from the on-line/traditional store retail duel (see chart below).
a column graph depicting the employment changes during the past decade between e-commerce retailers and brick & mortar retailers
The key point in all this is, as the economy advances, unimagined needs emerge. Employment adapts to meet these needs.

We suspect the employment issue in the years ahead will prove not to be a lack of jobs. Instead, the challenge will likely be filling available jobs.

Sources & Notes

1 Malcolm Frank, Paul Roehig and Ben Pring, What To Do When Machines Do Everything : How to Get Ahead in a World of Algorithms, Bots, and Big Data, 2017 Wiley
2 Michael Mandel and Bret Swanson, The Coming Productivity Boom, techceocounsel.org, 2017
3 Mathew Tracey and Joachim Fels, Productivity: A Surprise Upside Risk to Global Economy?, PIMCO, May 2017
4 Müge Adalet McGowan, Dan Andrews and Valentine Millot, The Walking Dead? Zombie Firms and Productivity Performance, Economics Department Working Paper No. 1372, January 2017
5 Robert Samuelson, The Decline of Macy’s and Sears May Signal Something Great, realclearmarkets.com, January 12, 2017
6 Wall Street Journal, July 8, 2017