5 Jan 2016
Turmoil and change are inherent features of free-market economies. In 1942, the Austro-American economist Joseph Schumpeter welcomed the “gale of creative destruction [...] incessantly destroying the old [economy], incessantly creating a new one.”
Yet if creative destruction is nothing new, it has reached a new level of intensity in the years since the financial crisis. A revolution born in the US is overturning long-established industries and reshaping economies worldwide. The list of afflicted industries grappling with disruptive challenges is long: retail; publishing; television; film; hotels; car rental firms; logistics; enterprise software; healthcare; education; and banking. And the list continues to grow.
Clearly, this is a major challenge for executives across a range of industries. But it poses questions to investors too. How is creative destruction working in practice? Why has the process of change intensified? And how should investors position themselves to profit?
More losers than winners
Creative destruction is nothing new. In 1900, for example, more than 24 million horses – one for every three Americans – were at work pulling buses, street trolleys, wagons and carriages. This “horse economy” was vast. But by the 1930s, the refinement of the internal combustion engine and Henry Ford’s production line had rendered working horses redundant, driving down the price of grain so dramatically that the US Bureau of Census described it as "one of the main contributing factors" to the Great Depression. By 1959 America’s equine population had declined to just 4.5 million horses. An entire mode of production was suddenly obsolete and a powerful new technology had emerged.
When we think about technological progress, we focus on the winners. Armchair stockpickers fondly imagine the returns they would have enjoyed had they bought shares in an automobile company at the dawn of the industry. In reality, this is often wishful thinking: even among the auto companies – the ‘disruptors’ of the horse-based economy – the losing companies vastly outnumbered the winners. So picking the next Apple is not straightforward. But might identifying the losers from the old economy– and shorting them – be easier? In the Artemis US Extended Alpha Fund, we have the flexibility to do just that.
Today, the economics of major industries are being devastated by young companies labelled as disruptors. It is no longer just booksellers – Barnes & Noble or Borders – being squeezed by Amazon. This has huge implications that have not, as yet, been fully appreciated. Take, for instance, passive funds. Holders of ETFs or tracker funds might not notice when the mom-and-pop stores go out of business, but they will feel the damage that Amazon is doing to companies with heavy weightings in market indices like Wal-Mart and Target.
Why now? The destructive and creative force of QE
In the conditions that have prevailed since the financial crisis – the so-called ‘new normal’ – inflation has been low and economic growth has been slow. The solution proposed by central banks? Money printing. Traditionally, businesses that don’t make money, or whose prospects of doing so in the future are slim, have had to pay a significant risk premium for capital. That made it hard for them to get their ideas off the ground. But the negative real yields on risk-free assets that quantitative easing (QE) has produced have reduced investors’ aversion to risk. This is an intended consequence of QE and has benefited economic growth. But there are unanticipated effects as well. By providing companies with extremely cheap financing, QE has supercharged creative destruction.
Amazon isn’t the only company uprooting established industries. There is a growing herd of ‘unicorns’: unlisted companies such as Airbnb, Uber, Snapchat, and Spotify that have been valued at $1 billion or more in private fundraisings. Forbes estimates that there are 140 of these unicorns worldwide, 93 in the US. Beyond their valuations, the common factor uniting them is the technology they use. The spread of high-speed internet connections combined with the computing power and capabilities (GPS devices, cameras) inside smartphones has created fertile ground for disruptive new businesses.
A game plan
So how should investors position themselves in a world of supercharged creative destruction? The group of publicly traded companies that have so far been clear beneficiaries is relatively small. Amazon is one and the Artemis US Extended Alpha Fund has shared in its success. But whether all of the ‘FANG’ (Facebook, Amazon, Netflix and Google) stocks will profit from the disruption they are causing remains to be seen. Netflix, for example, is helping to hasten the demise of traditional broadcasters. Many Americans are ‘cutting the cord’ – abandoning expensive cable packages in favour of cheaper content streamed on demand. But it is unlikely Netflix will be able to turn this into the profits needed to justify its current p/e multiple of 300x.
The ‘unicorns’, meanwhile, may be interesting – but they are only investable propositions for a small percentage of investors. The scale of funding that US companies have received from venture capital in recent years has been impressive. The Dow Jones Quarterly Venture Capital Report indicates that in the third quarter of 2012, US-based companies raised $8.29 billion from venture capital funds. That not-insubstantial amount has climbed steadily over the last three years: in the third quarter of 2015 US companies received funding worth $19.06 billion. Such is the abundance of venture capital money that disruptive companies have less need to subject themselves to the scrutiny and constraints that come with being a listed company. Many are content to remain in private hands.
In some industries, then, it might be easier to identify the companies that are on the wrong side of history and short their stocks. As Warren Buffett put it in an article for Fortune in 1999:
“Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then-- its better sometimes to turn these things upside down – and that was to short horses. Frankly, I'm disappointed that the Buffett family was not short horses through this entire period.”
So at this point, short selling is a better way to profit from creative destruction. It might not be possible to short the family-owned taxi companies threatened by Uber. But in the Artemis US Extended Alpha Fund we can go short of other possible losers, such as rental car companies and car manufacturers (One effect of Uber is to significantly increase utilisation rates of existing transport infrastructure). Another potential area for shorting: the large, bricks-and-mortar retailers that are squeezed by Amazon. Or if you are impressed by Airbnb’s achievement, you may anticipate shorting opportunities arising among the hotel groups.
Looking slightly further ahead, might car companies find their markets remade by the mooted Apple car or by Tesla’s electric vehicles? Will technology companies succeed in wresting control of the payments system from the banks? Or will peer-to-peer lending destroy their loan books? It is too soon to say. What we can be more certain of is that, thanks to the confluence of technological progress and cheap money, Schumpeter’s gale of creative destruction will continue to blow. Both long and short, the Artemis US Extended Alpha Fund intends to benefit.
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