A New Industrial Revolution
Businesses that combine closed-loop, arms dealer and monopoly characteristics represent something fundamental that is shifting in the global economy. They represent automation that is pervasive, smart, and is a layer that sits across the entire economy. Data processing and prediction build these business models. They permeate all services, including supply chains, logistics, mobility, and consumer offerings. Pervasive and innovative, they represent opportunities for increasing investment returns. Incumbents enhance their position, generate increasing value, create challenging barriers, enable more innovation to solidify their position and will sustain their value because of this new competitive dynamic. Innovation is always a threat, and value can be created from a new entrant, but the bar is increasingly higher for both the level of disruption and quality of innovation to an existing or even new market.
To be sure, new opportunities will be created as new technology develops. An example is the wireless data and smartphone market. Essentially, 4G mobile technology-enabled the substantial value creation at Facebook, Netflix, Uber and AirBnB. These companies could build their services on top of this technology platform and create not only a new competitive business but a new market where they could be the dominant player. As 5G develops and we see unimagined high-speed for data, entertainment, communication, and other services, we will have new businesses and opportunities created on this platform – only so much can be imagined today, others which are yet to come. But there will be a real-time connection with customers enabling new and innovative products and services, artificial intelligence permeating software and communication enhancing quality and innovation further, enhanced gaming (perhaps even to a professional level), and virtual reality and augmented reality perhaps finally becoming the market opportunity that has been imagined for many years. This list is far from exhaustive, and without doubt, there will be valuable companies created whose business models we can’t quite imagine today.
One interesting technological component is location-based services. Critically, location-based services, as our current pandemic magnifies, allowing for delivery of products, content, essential networking and infrastructure, as well as other forms of social media and interaction, along with enterprise services, collaboration tools, and other online services, become even more important and valuable. Combined with other technologies, new workplace and home environments, along with new services designed to meet these emerging demands, create increasing opportunities.
Fundamentally, those companies with existing infrastructure, such as Amazon, Walmart, Domino’s Pizza, Target, and other incumbents thrive in this new environment because the infrastructure required and technologies essential were already in place. Newcomers such as Zoom and Slack offering more potent online communication and collaboration have seen extraordinary growth. However, incumbents such as Microsoft and others, while perhaps delayed in their response, have the infrastructure and technologies essential to be formidable competitors to these new market entrants. Our thesis on the attractiveness of closed-loop businesses, in spite of this near-term disruption, is still intact.
Location-based services will become increasingly important as workforces become more fragmented geographically, and people choose to live lifestyles focused less on concentrated populations. This demographic shift, while being forced to accelerate because of the pandemic, seems to be a sustainable trend. Closed-loop incumbents look to benefit most from this.
Essentially, these developments and tools are fundamentally changing our personal and professional lives through personalized products and services, collaboration, and unprecedented access. Done well, it represents an opportunity for tremendous value creation.
Technological innovation has historically focused on economic opportunity. Sometimes what began as a decentralized and open platform became centralized within a competitive entity. In other words, all industries consolidate, whether it is manufacturers looking for scale or technological companies whose innovations disrupt markets focused on dominating those markets with competitive and comparative advantage. When Bell Labs developed the transistor, it was essentially free for all in 1956. But Intel developed proprietary microprocessor technology with transistor technology as its core foundation. Thus, Intel enjoyed the benefit of being a monopoly in the microprocessor world and the arms dealer for the development of the personal computer industry. While every PC needed the Microsoft operating system, every PC was powered by an Intel microprocessor. This is the classic example of a monopoly in an arms dealer creating tremendous value.
As hardware and software became separated, Microsoft understood the value of an effective operating system and specialist software that can run effectively on top of that operating system and made it available to all. Thus, we have another extraordinary financial opportunity created from this centralized dominance. With the browser open to all, per Microsoft’s settlement, Google was then able to develop the most effective search engine which came to dominate this sector. Once again, the slight advantage of Google’s search engine over all the others morphed into a monopolistic position with the Google search engine had to be part of every browser on every computer. Fragmented industry – more than six competitors in 1998 – essentially turned into a single competitor, Google, with over a 90% share of all Internet-based searches.
The next wave of centralization will probably belong to those with data who understand how to use it most effectively. Artificial intelligence is the new powerful tool in the arsenal enabling centralized competitors to consolidate and be a dominant player or duopoly within the most attractive sectors. Used most effectively, it is probably the most likely source of the slight advantage that spirals into competitive dominance.
While there is legislative pushback creating vulnerability to the competitive evolution, these developments, where fragmented industries consolidate into a few or perhaps a single market sector leader or dominant player, are natural to any competitive market. Regulators and legislators can jump up and down all they want but they cannot prevent the process of a fragmented industry fundamentally changed by technological innovation developing into a growing sector with a single dominant player (i.e. Google, Facebook, etc.). The nature of closed-loop data collection, analysis, and modification to provide more effective services makes this process even more unavoidable.
The cycle of growth, disruption, and dominance will continue to be ongoing. The massive data available, the ability to manipulate this data more effectively via artificial intelligence and machine learning, creates the potential for even more concentration. Few companies have the scale of companies like Google, Amazon, and Facebook. Collectively, these companies are committing over $40 billion annually to research and development. This hierarchy reinforced with this scale of capital spending will be particularly challenging to attack.
All new technologies, whether the printing press, radio, the automobile, or the Internet, creates many fragmented opportunities. But history has shown that only a few ultimately dominate. Industries, while fragmented and chaotic initially, narrow and centralize. The most recent example is looking at the Internet. It was, for lack of a better term, a “free-for-all” with erratic and inefficient business models, fragmented and minor players, and uncertain trajectory, and questionable revenue models. From this origin, the industry analyses and almost unprecedented concentration. Google has 91% of all search, Apple is almost 50% of all mobile web traffic, Facebook is 60% of all social media, and Amazon is about 50% or more of all online retail. These competitive advantages will not diminish because the closed-loop nature of their technologies creates and sustains this centralization. The hope of decentralized technologies and products, a decentralized World Wide Web, or profound disruption to incumbents does not seem realistic. Regulation and legislation will not change this fundamental aspect of business and competition.
A Word About Valuation
Many high-growth companies, while attractive businesses are valued in the public markets at a relatively high multiple to their earnings. Of course, the anticipation is that earnings will grow at an increasing rate, justifying the high multiple paid today. Eventually, the company becomes a steady earner and its multiple will drop, even if its earnings continue to increase. The multiple will decrease because the prospect of increasing earnings in the future is now lower. Earnings may increase but at a decreasing rate. This will impact the multiple on which these companies are valued. A question worth asking is if these companies worth their high multiple today?
One way to think about it is through this scenario:
An investment in a high-growth stock, given the risks associated with it, should earn at least a 15% annual return. In round numbers, a 15% annual return means the stock will double in five years (with some rounding).
The typical high-growth stock may be valued at 100 X earnings today because earnings growth is believed to be high. A more typical earnings multiple for a company that is more stable is approximately 20 X. If the company is earning $100 today, at 100 X earnings (its valuation multiple), the company would be valued at $10,000. Five years from now, the company’s multiple may be a more market-based multiple of 20 X. If the value of the stock is to double, that is the stock will be worth $20,000 in five years versus $10,000 today, and if its earnings are valued at 20 X in five years, that means the company must earn $500 in five years. Therefore, in order to earn a 15% annual return on the stock over the next five years, the company will need to increase its earnings by 5X over that time – from $100-$500. Is that possible? Is it truly an asymmetric and convex opportunity? That is the question worth asking to determine if this company is worth investing in today.
When thinking about an investment, the right question to ask is not “what do I think the price will be?” The right question to ask is “will this company earn enough money in the future to justify the current price? If it is valued at a reasonable multiple, will the return justify the risk?”