Crossing the digital Rubicon

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

Executive summary: In January 49 BC, Julius Caesar brought his 13th legion over the Rubicon river, at the time the northern boundary of Italy. Having crossed the Rubicon, there was no turning back. Indeed, his actions precipitated the Roman Civil War and led to Caesar’s rise to the throne. Consider now how all our behaviours have changed during the two months (and counting) most of the world has been in lockdown. From video conferencing to online purchases, digital has become the default. We doubt there is much turning back from this point. The future trends we have discussed regularly in the past are accelerating in both pace and intensity and our Fund is well-placed to benefit from them. At the same time, our emphasis remains on thematic diversification.

Most academic studies agree that it takes 66 days, on average, to form a habit. This can, of course, vary widely (the cited range is 18 to 254 days; read more here) depending on the person, behaviour and circumstances. What we do know is that the global events of 2020 – which none of us could have foreseen – have forced people to adopt a new set of habits very rapidly. The jury remains out on when, if ever, the world will return fully to normal. We are neither epidemiologists nor behavioural scientists, but we have strong conviction that some of the habits formed in lockdown will become so entrenched that they will be difficult to undo. More radically, it would be possible to argue that the pandemic has served only to accelerate the inevitable: the shift away from physical experiences towards a more digitally-dominated life.

When Satya Nadella, the humble yet generally perspicacious Chief Executive of Microsoft, the world’s biggest company, speaks, it is generally worth paying attention. During its last earnings call (on April 29th), he noted that “we have seen two years’ worth of digital transformation in two months.” What might he have meant by this statement? Well consider, simply, that COVID-19 has fundamentally changed how we think about the future. Pandemics are rare events at the best of times and this one is the first to have taken place in the digital world. Put another way, everything that we were already doing digitally has only intensified. Even if many did not have a choice in the matter – since they have been unable to leave their houses – digital yields clear benefits in terms of efficiency; doing more with less. We may well look back on this unique period as a clear tipping point.

We have heard similar messages from other industry leaders too. Dan Schulman, PayPal’s Chief Executive asserted that e-commerce trends had “accelerated by two to three years” when last speaking with the investment community (on May 6th). Meanwhile, Dan Rosensweig, the Chief Executive of Chegg made the bolder statement (on May 4th); that it was his belief that, “in every industry, a crisis often accelerates the inevitable and that is what we see happening in higher education.” People, places and things are being digitized, whether we like it or not.

Consider that there are 5.5bn adults on the planet. Of these, approximately 5bn have a mobile handset, 80% of which are smartphones. Furthermore, 1m more people go online for the first time every day (per the International Telecommunications Union and the World Economic Forum respectively). What are they doing with their phones? Well, what you and I might be doing too: communicating with others, both for work and pleasure, and sharing information as part of this process; shopping, learning and so on. Thought of another way, (almost) everything one might plausibly do in the physical world. If you can’t go to the office, see your friends, visit the shops or attend college, then you can still enjoy (an often superior) version of these experiences online.

Take the example of retail. Pre-pandemic, less than 3% of food and beverage purchases in the US were made online (per Euromonitor). However, as people were forced to stay at home, online orders have surged. During the first week of March, 11% of people surveyed by CivicScience said they were doing more grocery shopping digitally than physically. By the third week of March, this figure had grown to 30% and had reached close to 40% by the end of the month. Every one percentage-point of grocery retail that moves from the offline world to the online world in the US is equivalent to ~$10bn of spend (per eMarketer).

Now view this from a different perspective. Mastercard highlighted that 50% of its processed payment volumes in the first quarter of the year occurred without a card being present (i.e. were done online). The comparable figure for all of 2019 was 40%. Visa corroborated this data. Further, for those who decide to venture to shops, their use of contactless as a form of payment had accelerated substantially. Volumes here were up 40% year-on-year, per Mastercard. In a survey done by the business, 79% of its customers interviewed worldwide are now using contactless; 82% say it is “the cleanest way to pay” and 74% said they will continue to use post-pandemic for this reason and also owing to its speed.

It’s perhaps hardly surprising that people value speed and convenience; the promise embedded in online retail and electronic payment. Mastercard has been making the same argument for years. Its biggest competitor is cash. By volume, no more than 25% of all payments are currently done electronically (per Mastercard). The opportunity for conversion is significant, all the more so owing to the changes in behaviour brought on by the pandemic. Further, even if we purchase 33% of our electronic appliances and 28% of our sporting goods online (per Euromonitor, for the US), categories such as groceries – as noted earlier – are substantially lower. Globally, fewer than 15% of all consumer purchases are made online. In other words, the runway ahead is substantial.

The next question to consider is whether the infrastructure exists to support the shifts the world is undergoing. At the most basic level, every action has a reaction: we are producing and consuming more data. 90% of all data currently in existence was not even created two years ago (per McKinsey, for 2018). This ratio is likely to hold true or even accelerate going forward. Furthermore, Microsoft estimates that fewer than 100 firms collect more than half of the information they generate online. We have long asserted that for data to have any value, it needs to be stored, secured and analysed.

It is against this background that current consensus forecasts assume over $100bn will be spent in 2020 on hyperscale cloud projects by the eight largest players in the industry (per Bloomberg). Simply defined, hyperscale cloud relates to the architecture that scales appropriately as increased demand is added to the system. Think of it as high-performance computing with high availability and low redundancy. Listed alphabetically, the leading businesses are: Alibaba, Amazon, Apple, Baidu, Facebook, Google, Microsoft and Tencent. They have both size and strong cash balances in their favour.

The bigger challenge, we believe, is how to transform the physical world of retail, industry and their related supply chains into the digital world. This is not just a data exercise but a logistics exercise. What the pandemic has clearly highlighted is not only the more pronounced need to move online, but also to automate business processes. Even prior to the pandemic 87% of organisations surveyed by Zebra Technologies, a leading business within the field of automatic data capture and identification, said that they plan to expand their warehouse size while 86% stated that they wanted to increase the volume of items shipped. Facilities agree the need for speed is driving this expansion with 46% citing a need to support faster delivery to the end customer and 40% seeing an enhanced customer response.

Prologis, the largest owner of industrial real estate globally, estimates that accelerated e-commerce adoption and higher inventory levels have the potential to generate more demand for logistics real estate, equivalent to 400m+ square feet in the US alone over the next two to three years. Each 100 basis-point share shift from bricks and mortar to online translates into 46m square feet of net demand in the US. Do not forget that e-fulfilment requires three times the logistics space used by brick and mortar retailers due to higher inventory turnover levels, a broader product range (the ‘long tail’ famously cited by Amazon) and the shipping of parcels versus pallets. Furthermore, the experience of the pandemic will likely have brought home to many businesses the need to establish higher overall inventory levels than was the case pre-crisis in order to avoid shortages. As Charles Darwin wrote many years ago, it will be those species (businesses) “most responsive to change” that will endure.

Darwin’s quote is the guiding principle behind the Future Trends Fund: out-innovators – which we characterise as those businesses with research and development cultures and budgets that set them apart from their peers – should outperform over the long-term. The current crisis has been as surprising to us as it has been to everyone else. Nonetheless, we believe that the positioning of many of the businesses we own within the Future Trends Fund will only likely have strengthened as a result of the current crisis.

In terms of drawing the above commentary together, consider the following:

• ~10% of the Fund is exposed to growth in digital payments (Mastercard, PayPal);
• ~10% of the Fund is exposed to improving logistics as the retail world shifts from physical to digital (Jungheinrich, Prologis, Zebra Technologies);
• ~4% of the Fund is constituted by a direct play on the growth in online education (Chegg); and
• ~20% of the Fund is comprised of critical digital infrastructure that underpins and secures all of the above and more (Alibaba, Avast, Equinix, IBM and Microsoft).

Crucially, however, summing the above gets you to ~45%. Assuming ~5% cash in the Fund currently, what the above also implies is that ~50% of the Fund offers exposure to trends/themes other than those described above. As we have stated on many occasions, the Future Trends Fund is all about pan-thematic diversification, investing in everything from cloud (computing) to wind (turbines) and fish (salmon farms) to chips (of the semiconductor variety). Even if data is a crucial means to an end, it can bring benefits to many industries – not just those described in this commentary, but also others such as alternative energy, food innovation, healthcare, transportation and more.

Alexander Gunz, Fund Manager, Heptagon Capital