Modern Technology Titans

These questions come at a pivotal moment. The power of new technology titans has created seismic shifts within industries and sectors, facilitating innovation while accelerating disruption. Platform companies have established new tools for people to more easily consume, socialize, and even build companies. But these very same tools have raised concerns about how platforms are being manipulated by outsiders. Lawmakers and regulators, too, have taken note of the increasing concentration among a small number of mega-cap companies.

We recently got together in our Baltimore, MD, headquarters and shared perspectives on these and other topics, including perhaps the most pressing questions on investors’ minds—do these modern titans represent a new dynamic, and what are the prospects of another dot-com meltdown?

The following CIOs participated in the discussion: group CIO Robert Sharps; equity CIOs Henry Ellenbogen, John Linehan, and Justin Thomson; and fixed income CIO Mark Vaselkiv. We don’t hold a "house view" as a CIO group. In fact, the strength of our group is in how we challenge each other and debate ideas. We hope that our insights on a timely topic are helpful.

Yet these firms do have significant common characteristics. Understanding their competitive advantage and how they ascended to positions of prominence can offer valuable insights for investors. As Rob commented, "Taken together, these characteristics allow platform companies to pursue multiple large end markets, whether they’re segmented by geography, sector, or industry."

WHAT SETS THESE COMPANIES APART?

Indeed, we think these firms share four common characteristics.

• They boast an exceptionally large installed user base, across the business and consumer landscape.This helps drive network effects and serves as a valuable source of data—an indispensable asset as the world becomes increasingly digital.
• They benefit from computing capability at scale, which allows them to strategically leverage their data in day-to-day operations. As artificial intelligence platforms continue to develop, this advantage will widen the gap between platform companies and those with less data and inferior computing power.
• They can recruit the very best engineering talent and technological expertise. The modern titans operate on the cutting edge of technology and innovation. Their ambitious projects and massive proprietary data sets are unmatched.
• They have financial resources allowing them to aggressively invest in infrastructure and talent, both organically and through acquisition.

"Since 2010, approximately 20% of the incremental revenue growth of the S&P 500 has come from this handful of companies, which is really a stunning number," explained Henry.

WHAT LED TO SUCH AN ACCELERATEDPACE OF DOMINANCE?

First, and perhaps ironically, the technology, media, and telecommunications (TMT) bubble in the 2000s laid the foundation for the rise of these platform companies. These seven titans benefit from yesterday’s vast investments in the fiber-optic backbone of the Internet. Their businesses now run on rails that were built and paid for almost two decades ago.

Second, the rise of mobility means these companies can interact with their customers instantly. "In 2010, the mobile phone went global and became the remote control for people’s lives," Henry remarked. "These companies can now reach people throughout their daily lives, which unlocked billions of global users."

Third, people have become more willing to adopt technology, which is a prominent characteristic of millennials, but other generations, too, have adopted the same millennial mind-set. "Today’s consumer who has this mind-set puts its trust in technology and reviews over traditional marketing," Henry pointed out.

One silver lining, Mark said, is a potential wave of merger and acquisition activity in challenged industries. Consolidation has the potential to improve an industry’s fundamentals and provide some rationalization. Several years ago, Mark recalled, PetSmart lost significant market share to Chewy.com, an online pet supplies retailer founded in 2011. "There's no need to go to a PetSmart when a 50 pound bag of dog food can be delivered to your front door," Mark said. "The resolution of PetSmart’s strategic problems was to acquire Chewy." Though it’s yet to be seen if this acquisition will create a successful blend of online and offline retail, consolidation has the potential to improve an industry’s fundamentals.

Looking for derivative plays: Disruption can weaken demand in one part of an industry while strengthening it in others. For many years, paper manufacturers struggled amid the meteoric rise of the Internet and the decline in print publications. However, the platform and Internet companies driving publishing’s decline were simultaneously expanding e-commerce, much to the benefit of packaging and container companies. "If you think about value investments overall, it’s very easy to say that most of these companies are on the wrong side of disruption," John said, "but I think that if you take that mind-set, you do so at your own peril."

Looking ahead, electric self-driving vehicles will likely pressure several established business models, including service stations, automobile manufacturers, and automotive insurance. With less focus on the act of driving, cars may soon feature enhancements and additional components that heighten their functionality. John thinks companies exposed to automotive seating could be a fairly significant beneficiary.

Business model innovations: In our view, companies that are learning from today's modern titans can be strong investments. Disruption forces companies to allocate capital more effectively and to manage operations with more discipline. "By leveraging information technology, companies can lower their cost structure when dealing with suppliers or employees," explained Henry. "They can also gain market share or effectively deal with customers through proprietary mobile technology. This understanding led to some of our best investments, even in very mundane industries that might not be associated with technology."

Henry points to Vail Resorts, which operates some of the most visited ski resorts in North America. Vail Resorts introduced a subscription program, and now over 700,000 customers will prepay for their skiing this year, allowing Vail Resorts to lock in close to US$600 million in revenue before Thanksgiving. "Half of these subscribers are not local skiers but actually destination skiers," added Henry. "Vail Resorts created a tremendous customer relationship management and data analysis skill set that allows it to communicate with a small subset of the U.S. population—the 3 million people who represent its potential market." These innovations, Henry believes, drove Vail’s jump from approximately 12% to 22% market share and contributed to its stock’s strong performance.

Disrupted but not dead: A firm’s terminal value is an important consideration for equity investors because shareholders invest in perpetuity. "In the bond world," Mark explained, "the investment horizons are much shorter. So there are still opportunities to invest in some of these dying industries if an investor believes that the issuer will remain solvent for several years." Challenged or even dying industries, including traditional retail, consumer electronics, entertainment, and on-premise IT, may still generate solid returns. "About two years ago, new disruptive technologies in energy, like horizontal drilling, led to a sharp crash in commodity prices," recalled Mark. "It had a tremendous negative impact across both equity markets and credit markets, but we were able to purchase a number of well-capitalized companies and their bonds that were trading at deep discounts. One was an investment-grade energy and production company that had a two-year bond outstanding. It yielded a solid return at maturity."

However, Mark cautioned, today’s extremely low default rates can create a false sense of security. We foresee storm clouds accumulating in the next five to 10 years for some of these now healthy industries.

The same concept of looking at areas that are disrupted but not dead applies to perhaps the most disrupted part of the global economy—retail. It isn’t surprising that four of the top five most popular shorts in the U.S. today are in the consumer discretionary sector. However, investors may be too quick to interpret such data as evidence that they should avoid retail altogether. "A lot of people talk about how Wal-Mart will be left for dead by Amazon," said John. "In my mind, as we think forward, there will likely be a brick-and-mortar component to retailing, whether it’s done by Amazon, Wal-Mart, or others. Wal-Mart has a unique proposition given its very substantial store base." Firms need to recognize shifting industry trends, he adds, and pivot to address them.

Technology knows no borders: Several countries find themselves in the early stages of disruption with no clear leader dominating a particular industry. Justin thinks about India as one such region that is up for grabs. "India is at a very interesting juncture because it's late in the transition to e-commerce," he explained. "The physical infrastructure in terms of organized retail has never been there, and the logistical infrastructure's always been very difficult. Both have been a big obstacle for e-commerce’s growth." Amazon, Justin believes, should emerge triumphant from the threeway e-commerce battle between itself, Flipkart, and Alibaba, but Flipkart can still be relevant even after the dust settles.

Understanding emerging risks: Categories once viewed as immune to e-commerce, like off-price retail or auto parts retail, are being called into question. Additionally, we’ve observed platforms’ role in eroding the reach that many traditional brands historically wielded. Investors should consider how a particular industry or firm might be vulnerable to platform companies, even if future disruption seems far off.

The market correctly perceives that these platform companies could move into essentially any market. As a result, firms in industries susceptible to disruption find that transitory issues in fundamentals create more short-term volatility. "Even if an issue isn’t really a result of e-commerce gaining share—perhaps a company faced tough weather or difficult comparisons—the natural negative reaction gets amplified and people call into question the longer-term growth potential," Robsaid. While solid investment opportunities certainly exist in areas that are facing disruption, investors must be aware of the accompanying volatility.