The Times recently featured a rather curious article titled “Enjoy those gadgets while you still can” by Gerard Baker in which he bemoans the lack of innovation in the last decade. (link is to the Australian which allows a sample view). In fact, it looks like he is making the common mistake of confusing invention and innovation – a very important distinction for investors. He is correct that inventions such as the smart phone are not ‘new’, that Google and facebook have now been quoted companies for over 15 years and doubtless the source for his article – he quotes a Stanford University Study about falling productivity run scientific R&D – is also correct. But it is innovation around existing technologies that drives productivity, economic growth and ultimately makes people’s lives better. Moreover it is the bottom up process of identifying and responding to a market need or demand that does the work – rarely if ever is it anything to do with central planners. For investors it is also important to remember that the majority of the benefit of innovation goes as what economists refer to as a Consumer Surplus not a Producer Surplus. In other words, the company coming up with the new and exciting products isn’t always the one that makes the most money from them and the majority of the economic benefit does not go to shareholders, it goes to the consumer.
For example, ten years ago music streaming barely existed, yet now it accounts for almost half all music revenue with 68% of adults using some form of streaming service. The consumer surplus is obvious – your own radio station, either free with adverts or uninterrupted for the price of one CD a month. The losers are equally obvious, indeed, often the real importance for investors is not to find the winners, but to recognise the potential losers. It may well matter less to have bought into what were then tiny companies such as Spotify or Netflix (although the latter certainly paid off) as opposed to avoiding exposure to old retail like HMV or Blockbuster. Subsequently, streaming has changed the economics of film and television production and distribution as well as the actual products delivered. Instead of producers as well as ‘artists and creatives’ deciding what will sell, the algos are doing it instead. One small example, because musicians don’t get paid by Spotify unless the user listens for more than 30 seconds, many songs are now starting with the chorus.
The same issue of consumer v producer surplus is true of companies like Uber and Lyft. The innovation of using an App based service to deliver what are essentially owner-driver mini-cabs has transformed the lives of the users far more than it has enriched investors. Equally it has made things a lot harder for existing taxi services, which is why there is so much ‘resistance’ in many major cities from authorities claiming (somewhat unsuccessfully) to be looking out for consumer safety rather than producer interest. In fact ‘the naughties’ could be categorised as the decade when Applications of existing internet technology to existing consumer products really took hold. It was a decade of innovation rather than invention and it made certain companies extremely profitable while driving some big names largely or entirely out of business. Internet shopping is probably the most obvious example, transforming the physical high street as well as the consumer sector of stock markets. All (surviving) big retailers now have some sort of ‘omni-channel’ approach.
In this sense, the role of Apple was key, not only in producing the Ipad – in January 2010 – but also, more importantly, the IPhone 4S in November 2011. With a combination of Siri voice recognition, the iCloud and, perhaps more prosaically but in many ways more importantly a high definition camera, which in turn drove the whole chat and instagram culture. I recall being asked by some consultants in 2012 whether Apple was more likely to ‘double or halve from here’ – having gone up almost 70% relative to the S&P after the Ipad and then a further 56% after the IPhone 4S. My reply was ‘both’, that it was more likely to go down first (having been overhyped) but subsequently its central role in the hardware space meant it would then reassert its rise. The process was of course a classic trading move of one step forward two steps back – it fell 17%, then rose 32% then fell 44%. Then it doubled as the cash began flowing. And kept going.
As well as hardware, streaming and other ‘cloud based’ services have been made possible by exponential gains in storage capacity and its resultant price drop. A Gigabyte of storage had already come down from $1m in 1967 to just $1 for flash storage by 2010. Ten years later it is less than 2 cents a month for online storage and there are offers for 1000 gb at $4.99. Innovation in ‘stacking’ NAND drives vertically is just one way in which companies like Micron and Intel have been constantly improving the performance and in doing so ‘enabling’ all the other innovations to arise.
Another innovation of the last decade that was actually commercial exploitation of an old technology was fracking. The process of hydraulic fracturing, or fracking had been around for decades – indeed technically since the US civil war – but it was only the pick up in oil prices after the financial crisis that triggered the capital investment that essentially turned the US into an energy producer rather than a consumer and led to all the import LNG terminals switching to be export terminals. In doing so this trend initially helped investors although have subsequently led to substantial losses, while the consumers (including other businesses) have continued to benefit from low energy prices. The big losers of course have been the coal producers and while some would claim this is down to concerns over climate change, we very much doubt that without the ‘new competition’ from cheap and available gas that the US authorities would have allowed US energy prices to rise or the US to become any more dependent on the Middle East. As part of the new ‘trade deal’, the US expects China to import lots of LNG (along with agricultural products) which also adds a different dimension to GeoPolitics that would not have been there without this innovation.
In the article Gerard Baker briefly mentions digital payment systems and here again, this is innovation rather than invention and has succeeded because it delivers a consumer surplus in terms of convenience. Importantly much of the drive for this has come from China, which has been one of the major forces for change in the last decade as its vast and growing consumer base (there are now more middle class Chinese than there are people in the entire population of the United States) has combined with a lack of legacy issues and a government actively driving all aspects of infrastructure. Tencent and Alibaba dominate and it is difficult to see how the US competitors among the FANG stocks can get any meaningful foothold, suggesting that their projections of global advertising growth (with them capturing major market share) may be too optimistic. Here of course, Gerard baker is right, they may be the biggest stocks in the world right now, but Facebook and Google are basically digital advertising stories, while their ability to monetise their data, seen by investors as a huge positive but by consumers as a negative, is likely to be decided by regulators in favour of the latter. Indeed, it is difficult to imagine that the biggest stocks in the world at the end of the next decade will contain many or indeed any of the FANGs – an important point for passive investors to consider.
Banks are also challenged by new digital payments systems, but in other ways protected as most of the systems still rely on underlying credit cards. However, the model of (still) ultra high interest rates for short term credit balances that underpins these systems will get competed away leaving many banks as regulated, utility like structures underpinning assorted fintech innovations. Blockchain and bitcoin, two of the big hype stories of the latter half or the decade will continue to disrupt producers of legacy products rather than create new products, threatening huge compression of professional service fees in particular.
In terms of other innovations of the last decade, the internet of things and connectivity generally is a clear consumer surplus product, with manufacturers ‘required’ to incorporate this into their products, but as yet the real ‘killer app’ has yet to appear so beyond the suppliers of components it’s difficult to invest in this as a theme. A similar hype had previously surrounded issues such as 3D printing, which continues to enhance productivity rather than produce meaningful end consumer products. In a similar way, we regard Robotics as enhancing productivity rather than replacing humans.
Autonomous driving is another overhyped product in our opinion – its most likely future use being in operating some forms of mass transit systems rather than at the individual consumer level, with more of a ‘drive assist’ mode for consumers. These vehicles will almost certainly be electric – another innovation rather than invention of the last decade. While electric cars were ‘invented’ in the 19th century, it was only really in the last decade that Tesla transformed the industry. Now, with all the major manufacturers offering hybrids and increasingly pure electric vehicles we see the information flow set to turn steadily positive, partly because battery life is getting longer and people are recognising as spurious claims that cars producing zero roadside pollution are not green unless they are powered by clean energy power-station (in which case nor are the computers being used to write the commentary). Mainly however, it is likely to be that the big auto companies, who let’s not forget are some of the biggest advertisers in the world and thus exert a high degree of influence over the media, are now competing in the hybrid/electric space rather than trying to hinder competition to their ‘old’ technology. In our opinion, the big breakthrough will be when large trucks and buses can be meaningfully run as electric.
Materials technology has also been quietly working in the background, not by invention but by innovation. In medicine, carbon fibre is working with existing products such as titanium in the field of implants, while battery technology feeding into electric vehicles is getting steadily, if not exponentially, more efficient.
Elsewhere in medicine, the mapping of the human genome back in 2003 was also a bi-product of faster computing systems and the last 15 or so years has seen tremendous benefits in terms of medicines and treatments, particularly for cancers. Crisp-r gene editing technology is offering the exciting prospect of solving genetic diseases while simultaneously producing some serious ethical dilemmas. Meanwhile, chatbots, robots and other automation are transforming the efficiency of medics and the patient experience.
Looking forward, the developments in Quantum computing look extremely interesting, not so much that it is faster but that it has the ability to deal with vastly more complex problems. The most interesting areas are probably AI and molecular modelling – the ability to create entirely new drugs or materials, but it also presents challenges for existing businesses. For example, while it is possible to make encryption ‘Quantum Computing proof’, most of the current structures are not, meaning that anyone with an operational Quantum Computer could effectively hack almost any security system. Something that would ‘normally’ take thousands of years to crack can now theoretically be done in minutes if not seconds. However, whether it can ‘crack’ financial markets, or even the weather remains to be seen!
