The COVID-19 pandemic and the ensuing response have fast-forwarded certain multi-decade societal and economic shifts into a period of months, turning what were once trends into mainstream norms that are now the new drivers of corporate and market behavior. We at Greenwood Gearhart have been pondering these now-accelerated shifts for some time. The following represents some of our views on this emerging ‘New World’ and, importantly, implications for investing. Specifically, we address the following:
- Demographics & the Digital Revolution: The accelerated secular economic and societal shifts associated with the millennial generation, now the largest consumer block, and the related disruption caused by the ‘digitization’ of the economy.
- Capitalism 2.0: The path forward with regards to capitalism and the dual roles of government and corporations in promoting positive social and economic outcomes for the majority of citizens.
- Implications for Investing: How these now-accelerated mega-trends impact the markets and how we expect to invest successfully long-term.
Demographics & Millennials
Much has been written in recent years about the secular shifts associated with younger millennials increasingly supplanting their parents’ generation as the largest consumer block. This generation, generally defined as those born between 1985 and 1995, was the first digitally native ‘Internet Generation’ and largely entered the workforce in the aftermath of the 2008 financial crisis, factors which have had profound impacts on how they spend money. While the impact of this shift varies by sector, some common themes have emerged. These trends are not necessarily unique to millennials, but rather, they have permeated virtually every aspect of human life, now indiscriminately due to the pandemic:
- Increased adoption of technology and digital business models
- Prioritization of convenience and value
- Focus on health, wellness, and lifestyle
- Importance of brand identity
- Heightened perception of corporate social and environmental responsibility
Millennials have a preference to do business with companies that make it easy for them, provide meaningful value for their money, and who they feel good about supporting. Companies, in turn, have strategically pivoted to attract millennials, as is seen everywhere from local grocery store shelves to online retailers to the proliferation of ‘apps’ for everything from banking to ordering food or even buying a home. Certain companies are successfully adapting their marketing and distribution strategies to serve these customers while others are not.
The Digital Revolution
A strongly related shift has been the pace of technological change itself, which has had the effect of blurring the competitive boundaries between companies and sectors in recent years as more and more of the economy goes online. With younger consumers being more flexible in their consumption habits, opportunity has risen for more technologically savvy players to jump in, offer a superior digital version of formerly physical product or service, and take market share in the process. In many cases, these companies are supported by venture capital backers willing to take seemingly unlimited losses in hopes of striking gold down the road. Netflix vs. movie studios, Amazon vs. almost any retailer not named Walmart, Facebook and Google vs. print news media and advertising, AirBnb vs. hotels, Uber vs. taxi cabs, Zoom vs. business travel. We expect this list to grow in the coming decade and beyond. These newcomers or ‘disrupters’ will inflict serious damage upon the incumbents because they have something their legacy competitors lack: digital economies of scale. A valuable attribute of computer code is that it doesn’t matter if you sell ten copies or ten million copies, the single biggest cost – writing the code to begin with – is essentially the same. So with every additional sale made, the portion that is retained as profit increases, to the point where the fixed cost is spread out across such a large sales base that they can essentially offer it ‘free’. And if the company is able to find other ways of making money on the back of this then they can be quite profitable indeed.
This concept is sometimes referred to as ‘zero marginal cost’, and, after compounding of interest, may be the single most significant economic force in the world today. An example of a zero marginal cost product and its underlying services is the Google Suite (Gmail, Docs, Drive, Calendar, Meet), provided largely free of charge but which supports Google’s core business of search and advertising. Likewise, Facebook charges nothing to the user but makes substantial profits off of user data and advertising. On the flip side, some companies such as, Uber or AirBnb, have yet to prove they can sustainably turn a profit and may not outlast their investor capital, but are nevertheless inflicting great damage on incumbent competitors in the meantime. Because these ‘disrupters’ can instantaneously distribute their services to millions of customers over the internet, any existing firm doing it the old-fashioned way can suddenly find themselves unable to compete. While some legacy companies with strong competitive advantages and balance sheets, like Disney and Walmart, have had the lead time and resources to successfully defend themselves, many others are fading away by either being too slow to adapt or burdened by issues such as excessive debt. As Warren Buffett famously said, “you only find out who is swimming naked when the tide goes out.” Nieman Marcus, Hertz, and J.C. Penny were all swimming naked when the tide of COVID-19 finally exposed them.
The zero marginal cost phenomenon is applicable in others areas like energy, where technological advancements and scale are bringing down the costs of solar and wind below their fossil fuel brethren, or in the emerging ‘Internet of Things,’ where physical devices such as appliances, lights, cars, and home ‘assistants’ connected to the internet ‘tap into’ these free services, offering superior value over legacy devices. Identifying companies that employ these attributes will, in our opinion, inform a successful investment strategy going forward. Critically though, we must be confident that a company is fundamentally viable for the long term and not just riding high on investor enthusiasm.
The pandemic has also reignited the debate about the inadequacies of our current economic systems and the role of capitalism in the 21st century. The question we hear more and more is: What economic system can ensure the best social and economic outcomes for the majority of citizens and what are the appropriate roles of government and corporations in such a system? This question, combined with the aforementioned demographic and technological shifts, are further disrupting long-established business models in a variety of sectors. In many ways, the market has already begun placing its bet on the companies best equipped to compete in this emerging ‘Capitalism 2.0’.
This debate has perhaps been no more spirited than in discussion of labor markets. Greater adoption of technology has accelerated globalization and the outsourcing of jobs. As the world has become increasingly interconnected, companies have found themselves able to tap into cheaper labor markets elsewhere at lower costs. The resulting deindustrialization of the Rust Belt and widespread closure of factories had profound economic and political consequences in the West, including the rise of populism. And while the pandemic is renewing calls to bring manufacturing supply chains back home, the vast majority of these lost jobs are unlikely to come back due to another force: automation. Just as Americans have become comfortable ordering on Amazon or calling an Uber, companies likewise have been adopting robots and other automated systems in their factories, allowing them to both reduce their workforce while replacing well-paid engineers or machinists with lower paid workers. A similar dynamic has occurred with corporate support functions, such as call centers or payroll either migrating to cheaper places like India or otherwise being replaced with software. With the pace of technology only accelerating, the marginal value of a human worker is going down over time, resulting in more people working in lower paying service jobs as formerly reliable middle-class jobs disappear in developed economies. We are only beginning to see the impact of this shift.
The net result of these trends is an increasingly ‘winner take all’ economy where there are fewer companies competing, fewer companies capturing the majority of growth, and fewer human beings employed in the ‘winning’ knowledge jobs versus the contracting manufacturing or stagnant service jobs. A simple look at the changing composition of the S&P 500 illustrates this, with the top five companies increasing their combined share of the index to 20% and being responsible for a full 27% of total return over the last five years. Not surprisingly, these are the ‘mega-cap’ tech companies we all know of, but the trend of ‘winner take all’ is continuing down the line into more and more sectors as these disruptive forces increasingly dominate.
Coupled with other factors, such as taxation and share repurchases, a narrative of the ‘rich getting richer’ has emerged in recent years. The pandemic has served to simply accelerate this trend, or more accurately, to illuminate what had already transpired as the surge in layoffs has disproportionately impacted lower wage workers for whom ‘working from home’ is not an option. These layoffs have also disproportionately impacted minority communities where the share of low wage jobs is high, helping to further inflame racial tensions as these people struggle to find a new job, pay their rent, and make ends meet. While some of these jobs will bounce back with a successful reopening of the economy, many, such as those impacted by the surge in retail bankruptcies, will not. This, in turn, will result in significant variation across communities in terms of unemployment, eviction rates, small business closures, social unrest, and overall community resilience.
With governments largely paralyzed by political gridlock, the duty has fallen increasingly on corporate America to address these trends and the risk they pose to our economic system. Notable CEOs like Jamie Dimon of JP Morgan, Larry Fink of Blackrock, investor Ray Dalio, and Microsoft founder Bill Gates have been leading this emerging conversation about what Capitalism 2.0 looks like. Local executive Doug McMillon of Walmart is currently leading the Business Roundtable, which broke ground on this topic in August of 2019 by releasing a new statement on ‘The Purpose of a Corporation’ as one that moves away from ‘shareholder primacy’ towards a commitment to ‘all stakeholders’ – customers, employees, suppliers, and communities included. With the public placing more and more trust in corporate leaders over politicians, this conversation is growing louder by the day and McMillon is likely to emerge as a prominent voice in this discussion. Simply put, there is a growing consensus among business leaders that capitalism is not dead, but rather needs adjustments to address this growing wealth and labor gap and contribute to better outcomes for citizens. With socialist leanings gaining traction in the West, it’s clear that changes are coming, either by necessity on the part of corporate America or through the force of elections.
We believe societal and demographic trends will further drive these shifts. In a world where technology is leveling the playing field, companies increasingly need consumers and investors to want to do business with them. The importance of brand identity and corporate image is increasing with a new generation taking the reins, and companies perceived as being positive forces on society are, over time, likely to accrue incremental business away from those deemed as contributors to the problem. This is already manifesting in a variety of sectors, from retail – where brands are building entire marketing strategies based on taking a stand on social and environmental issues, to energy – where a variety of public sector pensions, corporate retirement funds, and sovereign wealth funds have divested from fossil fuels. A look in just about any company’s annual report is full of graphics and CEO commentary highlighting the strides the company has made on issues such as workplace diversity, gender equality, environmental sustainability, and employee satisfaction. The result of these trends is that those perceived on the ‘better’ side of the spectrum are likely to be rewarded with a premium market valuation and easier access to capital. On the flipside, companies on the wrong side of history and with a smaller buyer base are more likely to trade with a persistent discount, perhaps eventually running into the risk of banks backing away. The markets have shown, and companies are figuring out, that doing the right thing on social, environment, and governance (ESG) issues is great not just for public relations, but for the bottom line and shareholder value as well.
Implications for Investing
From accelerating demographic and technological shifts to growing inequality, political gridlock, and a new, untested brand of capitalism, we believe the investing landscape is in the midst of a generational shift. Markets are also grappling with the long-term impacts of unprecedented monetary stimulus which has flushed the financial system with money, driven interest rates in developed economies to zero, and driven asset valuations higher. By peeling back the curtain and thinking critically about the implications of these trends, Greenwood Gearhart is charting an investing path forward that is well positioned to succeed.
One of the most significant implications is the increasing shift of economic activity from physical to digital domains. This doesn’t mean we are becoming actors in ‘The Matrix’ anytime soon, but it does mean that over time more and more types of commerce will be done electronically, and within strictly physical sectors, more aspects of the supply and value chain will be digitalized where possible. This has implications for margins, economies of scale, and competitive dynamics within every sector, which therefore implies all companies must have a strong technology strategy to compete going forward, no matter how physical they are. It’s not about investing in ‘technology companies’ per se, it’s about investing in companies that most successfully adopt technology and adapt to technological change. The relevant questions to ask are:
- How, and to what extent, is technological disruption a risk to this company?
- Does this company have an adequate technology strategy in place to remain competitive?
- How is this company positioned versus their competitors in this regard?
For some companies, it may mean simply optimizing inventory and distribution, for others, a reinvention of the entire business model. One side effect of this is that the owners of this digital infrastructure, companies like Microsoft and Alphabet, earn higher ‘tolls’ as sectors and companies increasingly make the switch. But that doesn’t mean they are the only ones who can reap the rewards. Any company which can effectively leverage technology to drive sales while lowering costs is likely to capture extra value. And the market is likely to reward those that it thinks has the best shot of doing so with a higher valuation. This is where we will ‘fish’ for opportunities.
Value Investing in the 21st Century
At Greenwood Gearhart we have long oriented towards the Value Investing school of thought with regards to equity investing. This philosophy can be summarized as buying the stocks of quality companies with stable and consistent profits at a discount to their perceived value (which the Father of Value Investing Ben Graham called the ‘Margin of Safety’) and then compounding that discrepancy over time, a strategy Warren Buffett is perhaps the most famous for employing. This style of investing is very long-term focused and has been demonstrated to generate attractive risk-adjusted returns over time throughout the boom and bust cycles typical of higher-flying growth stocks. Since price is directly observable in the market, this style of investing thus crucially relies then on one’s definition of ‘perceived value’. Traditionally, this has been focused on quantitative metrics such as current profits or the stated value of assets on the balance sheet and qualitative attributes like competitive ‘moats’ or barriers to entry. Some successful investors have even formulized this approach and made money by betting on the market eventually recognizing these underappreciated assets and ‘mean-reverting’ over time. But what now is ‘perceived value’ in the context of this New World in which we find ourselves? If a company operates in a ‘winner takes all’ competitive environment, will their business prospects and thus, underlying price, ever revert to the mean?
At the most basic level, owning stock in a company entitles one to certain percentage ownership of the underlying business, and thus a share in its stream of profits. The ultimate value therefore is linked to the sum total of these profits over time. For most of the 20th century, companies with strong competitive advantages enjoyed a relatively consistent and predictable income stream over many years, often many decades, notwithstanding interim disruptions like wars, financial crashes, and the like. What the pandemic and the technological, societal, and demographic trends discussed above have done is accelerate the overall rate of change to the point where many previously unassailable business models are now challenged, effectively cutting short those predicted income streams for a wide spectrum of companies. While previously an investor could reasonably expect a stable company to continue generating profits for say 5-10 years, and thus value the stock with a fair degree of confidence, it’s now difficult to see more than just a few years out, resulting in wildly different notions of ‘perceived value’ depending on one’s assumptions.
A further complicating factor is the effect of extremely low interest rates in developed economies, a result of two primary factors: 1) governments pursuing unprecedented monetary policies to stimulate growth and 2) the deflationary effects of technological change and globalization. The result of low rates has been to shift the market’s focus from current profits to future profits when valuing a stock, since the returns on ‘risk-free’ government bonds and thus the ‘opportunity cost’ of owning a stock is so low. Further, those future profits are expected to be ‘worth more’ in the future because low inflation means less erosion of purchasing power.
To illustrate, in the 1980’s you could earn in excess of 10% per year owning an intermediate term US Treasury bond, which compounded over five years, resulted in a 61% gain. Despite the inflation risks of the time, those were attractive returns for a ‘safe asset’, which meant to buy a riskier stock you’d need to feel that the chances of earning more than that were pretty good. Because future profits were far less certain than current ones, investors placed more importance on what the company was earning right then than it did on forecasting distant future profits. And why wouldn’t they, when there is a simpler, ‘risk-free’ alternative paying handsomely in their back pocket? The effect of this was a higher degree of skepticism or ‘discount rate’ on future profits relative to current ones.
Nowadays however, with interest rates so low, you’re expected to earn only a cumulative 3.5% after five years on that same US Treasury bond. Because certain equities offer higher returns (especially in this ‘accelerated world’) this dynamic ‘pushes’ more investors into stocks in search of attractive returns. Further, the profits a company is expected to make ten or more years out in the future matter considerably more now with interest rates low than in the 1980s, when there were attractive ‘risk-free’ alternatives out there. The effect of low interest rates therefore is to simply amplify the effect of the technological, society, and demographic trends discussed above with respect to the future profit stream. Not only are company’s future prospects more uncertain than they used to be, they now matter more to the overall stock price as well. This results in a greater complexity in stock investing because of how unreliable growth projections can be. In today’s environment, many investors are blindly rushing into ‘growth’ stocks with rosy projections. But if these projections fail to manifest themselves, the doorway isn’t big enough to accommodate the flood of capital out. Managing against this risk is important.
Finally, whereas the assets generating these profits were formerly hard assets on the balance sheet like factories and equipment, they are increasingly intangibles like software, patents, intellectual property, strategic positioning, and brand value that don’t show up so neatly on the balance sheet. In fact, many of the most valuable companies today with some of the strongest profits are ‘asset light’ in this regard. These ‘hidden assets’ are increasingly the source of many companies’ competitive advantage and what markets increasingly see as underpinning future profit streams. The end result of all of these factors – demographic changes, technological ‘disruption’, low interest rates, and rise of intangibles – has been that the traditional quantitative metrics defining ‘perceived value’ are less predictive of investment success than they used to be. The role of the investment analyst in uncovering true sources of value is more important than ever.
Value investing in the 21st century, therefore, seems best applied as an investment philosophy rather than a textbook-defined methodology. It’s an intellectual framework, a lens of evaluating a company’s prospects that strives to meaningfully approach the same core question: what does this company’s future profit stream look like? In the context of the current environment, that means identifying companies that both possess the following characteristics and expect to sustain them into the future:
- A strong chance of being around for a long time due to wide competitive moats
- Barriers to entry within the industry they operate
- Clear strategies for leveraging technology to improve competitiveness
- Nimbleness to adapt in an increasingly fluid marketplace
- Intellectual property that provides a competitive edge
- Strong brand and corporate image that resonate with consumers and drive loyalty
- High market share relative to the competition
- Above average margins, returns on capital, and top-line growth compared to competitors
- High quality (predictable) earnings that are reasonably expected to sustain
- Low-to-manageable levels of debt, access to liquidity, and strong balance sheet
- Reasonable valuation with respect to likely and conservative growth assumption
In the context of traditional value investing, these characteristics critically augment the textbook definitions of ‘perceived value’, as they reduce the inherent uncertainty of future profits. If the traditional formulation put as much emphasis on price as it did value, it’s now about placing paramount importance on the value, and then seeking to acquire it as cheaply as possible (for which the market often provides opportunity). Whether the company isn’t around in five years or is a shadow of its former self, the stock is unlikely to be a good investment regardless of how cheaply it was acquired or how strong its earnings or assets were when you bought it. The ‘Margin of Safety’ is present both in terms of price paid and, just as importantly, in the characteristics of the company, its business, its ability to leverage technology, and its competitive position.
Further, the sources of yesterday’s competitive advantages aren’t necessarily the sources of competitive advantages today. With respect to asset value, we pay just as much attention to intangibles such as reputation and intellectual property driving earnings power as we do hard assets such as industrial equipment or oil reserves that are increasingly subject to write-downs. With respect to earnings, it means thinking not just about the price you are paying for current earnings, but the price you are paying for earnings five years from now. This doesn’t mean trying to predict the future or paying up on the basis of rosy growth projections, but rather asking what might be the likelihood of the current earnings alone staying the same in a rapidly evolving technological environment? For a company that is growing significantly, what is a fair and conservative price to pay for that growth, or, a fair price for half of that growth if the company doesn’t quite live up to market expectations? If these questions provide for more uncertainty than answers, then perhaps the ‘perceived value’ simply isn’t high enough to begin with, or if so, requires a greater price discount to account for the existing priced-in growth expectations. Indeed, markets are starting to think this way as judged by the wildly variant cross-sector valuations. Companies that are growing reliably and predictably are being rewarded with a premium valuation, and the astute investor occasionally will find opportunities to purchase them at attractive prices.
Value investing works so long as its application evolves with the times. Just as Warren Buffett extended Ben Graham’s ‘cigar butts’ to buying ‘great companies at fair prices’, the New World demands a more comprehensive application of time-tested methods. Planes, trains, and automobiles aren’t going away any time soon (nor are oil or air travel for that matter). There is strong value in having a diversified basket of quality companies in different sectors which together reflect the overall economy – especially when managing a client’s full net worth – as is common for Greenwood Gearhart’s client relationships. This diversification provides an important hedge against cyclical or structural factors in any one sector and reduces the overall risk of the portfolio. But in this New World, qualitative analysis is more important than ever, the numbers then serving to reinforce and verify investment decisions.
We are at the start of a new decade and the investing landscape is as dynamic as ever. The world is experiencing the convergence of many secular ‘mega-trends’ with simultaneously evolving impacts of a global pandemic, untested economic policies, and socio-political instabilities. This reality is likely to accelerate a transition to ‘Capitalism 2.0’, as markets, businesses, governments, and citizens together confront these challenges and chart a new and more sustainable path forward. Greenwood Gearhart is ready. By employing a modern Value-oriented investing philosophy designed for the 21st century we intend to capitalize and grow your (and our) investment portfolios.