Digital Disruption

Steve Clayton - Fund Manager

20 August 2018

Don Johnson famously drove a Ferrari Testarossa in the 1980s TV series Miami Vice.

Back then, one of the most desirable cars in the world cost around £100k and raced to sixty miles an hour in just 5.2 seconds. Today, despite thirty years of inflation, you can buy an Audi TT for less than half the price, and it will get up to speed at least as fast as the Ferrari ever did.

Clearly things have changed along the way. But then, they always have. We read a lot about Digital Disruption yet the truth of the matter is that the world is always in flux. It’s just that digital technologies are pushing the pace of change, dramatically so in some cases.

With the internet of things fast building scale, the amount of data moving around is set to soar ever higher. Generating data is one thing, analysing it is another altogether. Here, the world of artificial intelligence is set to give a further push on the throttle.

Disrupted investments

The implications for investors are profound, for if your money is on the wrong side of the argument, the consequences could be severe.

We’ve seen examples like the fall of Blockbuster and Toys Were Us at the hands of Spotify, Netflix and the video gaming industry. Only this last week or so we’ve seen the venerable House of Fraser fall into administration, in part because of the ongoing shift toward e-commerce.

But the impact of digital technology and the analysis of data to create better outcomes is changing the industries we don’t see day to day just as much as the ones we do.

Manufacturing is entering a new wave of automation as equipment producers incorporate more and more connectivity into their kit to make the factory of the future ever more flexible.

In the resources sector, companies like BP are using data analysis to better understand their assets and improve their success rate when drilling. Mining companies are replacing the drivers of their trucks and trains that move the ore from rock face to ship with automated equipment that will work 24/7, wage-free.

Challenges present opportunities

For the HL Select funds our challenge is to identify the companies that are leading the digital transformation and shy away from those that are seeing their positions weakened.

We hold stocks like Rightmove and Auto Trader that have driven the transformation of their industries from traditional print-based models to predominantly online. Interestingly, one was a digital start-up, the other, Auto Trader, an incumbent that managed to evolve into a digital-only business.

That shows it’s rash to just write-off the incumbents, for they start in a financially strong position and if they can use their cash flows to fund class-leading innovation, the digital future is theirs to take.

But incumbents can struggle if the transformation needed is destructive to their existing operations. The High Street banks maintained vast branch networks for years after their customers moved online and are only now taking the difficult decisions to move their centres of gravity into cyberspace.

Even technology companies can be wrong-footed. We hold Sage, the accounting software company because it has a long track record of strong cash generation. But they have been slow to move their products onto the cloud and others have rushed into the void. Sage are fighting back and growing their cloud revenues rapidly now, but they could have been badly damaged had they left the field open much longer.

Another software stock we own, Ideagen, which serves the Governance and Risk Control sectors has been much more pro-active and now most of what they offer can be delivered from the cloud on a subscription basis. Their financial performance has been very strong and we have no doubt that migrating to the cloud has been part of this.

Threat of Amazon

We have significant holdings in consumer branded goods companies. Brand loyalty has a long history of allowing the brand owners to earn strong margins and cash flow. But even these sectors are not immune to disruption.

As Amazon gains share, brands must fight to ensure that their products are at the top of the selections generated by searching on Amazon and other digital platforms.

Get it wrong, and a brand can quickly drop into digital obscurity. Amazon now sell more own-label batteries than any brand, much to Duracell’s dismay. In the world of shaving, Gillette’s dominance has been dented by the arrival of cheaper online subscription services that deliver new blades regularly at competitive prices.

Unilever, which we hold, bought Dollar Shave Club, so one incumbent is now disrupting another. Ascential, one of our portfolio companies, owns a couple of businesses that use data analytics to show brands how to optimise their online sales and their positioning with Amazon. Unsurprisingly, both seem to be growing strongly within the group.

We hold no conventional retailers, because they are simply in the wrong place, at the wrong time in history and carrying too much heavy baggage, in the form of lease commitments.

Every time we consider stocks, we find ourselves spending more time thinking about where the digital threats and opportunities will come from.

Finding a new entrant about to scoop the pool can be wonderfully profitable, but don’t automatically write-off the incumbents, because all too often, the start-ups just stop.