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Companies to live or die on digital strategy

Damien McIntyre
— 1 minute read

The ability for companies to pivot their offering to a more digitally focused strategy is likely to determine their longevity, with COVID-19 accelerating the pace of change.

Damien McIntyre

It’s one of the biggest questions global fund managers are asking chief investments officers and chief executives of the companies they’re investing in – what’s the company’s strategy for the digital age, and what’s required to achieve this?

To put it simply, without a digital strategy, a company will not just be surviving; it will die.

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For investors, the COVID shock is best viewed as a forced experiment, compelling much of the economy online, into the digital sphere, and offering an opportunity to assess what works and what doesn’t. 

In a recent investor communication, Bill Priest, executive chairman and co-CIO of Epoch Investment Partners, noted the pandemic had massively accelerated the adoption of remote activities such as working, studying, shopping, consulting a physician and exercising from home. It is likely that some telepresence activities will snap back, like a rubber band, to their pre-COVID levels post the pandemic. However, he said much of the digital acceleration will be permanent. For most activities, hybrid models will prove most resilient and successful. Consequently, in coming years, technology – the great disruptor – is likely to play an even more central role in shaping the modern economy and driving equity market returns.

From a macro perspective, digital platforms feature low marginal costs and increasing returns to scale. This creates winner-takes-all markets that favour global champions. Further, the asset-light business model in which technology is increasingly being substituted for capital and labour – points to improved free cash flow margins and higher return on investment. This will allow many companies to increase dividends and buy-backs, keeping overall payout ratios well above historical norms.

Even before the pandemic the digital economy was growing more than four times as quickly as the rest of the economy. With the lockdown-induced boost, this growth differential is likely to increase even further. While historically low-interest rates help buy time for the rising proportion of “zombie” companies, they can’t escape the gale-force headwinds posed by the accelerating substitution of technology for labour and physical assets. As companies seek to improve their profitability in a slow-growth world, this means capital-light models will prevail in all industries.

While the digitisation of the modern economy has been turbocharged by the pandemic, that is not the only catalyst. Mr Priest said other critical factors include massive improvements in tech hardware, cloud computing, the ongoing roll-out of 5G, and exponential gains in AI efficiency. 

With an increasing proportion of activities moving from traditional bricks and mortar to the virtual world, he said digital platforms will soon likely represent the vast majority of equity market capitalisation by the end of the decade. The heaviest concentration will be in areas of technology, science and arguably, communication-based stocks.

The well documented and much-hyped FAANG stocks, comprised of Facebook, Amazon, Apple, Netflix, and Alphabet (formerly Google), accounted for a staggering 50 per cent of the S&P 500’s rise since 2015. As an active manager using this index, it will be a struggle to outperform if you don’t have a stake in any or all of these stocks, making the case for a strategy in the digital age even more compelling.

At the core of digital business strategies is the notion that data is the new oil. Reflecting on world wars over the past few hundred years, they were always territory or resources-based. But the war today is about data: who can gather it, who can interpret it, and who can apply it? It’s all about data and the ability to aggregate content seamlessly to the benefit of the end user.

The FAANG stocks have positioned themselves to be at the forefront of this new world order with data, capturing it and using the trends in steering the business forward. 

Another similarity between these stocks – which may go some way in explaining their outperformance over a sustained period – is their ability to generate free cash flow which is then reinvested into the business. The future growth rate that will accelerate that cash flow and the multiples today make them very reasonable buys, particularly Facebook, Amazon and Alphabet (Google). 

Mr Priest said that while it’s impossible to predict whether this level of outperformance will be the same moving forward, the concept these companies all represent will grow increasingly relevant. They dominate strategies in their respective market segments, and they’ve employed digital technology to get there.

Favoured companies that possess superior managements with effective capital allocation policies will likely be stock winners. These attributes are likely to be even more important going forward, as management is tasked with creating value by marshalling talent and technologies during a period of unprecedented innovation and disruption.

Damien McIntyre, chief executive, GSFM

 

Companies to live or die on digital strategy
Damien McIntyre
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