How to position portfolios in an age of disruption

There is no doubt that disruptive technologies are having a huge impact on the global economy. Almost every sector seems to be feeling the impact, with new innovations shaking up the established order, while completely new industries are being created from scratch. Mainstream media is littered with references to Artificial Intelligence, BlockChain, crypto-currencies, robotics, 3D printing, automation and so on. The list seems to be endless.

The pace of this disruption is going to accelerate because of lower capital requirements, believes Frédérique Carrier, head of investment strategy at RBC Wealth Management. “The services and products that are being developed today have much lower capital requirements than was the case in the past – think of the cost of setting up Airbnb as compared to developing the railways.”

These lower capital requirements reduces the barriers for entry for potential disruptors, enhances competition and puts more pressure on incumbent companies, she explains, and it would be foolish for investors, and businesses, to underestimate this trend.

Ms Carrier highlights the example of video rental firm Blockbuster. In 2008 its CEO Jim Keys said: “Neither RedBox nor Netflix are even on the radar screen in terms of competition.” Two years later Blockbuster filed for bankruptcy, and Netflix now has 116m subscribers worldwide.

So how can investors avoid holding any ‘Blockbusters’ in their portfolios?

The first step is to identify the threats to industries, she says. These could come from technology, regulation, or other areas, and those sectors most at risk could be hit by a tsunami of all these.

For example the motor industry is facing technological change at a time when regulations are increasing, says Ms Carrier. “Here we have lithium ion batteries, electric cars and driverless cars on the tech side. And this is at a time when the regulatory burden is increasing. Safety regulations have been around for a long time but cars are now facing increasing clean air and carbon emissions standards in more and more countries.”

Added to that are societal changes, with the growing concept of the sharing economy. “We have seen studies showing how one shared vehicle could replace 10 privately-owned cars,” she says.

The second step is to assess which companies could successfully adapt to this disruption, says Ms Carrier. It helps if a company has had historical high returns, and has demonstrated an ability to innovate. “But the real key is the management’s ability and willingness to change. And the acid test of that is: is it willing to let its ‘sacred cows’ die off?”

This can be hard for businesses to do, as many feel the need to protect their legacy business. She gives the example of Kodak, who saw the threat of digital cameras coming but chose to try and protect its portable camera and film business, and ended up going through a painful bankruptcy.

Canon faced similar threats but responded differently, moving away from the mass market to focus on the high end hobbyist and professional market and aggressively went into new businesses, including medical imaging, 3D printing materials and surveillance cameras. They avoided Kodak’s fate and remain a major player.

Widespread phenomenon

What is particularly interesting about this era of disruption is that it is affecting so many different sectors, says David Older, head of equities at Carmignac. He explains how in the tech valuation bubble of 1999/2000, it was enterprise-focused companies which were coming to the fore, whereas now it is consumer-orientated firms, which provides for a much greater scope of disruption. 

“And it is much more global phenomenon now. Fifteen years ago those companies were only selling into developed countries. Now, when Apple releases an iPhone, it is a global event.”

The major players in technology sector have been so successful because they have managed to consistently expand their addressable markets, he explains. “Think of Amazon’s move into groceries – a new $800bn opportunity for them. It is part of these companies’ mindsets to keep on disrupting – the idea of being paranoid to survive. If you are not disrupting you are dying.”

Although some sectors are, to a certain extent, “un-Amazonable”, for example healthcare, a huge number of companies will need to alter their business models in order to survive.

“The incumbent companies are trying to adapt,” says Mr Older, “and the best will survive. I don’t think WalMart will just go away. It is in their DNA to be the price leader, take costs out where they can, and they are making some smart moves. But there will be a lot of roadkill.”

A lot of companies are in real trouble, he says, as they simply cannot change the DNA of their existing business. “The capital required for these businesses to change is so huge, and the margin dilution is too painful, it is often a bridge too far in order for them to compete.”

So it is very important for investors to avoid the losers, but are shares in the winners too highly valued?

“I don’t think those companies are expensive. Facebook is trading at 25x 2018 earnings, but those earnings are growing 65 per cent this year. And there is still plenty of growth to come – Google has $90bn in revenues and $12bn in growth expected next year. So these bigger tech guys are actually pretty cheap and will continue to win.”

But the benefits of these global companies are pretty well understood, and managers need to offer their clients more than simply buying into the biggest names to play this theme. “So we then try to balance them out with some less discovered companies, mid-cap names where we can find something the consensus is missing.”

Investing in disruption is about more than just seeking exposure to artificial intelligence or robotics, says Wesley Lebeau, portfolio manager of the Global Disruptive Opportunities fund at CPR Asset Management, rather a multi-sector approach is more likely to provide sustainable growth.

“This means investing in companies either transforming an existing market, changing the established order, or creating a new market, across the following four dimensions: the digital economy, industry 4.0, life sciences and earth. And disruptive opportunities are found in both mature, incumbent players like Google and Amazon, but also smaller early-stage companies. Therefore it’s important to have a diversified portfolio.”

Opportunities are not limited to developed markets either, he says, for example with China attempting to position itself as the world leader for electric-powered vehicles, following the government’s recent announcement that it was putting a stop date on the sale of conventional cars.

It is often difficult to identify disruptors and technologies which will have an impact across multiple sectors, admits Mr Lebeau. A global approach is needed to identify actors at all levels of maturity, regardless of origin, sector or market capitalisation, he says, along with effective bottom-up research. “But the returns are significant for investors willing to take a long-term view and avoid narrow definitions of what disruption means.”

A robotic future

Automation is playing an increasingly important role in the global economy, and the robotics industry will be a key beneficiary of this, believes Marc Posso, portfolio manager at Man Capital LLP, which invests directly in listed robotics funds. 

Industrial robots are reinventing the manufacturing process on the production lines, he says. “Industrial robots are more mobile and much more efficient than they once were. Here we have high exposure to Japanese companies because they are quite advanced in this space and have a competitive advantage. A lot of the innovation is coming from Japan.”

Robots are also disrupting the healthcare and medical industries by improving precision in surgery and reaching difficult to access parts of the human body, says Mr Posso. “This will help solve the problem of shortage of doctors and surgeons. Medical robots can also transform the field of diagnostics, by being able to diagnose patients faster and more accurately than a doctor.”

But investors should be wary of fad-driven investing in this sector and be wary of overhyped areas, he warns. “We looked at drones, and while it is an interesting story, the competition from Chinese drone makers is eating the market share of some of the more established players in Europe. They are struggling to compete with Chinese drones, because the latter are very good quality and cheaper.”

Jonathan Cohen, managing partner at RoboCap, agrees that industrial robotics is a sub-theme which is growing strongly. “There is a shortage of key components such as high-precision gears and a 40-week delivery delay is not uncommon, giving suppliers a lot of pricing power.”

Software is also interesting, he believes, because margins and barriers to entry are high, while surgical robots is an area to watch over the next decade.

One sector to be cautious about though is 3D printing, warns Mr Cohen. “The competition is currently intense and some technology-leaders are private,” he adds.