The history of technology is really a story of continual creative insurgency. Once every 20 years or so, an outbreak of innovative technologies has upended the status quo and ushered in a new generation of market leaders.
The process continues today—but at a much faster pace and with even greater commercial promise. Institutional investors that adhere to benchmark-sensitive or index-tracking approaches will be overly bound to legacy technologies and, thus, at greater risk of getting left behind. Thematic investing strategies that are less constrained and more forward-looking may offer a better way to capitalize on this era of accelerating innovation.
As they gain support, insurgent technologies ultimately topple long-dominant regimes. The losers fall further and faster than anyone expects, and the winners come out on top in all kinds of unexpected ways. For example, mainframes displaced adding machines in the 1950s, only to be uprooted by personal computers (PCs) in the 1980s. Today, new-era services that leverage the wireless Internet and cloud computing—which work on a wide range of devices from tablets to TVs (and, soon, eyeglasses and watches)—are displacing PCs.
Creative Insurgency
At the root of this insurgency is the nature of technological innovation itself. As history has shown, technological progress advances exponentially rather than linearly, at least for a time. This is a difficult concept for most people to grasp: it’s much easier for our minds to make sense of linear growth than exponential growth.
Yet the effects of exponential growth are all around us. Cells in our bodies grow exponentially, as do bacteria and viruses, if left unchecked. In the world of technology, we have benefited from exponential growth in the number of transistors on a silicon chip—a concept known as Moore’s Law. In biotechnology, we have witnessed an exponential decrease in the cost to decode the human genome.
Propelled by this relentless exponential improvement in the cost and performance of information technologies and a hospitable climate of experimentation, the entry and adoption of new products and services are advancing at an ever-accelerating pace. Institutional investors need to consider the implications of the profound gains to come from technological innovation.
The speed at which new technologies are embraced—and which incumbent players are threatened—are among the most significant issues that investors must grapple with. The adoption of consumer computing devices over the past several decades provides an instructive example. It took the PC roughly 30 years to achieve 75% penetration of U.S. households. Laptops—introduced about a decade later—achieved that milestone in only 20 years. Today, the smartphone has reached nearly 60% per-capita penetration of the market in just five years, and the tablet is on a similarly swift trajectory.
The implications of this acceleration are apparent in equity returns, as are the dangers of using a benchmark-sensitive approach to selecting stocks. According to Bloomberg, from 2007 to 2013, Apple shares soared 561%, while Microsoft shares rose just 25%. Yet, reflecting the backwardlooking nature of benchmarks, Microsoft was the single largest technology stock in the S&P 500 Index in 2007, with a market cap nearly 3.5 times larger than Apple’s. Traditional barriers to scale are also eroding. The Internet offers unprecedented reach, while the capital and time needed to attract millions of users are declining rapidly. This makes it easier for innovators to move from idea to scale than ever before.
Facebook, which recently acquired WhatsApp for $19 billion, provides an interesting example. Facebook has more than one billion users—a seemingly high competitive barrier. However, in a very short time, WhatsApp attracted 450 million users of its own, more than half of whom arrived in the nine months preceding the acquisition. The accelerated pace of technological innovation in recent where an innovator (WhatsApp) was able to quickly build massive scale, posing such a huge potential threat that the incumbent (Facebook) was compelled to pay many billions of dollars to acquire the innovator.
And the commercial impact of the accelerating pace of technological innovation extends far beyond the traditional IT realm. There are examples across healthcare, agriculture, consumer products and even the military (see “The Next Generation,” below).
Thematic Investing
As these and other disruptive technologies continue to win ever-greater customer acceptance, institutional investors will increasingly need to embrace creative disruption as a tailwind, rather than a headwind, in their portfolios. That will require keeping up with the latest scientific and technological advances, as well as the experience and expertise to knowledgeably evaluate their potential.
Development is never linear, and innovators must clear many hurdles on their way to commercial success. And, of course, there is no guarantee that even successful technological innovations will translate into strong profit growth or equity performance. Identifying tomorrow’s winning disrupters takes know-how, patience and painstaking research.
For these reasons, less-constrained approaches such as thematic investing may be best positioned to fully exploit the trend of accelerating technological innovation, because they are free to follow innovation. Benchmark-sensitive or passive index-tracking approaches, by contrast, are inherently at a disadvantage when it comes to investing in innovative disruptions.
As Microsoft’s mammoth index weight in 2007 demonstrated, benchmarks are backward-looking and reflect yesterday’s successes, not tomorrow’s. Thematic portfolios access markedly different characteristics than other strategies and typically offer returns with low correlations to returns from other equity investing approaches. In general, there are three key elements that differentiate thematic investing from more traditional approaches.
1. Big-picture research focus – Thematic investing typically involves a greater reliance on top-down or big-picture analysis than traditional equity strategies, reflecting the need to select and manage exposures to themes.
2. Lack of tethering to sectors or geographies – The analysis underpinning thematic portfolios is not generally organized by conventional sector and geographic constructs. Traditional benchmark-sensitive portfolios are often biased toward past successes (disrupted technologies) and will naturally give short shrift to the innovation (disrupters) that thematic portfolios seek to capture.
3. Long-term investment horizon – Because it focuses mainly on secular growth trends, thematic investing tends to take a long-term view, filtering out near-term “noise” and preferring to exploit drivers that take as long as three to five years to fully pay off. Given their longer-term investment horizons, institutional investors are in a particularly advantageous position to exploit the long-term alpha potential of investing in successful disruptive innovators.
The primary drawback facing thematic investing strategies is the potential for heightened volatility of short-term returns. While disrupters stand to profit over time, growth can take time to develop. That can make the stocks of these companies appear expensive on traditional valuation metrics based on shorter-term sales and earnings. As a result, these stocks can suffer during “risk-off ” periods, when investors tend to seek safer, more predictable investment alternatives.
Competition, choice and the exponential growth of technological innovation are powerful forces bringing upheaval across all sectors of the economy—from retail to financial services, to pharmaceuticals to entertainment. This creative destruction makes investing in the industry particularly difficult—but also, of course, particularly rewarding when you get it right.
Thematic investing offers a way to translate the acceleration of technological disruption across all sectors of the economy into a profitable investment portfolio.
Dan Roarty is team leader, global growth/ thematic portfolios, with AllianceBernstein.
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