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Value investing in an age of disruption

Value investing in an age of disruption

In Stephen Potter’s book One-Upmanship, he wrote that the sure-fire rejoinder to someone saying something knowledgeable about India was: ‘Ah yes, but not in the south.’

The riposte to investment cases in a dozen industries these days is: ‘Ah yes, but what about disruption?’

Recent examples include the music business, with digital replacing physical and now streaming replacing downloads. Similarly, smartphones replaced computers and the cloud is taking over from local servers.

Disruption itself is not new, however there are always disruption-deniers.

For example, early in the 20th century Daimler thought there would be no need for more than 10,000 cars because there would not be enough chauffeurs to drive them.

Such forecasts are notoriously wide of the mark. McKinsey in 1986 predicted that roughly a million mobile phones might be in use by 2000. The figure was actually 109 million.

The car sector is one area in which there is a lot of disruption. Apart from the ordinary to and fro of economic cycles there are two technological threats to traditional carmakers: electric vehicles and autonomous or driverless cars. Investors seem only to have eyes for the obvious disruptors, such as Tesla and Uber.

However, this misses several points, one of which surrounds the difficulty in making lots of cars cost-effectively. In its risk factors, Tesla states among many other points: ‘We have no experience to date in manufacturing vehicles at the high volumes that we anticipate.’

The mass market Model 3, unveiled in March, has had 400,000 pre-orders – nearly all of Tesla’s planned annual production by 2020 of 500,000 vehicles. In 2016, the company produced only 84,000 vehicles. It may well succeed, but it does not have the track record to make this a safe judgement.

The incumbents are not sitting on their hands. All are building, or have plans to build, electric vehicles. Ford plans to invest $4.5 billion (£3.4 billion) and introduce 13 vehicles, representing 40% of its model line-up. Volkswagen is aiming for 30 electric models to comprise more than 20% of its total sales by 2025.

Tesla and others may well make significant inroads into the electric vehicle market but there is no obvious reason why the traditional carmakers should not be successful with electric cars.

In our global portfolios we have had five investments in the automotive sector, mainly successful, since 2010: Fiat, Renault, Volkswagen, General Motors and Toyota.

Predicting disruption

While it is true that the speed of obsolescence today is staggeringly fast, not all disruption is successful. Even when it is, it can take much longer than expected.

In 1967, The Harvard Business Review published an article by Messrs Doody and Davidson that described a world of ‘online tele-shopping’, next day delivery and electronic payments. They envisioned a world where ‘a substantial share of staple groceries, toiletries, drugs and household supplies may be marketed through relatively few large central distribution facilities in each major market area’.

Their clarity of vision was remarkable but they were wrong in respect of timing. They had argued that all of the technology elements were available at the time and that they foresaw their vision becoming ‘commonplace sometime in the 1970s’.

Investors have shown repeatedly that they too share this foible, tending to draw steep straight or parabolic lines for such transitions. While this is certainly true in some areas, like music and video, in others the gradient of the lines are much shallower, such as the replacement of the venerable mainframe computer, which was forecast nearly 40 years ago, and that the age of the paperless office was finally within our grasp, with the launch of the iPad in 2010.

While the internet has transformed retail, its impact varies massively across the different product categories. The innovation brought by the likes of Amazon has laid waste to many bricks and mortar retailers from across many categories.

Yet Amazon remains mired in losses in its efforts to ‘win’ in online grocery, which is proving a very hard slog. Amazon has about 1% of the grocery market in the US, albeit a quarter of the online US grocery market, some 10 years after ‘Amazon Fresh’ was launched there.

Today Amazon stocks more grocery items than Walmart and with prices that match, but Amazon and its competitors have clearly struggled with the difficulties of getting bulky, relatively low value items (including chilled and frozen) to the customer when and where they want it at a cost that makes sense for both parties.

Managers like us may be thought to have an old-fashioned approach to investing with the scale and pace of technological change rendering the patient value-driven approach obsolete.

In the rush to the new and exotic, investors tend to overestimate the scale and pace of disruption on those deemed to be disrupted, providing investors like us with a source of opportunity.

Sir John Templeton’s famous aphorism was that the four (or five) most dangerous words in investing are ‘this time it’s different’. Since only with the benefit of long hindsight will we know whether this aphorism still holds true, we stick firmly to the simple and time-tested theory that low valuations are the single most important determinant of future returns.

In looking at individual companies, we try to be sceptics, taking time to appraise the changing fundamentals; but we dispense with our view of valuations only when we see that the company’s prospects are indeed permanently disrupted. 

Nigel Waller and Andrew Goodwin are managers of the Overstone Global Equity fund which over the last three years has returned 56.1% versus a peer return of 45.8%

 

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