Until now, the primary beneficiaries of the increased technology spending on cloud infrastructure, subscription software-as-a-service, automation, artificial intelligence (AI), machine learning, and digitisation have been the suppliers of the technology. However, we expect the future incremental profit pools of the technological transformation of the economy to accrue to the firms with the size and scale to deploy the technology to transform their businesses. Combined with the valuation disparity with growth vs. value in which the excessive relative-growth valuations are these same firms, this is an interesting time for investors to evolve with them as valuations support it. Specifically, much of the innovation of industrial and financial cyclicals that have leading market positions and will exploit such technologies resides within value, less so in growth.
We expect the future incremental profit pools of the technological transformation of the economy to accrue to the firms with the size and scale to deploy the technology to transform their businesses.
We believe this transformation is in the early stages of playing out. The companies deploying technologies such as cloud infrastructure, automation, and artificial intelligence have already spent vast amounts of capital, which is why the suppliers of the technologies have had massive growth in profits and market capitalisations. While the argument could be made that the value created from that investment has already shown up in higher market shares and greater efficiencies for the large industrials and financials, most of the value creation is yet to come for two primary reasons:
- there will be significant capital investment; and
- the return on that investment takes years to be realised.
For example, the market share growth of the big banks, while already increasing, will have years of acceleration as the technology investment is scaled. Similarly, factory automation is very early stage. Thus, within value, we believe this dynamic is an advantage for active portfolio management with a deep fundamental approach, combined with disciplined valuation as the medium-to long-term winners may not be obvious right away. By comparison, growth investing in some ways has become more straightforward because there is an immediate impact from technology spending on the revenue and profit growth of the technology suppliers. For example, the three dominant cloud services providers are well known and it is easy to follow their progress each quarter; the same can be said for software-as-a-service providers within each total addressable market. Investment performance becomes more of a valuation exercise, which still requires a thoughtful, fundamental view, but arguably is less complex and nuanced than assessing the winners of longer-term trends for the technology adopters such as structural improvements of efficiency ratios for banks, sustainably increased market shares, and less cyclical industrial operating margins.Three groups that represent about 25% of the value index have transformational opportunities.
The four biggest US banks collectively spend 1.5 times the more on technology per year than all the remaining US banks combined. This is reflected in their market share.