Key themes in the tech sector
Alphabet. Amazon. Microsoft. We all know who they are, we all use their technology, but what does the future have in store for some of the worlds most recognisable firms. To help answer this, we sat down with portfolio manager Chris Wheldon to get his thoughts on several key investment themes in the technology sector. In a thought provoking discussion, Chris touches on a variety of issues including the future impact of driverless cars, the potential winners and losers in the smartphone market, one of our highest conviction holdings and one company that he believes could be the next Amazon.
Chris, we're hearing more and more about artificial intelligence. Maybe you could give us a bit of an insight into some of the leading companies as well as some of the emerging companies in that field.
We are hearing more and more about it every day, but not only that, we're touching it and experiencing it more in our daily lives. It might be something like a Netflix serving us video recommendations, Amazon serving book recommendations or Google Maps telling us the fastest way to get from point A to point B. These are all examples of artificial narrow intelligence, and it's worth just separating artificial narrow intelligence from artificial general intelligence. AGI in layman's terms, is this super human intelligence that the industry seems to be working towards and some experts are quite concerned about. But artificial narrow intelligence is what we're all experiencing ourselves these days. And it's quite limited to certain industries and use cases as described above.
You think through artificial intelligence, what’s really required to make it all work is huge amounts of data. High quality, high fidelity data. Services like machine learning and natural language processing, computer vision, they need an enormous amount of data in order to work, and that's why we like companies like Alphabet. You think about all the data that Alphabet collects about clicks from us as users of its services. Alphabet has nine different apps or services with over a billion monthly users. So that can be things like Maps or Gmail or Google Calendar, Google Search, all with over a billion monthly users.
On top of that, there are over 6 billion search queries on Google every single day, so an enormous amount of data coming into Google, which allows them to refine and improve their AI services.
You combine all that data with Alphabet's, $20 billion annual R&D budget, and the fact that roughly half of the top 100 AI engineers and academics around the world work at Alphabet, its clear to see that they bring a lot to the table here in terms of their AI capabilities.
They are also creating new businesses, like Waymo, their autonomous vehicle driving unit. That service, that capability is all about creating the world's most capable driver, and that is a huge AI challenge. In the real world these cars have already done about 10 million real world miles on roads around the world. But more impressive than that is the 10 billion simulated miles, which is allowing them again to refine and improve those AI systems to develop this autonomous vehicle capability.
When do you think we'll see these autonomous vehicles and what are some of the potential implications?
I mean, they are already driving these cars around in the real world. It's not mainstream yet but they are on that journey. If you flew to Phoenix today, there are Waymo cars driving around autonomously in the city, around the airports. It exists. It's happening. This is not just a concept anymore. This is real world experience. When will this become mainstream? That is hard to know. I mean, there are use cases already in certain markets around the world. But there's a lot of debate in terms of how safe these things need to be. So there is a lot of water left to go under this bridge, but it is happening, we are moving in this direction.
And then that forces you to think through the implications. At an individual or household level, there's just less requirement for us to own our own car. So it's quite an obvious first order implication. But the second order implications are much more interesting, and in fact, harder to think through what the consequences could be.
You think about the auto insurance industry, for example. If we have autonomous vehicles driving on roads, they are mainstream, they are safer, why do we need to have auto insurance? So what happens to that industry over time? You think about the huge amount of land around the world, in our homes and garages or in public spaces with public car parking.
If we no longer have that ownership model, and instead, there's these fleets of autonomous vehicles constantly moving around and not parking anywhere, how are we going to repurpose that land?
There are other second order implications. If we are in these cars, as users of these services, and we're not in control and not driving them, what will we do with that time? Will we spend more time on Facebook? There's going to be a lot of commuting time in our day freed up that we will need to fill somehow. We don't know the answer to those things yet, but they will present opportunities and threats to various industries.
We've recently disclosed that Alibaba is in the portfolio in a meaningful position. What’s the thesis behind that holding?
There's lot to like about Alibaba. I think the two easiest ways to answer that question is for us to first to talk about what in the industry, in the market appeals to us and what is it about Alibaba specifically that appeals to us. If you start on the market side, you just have to recognise that in China today, there is an enormous market opportunity. We're speaking about a market with 20% of the world’s population. That in itself is an enormous market. But then you start drilling down into some of the growth opportunities, things like the middle class in China, which is already 300 million people and expected to double over the next 5 to 10 years. That's another 300 million people joining the middle class. That's the entire US population today. These are enormous numbers that can come into the consumer class, the consumption class in China going forward.
You still have urbanisation trends in China today. There's still another 30 million people in China each year that move from rural centres to urban centres in China, and with that comes job creation and spending power. There are already over 150 cities with more than a million people in them. So it's an enormous market with enormous growth tailwinds behind it.
What is it about Ali specifically that we find so appealing? Well it’s a very high quality business, which is always where we start at Magellan. The core of Alibaba today is its eCommerce marketplace business. That business has about 70% market share of all eCommerce in China, so it's incredibly dominant. And some of the numbers are quite breathtaking. This business is 20 years old, but it already has over 700 million users on those eCommerce platforms, that's half the China population today.
If you look at the value of the transactions that took place last year on Alibaba's eCommerce marketplace it’s about US$850 billion, which is larger than the entire US eCommerce industry.
They grew users by 20 million in just the last quarter. The eCommerce business has just under 70% market share. It's still growing its revenues in the 20 to 30% range. It earns margins of nearly 70%. So it's incredibly dominant, high quality and very profitable. But then there's all these other parts of Alibaba as well, which really interesting going forward. It has the largest cloud computing business in China, three times the size of its next largest rival.
You think about the growth tailwinds behind Cloud computing. Alibaba also has a big shareholding in the largest digital finance company and payments company in China. Again, thinking about the tailwind that will provide going forward. It is a gem of a business, leading positions across all these different parts that it operates. Long-term enduring tailwinds, the growth of the middle class, urbanisation, eCommerce, digital advertising, all these things are providing good visibility into the growth prospects of Alibaba going forward.
And we think it's cheap. We think it's meaningful undervalued at the moment, which is quite interesting. Because if you look at where it's trailing on a forward price earnings multiple, it’s about 31 times, which many people would look at and go, that's quite expensive. It's almost double where the S&P or MSCI global market is at the moment. But if you dig into the valuation, and you sort of strip back the different layers, and those nascent loss making businesses, if you kind of think about how they should be treated and valued separately. And just drill down to what that core eCommerce marketplace business is. That incredibly dominant, high growth, high margin business, you do that work, we think that's valued in markets today about 18 times Ford earnings, which is about where the S&P 500 is trading.
What we think is one of the highest quality businesses on the planet valued at about where the market is valued overall, but of course, it's growing 20 to 30% per year. It's got these enormous margins. It's very, very dominant in its industries. And has all these nascent but very likely high performing, high growth businesses attached to it, like the cloud business and the digital payments business going forward. So there's a lot to like Ali both at the market level, at the company level, and also from a valuation point of view, which is why, as you pointed out, it's become a meaningful position for us.
Let's talk about smartphones. Obviously, Apple and Samsung are the dominant players in that market. But presumably, there a secondary players that are involved in app software, other phone makers. What do you see is the future trends in this space?
Yeah, it's such a good question. We really like parts of this industry, not all of it, but certain parts of it, particularly at the operating system level. And you mentioned Apple, and the other key player at the operating system level is Android owned by Alphabet. That's effectively a global duopoly. Most premium smartphones around the world either run on Apple's iOS or Google's Android operating system.
That's important, because if you look across the rest of the industry, at the components and all the other parts that you spoke about, to be honest, the first issue we run into there is many of them are too small for us at Magellan. And that's always been the case. The second issue, which is just as important, is they're not of sufficient quality. And part of the reason they're not of sufficient quality is because they're often suppliers into Apple or Google. And when you have that duopoly to begin with, you don't have much bargaining power when you're trying to deal with these two big dominant players in the industry.
But that's not to say that there aren’t certain businesses that benefit and have benefited enormously from the growth in smartphones around the world, and the different components of smartphones and the software on them. If you think through our investments in Facebook and their suite of apps like Facebook, Instagram and WhatsApp, you think about our investment in Alphabet, in Google and Gmail and Maps. Even our new investment in Alibaba in its suite of apps. They were all benefiting from the growth in premium smartphones around the world.
We use these apps more and more every single day, because we're engaging with our smartphones more and more every single day. So those software players have been enormous winners in the growth in premium smartphones around the world.
And then there is going forward, as well, if you think about a business like Apple, which has really benefited from the growth in the hardware sales of smartphones over the last couple of decades. What you've seen at Apple specifically is a quite a meaningful pivot, not to the exclusion of the hardware business, they still sell a lot of iPhones every year. But they've recognised now that that is quite a mature industry. And around the world, many of the people that wanted and could afford a premium smartphone now have one. And so what we've seen at Apple is them pivot into services. And they're taking those very loyal users of iPhones and they're starting to sell services like Apple Pay, Apple Music and Apple TV, and things like the App Store. They are the growing parts and very high growth parts of Apple today.
The core hardware business, the iPhone business is still growing, but it's becoming much more mature business overall for Apple. But there's enormous growth going forward in a services part of Apple. So you really need to look across the whole smartphone ecosystem and recognise there parts that are still very good, but are slow growing.
Do you have a view on the greater growth potential? Is it in hardware or software?
That's a tough question. I'm not sure at a hardware versus software level, how to really answer that. But I think you need to go into the weeds a little on each of those different pieces. Because if you look at hardware, I mean, there are parts of consumer hardware that had become very mature and quite slow growth. We spoke about iPhone sales and other smartphone sales. The global personal computer market around the world is very mature, so you're not seeing much growth in certain parts of consumer hardware like PC sales and smartphone sales. But if you look at other parts of consumer hardware, wearables like AirPods, sales have performed incredibly well for Apple. Digital watch sales around the world are growing incredibly strongly.
Software seems to be growing quite rapidly, wherever you look at the moment. And to be honest, at Magellan, that's where we've been most interested over time, is software businesses because you tend to get higher quality businesses within software compared to hardware. Because you have these platforms, these network effects and these switching costs in the software space, that you tend not to see in the hardware space. So if you look at our investments in things like Microsoft, it has a series of platforms. The Windows operating system, Azure in Cloud computing, Office, you know, Word, Excel and PowerPoint.
Of course, Apple's iPhone operating system and Google's Android operating system are very, very dominant businesses that continue to grow very rapidly around the world.
So software, we would find more appealing, because there tends to be a bit more growth there and they tend to be high quality businesses.
But there are certain parts of consumer hardware and industrial hardware as well. They're also quite appealing, but we just have to be very selective about the quality of the businesses that we may want to get some exposure to for clients in the hardware space.
And so Chris, what would your next pick be for the next Amazon?
The next Amazon? That's a tough question. Because they've had tremendous success. Maybe a place to start would be Alibaba, that has core similarities to Amazon today. You look at the businesses in the industries that are in. They each have the respective leading eCommerce business in China and then outside of China. Amazon's very dominant in eCommerce around the world, Alibaba very dominant in eCommerce in China. They both had the leading Cloud computing businesses inside of China or outside of China. They're both in digital entertainment and all these other nascent businesses. So I think there is an analogy there. But there's there's other parts of Alibaba that don't look quite the same. I'd argue probably Alibaba is even a little higher quality than Amazon, though Amazon is a great business.
Maybe another way of thinking through that answer is, is potentially, this might sound a little odd but Amazon is potentially the next Amazon. And the reason I mentioned that is they have had a demonstrated ability to reinvent themselves and create new businesses within Amazon over time. You think for a long, long time this was just a core first-party marketplace business, where effectively they were buying inventory and reselling it on their website. And then they morphed into a third-party marketplace where they would allow other merchants to sell on their website. Alibaba never took control of that inventory. They just served as a marketplace for buyers and sellers.
Then they built a logistics business on the side of that, then they build out an enormous Cloud computing business, and the other into personal assistance in consumer hardware, and more and more industries around the world. So they've got quite a demonstrated ability to engage in meaningful experimentation and innovation. I think that comes right from Jeff Bezos all the way down. It's a cultural thing with it within the organisation. And I suspect, 10, 15 years from now, Amazon will look quite different from how it looks today. It might sound a bit of an odd response to the question, but perhaps Amazon is in a way the next Amazon.
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