Storm Uru

Why innovation is important to income investing

Storm Uru

In 2011, Marc Andreesen famously penned “Why Software Is Eating the World” in the Wall Street Journal. Today, the idea that “every company needs to become a software company” is almost considered a cliché.

No matter your industry, you’re expected to be reimagining your business model to make sure you’re not the next local taxi company or hotel chain caught completely off guard by your equivalent of Uber or Airbnb.

The playbook used to be simple – size and market power mattered – and the strategy was to create value by controlling the value chain and re-deploying capital to grow your competitive position. From retail to manufacturing, this concept is now broken, and more companies than ever are required to pivot and innovate in a digital world to keep pace with a new generation of software companies.

Business model innovation is not a new concept (just ask Clayton Christensen). It has occurred frequently, reshaping entire industries and redistributing billions of dollars of value. Retail discounters such as Wal-Mart and Target entered the market with pioneering business models and quickly grabbed powerful market positions in the retail sector only to bow to a new dominant player, Amazon.

Even with a backdrop of business model innovation, one theme has remained consistent, spanning across sectors from retail to manufacturing to healthcare: the benefits of economies of scale. It is often used by companies in strong competitive positions to capture the economic profit in a value chain and exploited by linear growth. Importantly, these companies tend to use size and market power to exploit suppliers, essentially meaning the firm with the biggest cheque book and strongest market position won.

During this time, industry dynamics tended to change at a rate that incumbents could respond to − but not anymore. Enter a new cohort of a well-funded, highly motivated group of software focused entrepreneurs intent on disrupting every industry, armed with new business models that tend to have a near-zero marginal cost of manufacturing and therefore near-zero marginal cost of distribution.

The velocity and breadth of innovation has caught many incumbents by surprise and has resulted in many lowering expectations for future growth. For evidence, you only need to look at a company’s proxy statements to see how management’s incentivised growth targets have collapsed over the last decade. In response, management teams are now aggressively reallocating capital to digital transformation, and, in some cases, missing the structural change by continuing to pursue old strategies from tried and tested playbooks.

One of the key themes starting to emerge is that digital transformation just isn’t that easy. In fact, McKinsey recently published a report highlighting that most companies fail to achieve a return on investment in digital transformation initiatives greater than the cost of capital.

Some compelling research conducted by the OECD adds some weight to these findings by showing that digital transformation is leading to a confounding outcome. Those with leading digital capabilities are simply extending their lead while laggards show no sign of convergence, historically a key characteristic in key technological shifts, such as lean manufacturing. 

This “productivity paradox” is creating a backdrop where it’s becoming increasingly risky to rely on reversion to the mean or investing in strategies that have historically withheld the test of time. This is why we invest in Global Leaders who do not just rely on size and market power, but also have a culture of innovation and are able to extend their market leadership position and increase dividends long into the future.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in funds managed by the Global Equity (GE) team may involve investment in smaller companies - these stocks may be less liquid and the price swings greater than those in, for example, larger companies. Investment in funds managed by the GE team may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The team may invest in emerging markets/soft currencies or in financial derivative instruments, both of which may have the effect of increasing volatility. Some of the funds managed by the GE team hold a concentrated portfolio of stocks, meaning that if the price of one of these stocks should move significantly, this may have a notable effect on the value of that portfolio.


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Monday, May 4, 2020, 10:10 AM