Part 3: A walk along Risk Road with Jim Hall
The Disruptors vs. The Disrupted – know the winners, avoid the losers
At Mawer, we spend a great deal of time asking and answering the question: So what? A company’s share price is down 6%…so what? A central bank moved interest rates up…so what? Google re-named itself Alphabet…so what?
It is not always an easy question to answer and often leads us to ask even more questions in an effort to develop key investment insights. “So what?” is one of the questions that can lead us to investment action (or inaction) in our process of building well-diversified, resilient portfolios. In an effort to pass on our “so what” learnings, I interviewed our Chief Investment Officer, Jim Hall, with specific questions pertaining to his views on risks in the current environment.
CW: Jim, we decided at the conclusion of our slow growth world discussion that we’d address technological disruption. Let’s get into the “so what?” of it. What is technological disruption?
JH: It’s many things. It has happened in many industries; rail to auto, telegraph to telephone, typewriter to word processing, CD’s to online music. Of interest to me is where an innovation ends up displacing a whole industry and the ones that support it—and sometimes changes society too. For example, take e-commerce and the sharing economy. Companies like Uber and Airbnb are changing the economy in significant ways through the application of technology. These companies are growing very fast and they are stealing business from other companies. This may lead to lower growth overall, at least temporarily. That’s the disruption. This dynamic has been around a long time. Clayton Christensen called it “disruptive innovation” and John Maynard Keynes called it “technological unemployment.” Many people have written and talked about the consequences of structural economic disruption over the years—and many are fretting about it now.
CW: How does the disruption manifest itself?
JH: History has shown that two primary displacements may occur: excess capacity, and structural shifts of employment. Let’s start with excess capacity. These newer businesses often don’t use as many fixed assets or they require less for a given unit of output, so asset utilization rises. Meanwhile, the capacity in the old industries is now sitting idle. This suggests less investment (capital expenditure, or capex) is required overall, so the more efficient use of assets can actually lead to deflationary pressure and slower near-term growth. If you look back at major technological changes over centuries, that’s often what happens. Electricity was introduced and it put the water mills and steam engines out of work. The automobile came along and replaced horse deliveries and rail trips. On and on, these major technological changes put people out of business, companies out of business, and entire industries out of business. And the short term impact of all this is often lower prices or deflation.
CW: OK, so technological disruption is an important economic shift. How does it progress?
JH: There’s also the employment side. While the disruption is happening, it can be brutal. Unemployment rises but ultimately it turns over and society benefits. You have higher asset utilization and an eventual shift of disrupted resources to higher value-added areas. But the shift sometimes takes decades. So maybe we’re in the throes of, or even at the beginning of, that disruption right now. We’re getting some benefit as consumers, but the overall economic pie might be shrinking for the time being as we work through this.
CW: How do we approach investing if we’re in the midst of the disruption?
JH: It becomes an exercise of getting your head around who might be “winners” and “losers” in all of this. It’s an evaluation of the disruptors and the disrupted. So a company like Uber, potentially a winner. Google, potentially a winner. If more economic activity is conducted over communication networks, then potentially the Telecom companies become the highly valued necessary utility like railroads or canals once were. You can’t conduct modern commerce without the networks so the Telecom companies may be well positioned to collect a toll. In energy, I’m watching the development of batteries and storage—that’s a potential disruptor in energy if a storage solution is found.
CW: How do we identify winners and pay the right price?
JH: Identifying winners is very difficult and usually the market will anticipate multiple winners. There is often only one winner in 100 but all 100 are priced to succeed. Often, they just give a product/service away and the customers get all the benefit. So instead of trying to identify winners, these considerations often can steer us away from a sector—especially those where there is a lot of hype and not much profit. Many times, we have found a better strategy for long-term portfolio growth is to make sure you’re not stuck with the losers, rather than trying to identify winners ahead of everyone else.
CW: Can you give us a few examples of what we’re avoiding?
JH: Sure. In the case of Uber’s business, the losers are probably the medallion taxis. Retail real estate potentially is another. With rising online purchasing, a shift is happening where retail space is seeing less demand while warehouse/logistics and industrial space may see rising demand. The 15,000 square foot retail store may be out of business. The landlord who owns the 15,000 square foot store in a mall has nobody in it. China is one of the better test cases because significant retail purchasing is done online. In China you see growing excess capacity in retail shopping space; therefore, avoiding mall owners in China is one practical risk management approach.
CW: Many of the disruptors have found financing in the private equity world. The ‘unicorn’ list of private companies valued at over $1 billion comes to mind. Since we only invest in public companies, is Mawer missing out on attractive opportunities?
JH: There doesn’t seem to be any shortage of growing companies to invest in through the public markets. There may be many more private ones but it doesn’t mean there aren’t public ones in which to invest. Sure, we may miss out on some opportunities, but we don’t need to own everything out there. We need to earn a good return without taking too much risk. And there are opportunities in public companies; Visa, Google, and Tencent come to mind here.
CW: Good returns without too much risk. That’s a good message from the whole ‘Risk Road’ series. How would you like to sum it up?
JH: We’ve covered some major concerns: deflation/inflation, slow-growth, and technological disruption. All may be tied together in the current environment and appear to be winding their way through markets. The “so what?” portfolio actions are the basic lessons; pursue diversification, be balanced, don’t get too carried away with one scenario over another. That means doing your best to research and understand what’s going on while recognizing that anyone’s ability to do so is limited. Focus on identifying the “losers” not the “winners” is our long-term risk management approach. It may be kind of boring, but it works pretty well.
CW: Thanks Jim. I look forward to doing this again.