3 long-term themes that underpin the "Fourth Industrial Revolution"

Glenn Freeman

Livewire Markets

Often regarded as investor enemy number #1, uncertainty and volatility are key drivers of the short-term thinking that is so dominant in the retail market currently. 

Rising above the crowded trades to find more enduring opportunities requires a bigger-picture perspective that may be more time-consuming and trickier to achieve, but should ultimately yield better results. This is a core message Matt Reynolds emphasised in a recent interview.

"The Fourth Industrial Revolution"

In the following interview, the global fund manager’s investment director expands on one of these opportunities he addressed during an investor webinar earlier this month, where he discussed the structural shifts driven by cloud technology. Drawing comparisons with other world-changing developments such as the steam revolution that underpinned the industrial age, Reynolds and his team dub this the Fourth Industrial Revolution.

“There are studies that suggest the global spend on digital transformation by companies in 2020 was about US$1.3 trillion and there are forecasts suggesting this spend could increase to around US$2.4 trillion a year by 2024,” Reynolds says.

He details three layers of investment opportunities presented by this digital transformation, driven by Enablers, Solutions and Beneficiaries. 

Pointing to several companies as examples, Reynolds explains why he regards them as less economically sensitive than “old economy” businesses. One of these, the "Amazon of healthcare,” runs a global franchise of products that ranges from million-dollar medical machines to low-value consumables such as test tubes and pipettes. He also details the biggest risk for investors pursuing the cloud thematic and how to best mitigate this.

Edited transcript

Can you explain how the “big picture” thinking you discussed in your recent webinar, in your view, is more important than the reactive decisions we see so commonly in the equity market?

Investors generally are looking for drivers of change over the medium to longer-term and almost always, looking for positive change. When you're considering investment ideas, particularly big secular ideas as opposed to cyclical ideas – then finding secular, longer growth tailwinds for an industry and companies within an industry can be very powerful and represent enduring earnings drivers for companies.

Equity markets are quite efficient at discounting very near-term expectations – as an investor, this is an occurrence that might fall into your reactive bucket. When investors are very short-term focused and the market is moving, that type of discounting happens very frequently. But markets, arguably, become increasingly less efficient as the horizon of the investment extends out to the medium to longer term.

Bigger picture thinking allows investors to look further out to try to make sense of what a company or industry can achieve in that longer-term. That's why we use a framework like the cloud - because using a framework helps to give a structure to that longer-term thought process. As an investor, it gets you away from that near-term, highly discounted, highly efficient, and sometimes volatile short-term market pricing.

And that’s something all investors can do. There's no monopoly on thinking longer-term and no one owns the space. Clearly, institutions have the benefit of doing this for a living and they can have a structured thought process, but many individual investors also think long term.  All investors can take advantage of short-term price volatility to invest in companies in industries that they think have brighter prospects than what's perhaps being talked about on a day-to-day basis.

It's about balancing that short-term volatility and efficiency with the long-term, big picture analysis and thinking and striking a balance that works for you and your portfolio.

You speak about “three layers” to the investment opportunities cloud presents - can you talk us through them?

We use a simple three level framework that, I think, neatly captures companies and industries with exposure to the cloud. So the first layer comprises what we call the Enablers. These are companies that make hardware components, that build and power the cloud platform and its supporting infrastructure. These companies, if you like, make the physical pieces of kit that power the cloud. A good example would be the semiconductor companies like TSMC and even suppliers into the semiconductor manufacturing companies. There's a company in the Netherlands, ASML that makes the machines that sit in the semiconductor manufacturing plants. This type of "cloud-enabling" company that is, essentially, one of the physical equipment makers. 

The second level is what we call the Solutions companies. These are companies that are both infrastructure hardware-type companies, as well as software providers that offer the cloud as a solution to users. These companies combine both hardware and software. Examples include infrastructure companies such as Amazon Web Services and Microsoft Azure, which are two of the biggest solutions companies in the world.

On the software side, companies such as the software as a service company, HubSpot, are examples. That company provides cloud-based marketing, sales, and customer service tools to small to medium enterprise businesses.

Another example would be Sinch, which provides global communication platforms as a service based on the cloud. And at the solutions level are both the hardware, big hardware, as well as some of the software-to-service type companies.

The third level is a much broader level, and these are the companies that we call the Beneficiaries of the cloud. To us, the beneficiaries really take advantage of the ability of the cloud, to not only store vast amounts of information, but also to analyse that information for insights that are relevant for a company or an industry. Companies in this part of the cloud framework can use those insights that come from analysing the data, to make their own performance more efficient over time. And we can see these types of beneficiary companies being quite disruptive to their own industries. In the energy industry, for example, particularly in the renewable energy industry, offshore wind farm specialist companies are a good example. Also in the media industry, where I think everyone would agree that Netflix has proven to be one of the most disruptive providers of media and content that we've ever seen.

And it's the combination of the hardware and the software that allows the cloud to bring visibility analytics to a business, and some use of machine learning and artificial intelligence to existing business operations. The result is that this can be very good for growing, existing revenue streams. In Netflix's case, creating a whole new revenue stream, and also for incumbent companies that are operating in an existing industry. Actually, it can support potentially improved margins as well.

Part of our job is to do the research to find these beneficiary companies over time. That's what our investment analysts spend a huge amount of time doing: unearthing, and digging through companies in all of the industries, to find the management teams and the businesses that can take advantage of the opportunities that are created by the cloud. The second part of that is to have that long-term perspective and invest for the long term.

You've also spoken about how some of these companies, or these industries, are becoming less cyclical. Can you just talk us through a bit of the context for that, what it means, and how investors can take advantage of that decreasing cyclicality?

"Less cyclical" is shorthand for less economically cyclical. And this is where the cloud framework gets interesting because I see many beneficiary companies as being not overly dependent upon an upturn in the economy to be successful. So, the changes these companies are making are independent of the economic cycle, if you like. This is very attractive to investors because it means there are investment opportunities available in the market, and large numbers of companies are very, very dependent on the economic cycle to generate their earnings growth. For example, think of the banks, and the resource companies, the two classic examples. If investors can find and invest in companies that are not dependent on the economic cycle, especially not potentially affected by the down part of the economic cycle, then this can be very, very supportive of solid long-term investment results.

What are the specific sectors - and maybe some of the companies - you regard as the most appealing investment prospects and why?

If I can take a little step back for a moment, one of the reasons I've been labelling it as the Fourth Industrial Revolution, is that the abilities of cloud computing can positively impact a large number of companies in that Beneficiaries level. Other industries that could potentially benefit range very broadly, all the way from Utilities, and Healthcare sectors to Manufacturing, Agriculture, Education, Transport, and Government. There are companies in all of those sectors that are taking advantage of the benefits of the cloud. 

One of the numbers I look at to get a sense of how big this could be is the global spend on digital transformation. There are studies that suggest the global spend on digital transformation by companies in 2020 was about US$1.3 trillion and there are forecasts suggesting this spend could increase to around US$2.4 trillion a year by 2024.

So, the more industries that take on cloud computing and increase their proportionate spending here, and transform their businesses over time from a digital point of view, then that brings forth a larger number of ways cloud computing could be used, and this could underpin long term value creation across many cloud-related companies. And that's why we have the cloud framework, to find those companies and provide a degree of sensitivity to looking for those opportunities longer term. And that's where fundamental research kicks in, that's where looking for those companies and digging a little bit deeper in each of those industries, can reveal interesting ideas.

You described one company as “the Amazon of healthcare” - what underpins such a business and why is this type of opportunity being created now? What’s changed?

That's ThermoFisher, a business that sells a broad array of medical hardware and instruments, testing equipment, measurement equipment - it's a business you can buy almost anything from. You can buy very large machines, like DNA sequencers, worth over $1 million each but you can also buy right down to the tiny little test tubes and pipettes that are needed on a daily basis by labs around the world. So, in that respect, it's similar to the concept of Amazon, if you like, that almost everything is available to be bought.

It's not so much an opportunity that was created right now for that business, it was more of a global franchise that's been carefully crafted and put together over many years, and obviously, with careful management.

And it's an interesting business from an investor's perspective because, with the tests that are being undertaken around the globe with COVID, almost everything required by labs around the world to conduct these tests can be bought from Thermo Fisher. To their credit, many healthcare companies around the world are very busy, obviously, coming up with different ideas for vaccines and pandemic research. That all requires work, and it requires the purchase of new equipment, almost continuously, so from an investor's point of view, being able to access that thematic is interesting.

What are some of the biggest risks to these themes?

I think the biggest risk for investors is probably paying too much for the opportunities that come along at a point in time. In a rising interest rate environment, I think investors will probably keep their imagination when evaluating a company, and less so for the valuation, if you like. So investors will evaluate companies and have a view underpinned by a framework as to what the company can achieve long term. But in a rising rate environment, the valuation is going to be less imaginative, if you like. People are going to be a bit harder on the valuation. The risk right now is paying too much for that opportunity set, or that the investor makes a mistake in determining how big, or profitable, an opportunity can be.

It's really a stock-by-stock selection issue. Clear modelling of companies and their prospects is really important. Comparing the price that you are being offered today in the market to that longer-term value, is one way to dampen the risk of paying too much. I don't think you can ever remove the risk entirely, because by definition, the future is unknowable, but if you've got experienced analysts, and we're fortunate we've got many of them, you can certainly help to pick the right stocks for long term investment. And I think that is probably the singular focus for investors at the moment.

Position for the structural shifts driven by cloud technology

Capital Group believes in a smarter way of investing that combines individuality and teamwork into a tailored approach to help investors meet their goals. Visit Capital Group's website here or follow Matt Reynolds for first access to his insights. 

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the...

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