The internet has been with us for decades and the technology giants it has spawned dominate the top ten market capitalisations. However, the Digital Economy’s transformation of the corporate sector is still at a relatively early stage.
The Digital Economy phenomenon encompasses not just the formation of new online businesses. It also includes the shift of existing corporates online, with all the cost, business model and cultural disruption that this entails. From a technological standpoint, the changes are being driven by three things: the ubiquity of mobile internet access, increased broadband capacity and the availability of cloud storage. At the same time, consumers are demanding an ever-greater range of services which is intensifying competition and with it, the pace of change.
The McKinsey Global Institute recently compiled an index to gauge how companies are building their digital assets, intensifying usage, and creating more technologically empowered workforces. Comparing the US as a whole to the performance of its leading sectors, the Institute concludes that the economy is operating at only c18 per cent of its digital potential. If we assume that the shift online will encompass most industries over time, this development could last for several decades more. The investment profession itself is being transformed by technology, creating the need to combine high quality thoughtful fundamental analysis with new digital tools and data sets.
The study looks at, amongst other things, the labour force, and measures the degree to which companies have empowered their employees in this area. The gaps here are stark. Companies in leading sectors have workforces that are 13 times more digitally engaged than the rest of the economy. This may prove to be the biggest data test that investors face in assessing winners and losers.
Implications for Long Term Equity Investment
From an asset allocation basis, the digitalisation of consumer industries is being led by the US and China. Between them, these two countries have created some of the world’s leading online companies including Facebook, Tencent, Alphabet and Alibaba.
However, in the manufacturing space, Europe, Korea and Japan, may be among the most well-positioned to capitalize on digitalisation. These regions already boast world-leading manufacturing operations and are likely to benefit from the efficiency gains digitalisation offers. Conversely, for many emerging markets, digitalisation could pose a threat to their long-term economic fortunes. More advanced automation means manufacturing can be ‘reshored’ to the consumer’s home market, potentially raising productivity but also decreasing foreign direct investment.
Indeed, one of the greatest challenges for fundamental analysis is the so-called ‘digital workforce’. This phrase includes the human capital, the data analysts and engineers which are so vital to the businesses. Currently, these are treated as costs against profits, rather than as revenue generating assets. Increased focus on revenue per employee gives some clue to trends in the labour force, but more granular data is required. If an estimated 47 per cent of jobs are susceptible to computerisation, we could see digital apartheid between the technologically enabled and automatable roles.
This brings us to the environmental, social and governance (ESG) issues that our global economy’s digital transition presents. Technology has enabled companies to go from start-up to mega-cap at breakneck speed: typically 5 years compared to 20 for the average company. This puts tremendous strain on the development of corporate culture. In some cases, ownership structures, pay and voting rights for globally dominant companies are virtually unchanged from start up. This can lead to the type of problematic corporate behaviour – and ensuing regulatory retaliation – we have seen at the likes of Uber, Google and Amazon.
Valuation is always a mixture of art and science, but in this era, even more art is required. Technological innovations often have network effects associated with them, leading to greater scale and margin divergence between companies. The extremes to which company values can go has risen as the outcomes between immense scale and profitability or corporate ruin have diverged. Today there are seven $400bn+ market cap companies versus only one (ExxonMobil) 10 years ago, and all except one of these (Berkshire Hathaway) are technology enabled versus none a decade ago.
The maturity of the Digital Economy is at an early stage. At present, digitalisation’s disruptive challenges for the corporate sector are more apparent than its benefits. As the transition progresses, the latter should gradually appear, as the significant investment phase ends, productivity gains are reaped and industry structures become clearer.
In the meantime, the fortunes of companies are diverging more than ever before. For the active manager, this creates ideal opportunities for higher alpha generation. It is vital to pick those companies that are leading, and profiting from, the digitalisation trends in their industries, while at the same time avoiding the losers. These well-positioned companies may attract valuation premia for longer than usual, testing sell disciplines. Correctly identifying and valuing those companies that are best positioned to adapt to the opportunities that digitalisation bring will determine relative investment performance for years to come.
Lucy Macdonald, Brunner Investment Trust.
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