Over the course of this
research series, we have explored the structural force of disruptive innovation
and outlined how, in our view, this is accelerating. This has a range of
consequences for businesses, regulators and investors, which have been further underlined
during the current global health pandemic. Long-standing industry incumbents
such as fashion retailer J Crew, department store operators Neiman Marcus and
J.C. Penny, as well as car rental giant Hertz have all filed for bankruptcy
since the first instalment of this series. And as we previously highlighted,
the average tenure of a large-cap company has never been shorter than it is today,
a trend which appears to be gaining pace. This presents investors with a number
of compelling opportunities, but it also creates a considerable amount of risk.
The sky’s the limit for cloud-based services
At EdenTree, we continue to direct capital towards the enablers of this transition. One such area is Cloud-based services, which deliver technologies such as compute, storage, communication and security over the Internet. While the Cloud market has grown rapidly in recent years, adoption is still limited, as enterprises have only recently started to migrate mission-critical production workloads. According to the research firm Gartner, the market for Cloud software reached approximately $172 billion in annual revenue in 2019. This represents approximately 38% of the $457 billion global enterprise software market. However, keep in mind that Cloud software is not just chipping away at the enterprise software budget, but also at hardware, data centres, networking, I.T. services, and even semiconductors.
Since Cloud vendors are providing an all-in-one, pre-integrated solution, a greater share of the enterprise I.T. wallet is likely to be directed to the Cloud vendors in the coming years. Viewed this way, the 2019 estimated Cloud spend accounted for less than 5% of global enterprise I.T. spend of $3.73 trillion, leaving a long runway for Cloud vendors ahead. In total, Gartner estimates that annual expenditure on cloud technology will reach $328 billion by 2023 (representing a 5 year compounded annual growth rate of 18%), at which point, expenditure on Cloud would still only equate to 8% of total I.T. expenditure. We view this as a conservative forecast given the technological and economic benefits Cloud computing provides to its users. Those companies with scale and the most comprehensive suite of solutions are, in our view, among those that are best positioned to benefit from this secular trend.
In the Amity International Fund, this includes companies like Microsoft, Alphabet, Salesforce and SAP. Microsoft CEO Satya Nadella recently stated that the company has seen “two years’ worth of digital transformation in two months... There is both immediate surge demand, and systemic, structural changes across all of our solution areas that will define the way we live and work going forward.” In a world increasingly moving to the Cloud, but still encumbered by legacy investments, we believe that Microsoft (the world’s largest software maker and a leading provider of operating systems and productivity suites) is uniquely positioned to take an increasingly large percentage of global I.T. budgets in the future. The company is rapidly becoming a strategic partner in organisations' digital transformations, and key parts of its portfolio (Azure and Office 365) are serving mission-critical functions. With the unmatched depth and breadth of its technology portfolio, we believe the company has multiple levers to continue to grow revenue, margins, and its customer base over the next several years.
According to the research firm Gartner, the market for Cloud software reached approximately $172 billion in annual revenue in 2019. This represents approximately 38% of the $457 billion global enterprise software market.
Looking for tech-driven innovative business models
We also continue to direct capital towards those companies that are utilising disruptive technology to enhance their existing business model. One such example is the sportswear giant adidas, which is harnessing is technologies such as artificial intelligence, digital design software and 3D printing tools to enhance the sustainability, efficiency and economics of its supply chain, while also the quality and durability of its products. The company is also in the midst of a strategic shift towards driving a greater proportion of its sales volumes through direct channels (including e-commerce and company owned stores). And as result of investments in direct sales channels, the company’s e-commerce revenue growth grew by a ”triple digit percentage" magnitude (on a year-over-year basis) in April 2020, following +55% in March and +35% in Q1 2020 (all measured on the same basis). As a result the company recently raised its FY2020 e-commerce revenue target to more than €4bn (equating to approximately 30% of the overall business).
As for the risks that accelerating disruption presents, we believe that it is essential to ensure that companies continue to seek to improve their offerings and their operations. As Kodak proved, a dominant market position for an industry incumbent counts for nothing if that market is facing structural challenges. Consequently, a company’s commitment to constantly improve and evolve forms a key part of the fundamental research process. We believe this is achieved by assessing a company on a number of investment-focused metrics including R&D expenditure (in absolute terms and relative to top-line and cash flow), capex to depreciation ratios and return on invested capital metrics, to determine a company’s willingness, ability and success in investing for the future. We also engage with companies frequently to evaluate their strategy around sustainable growth, industry competition and long-term capital allocation. Overall, this helps us determine how prepared a company is for disruptive change.
From a portfolio management perspective, the permeation of disruptive innovation affects every sector of the global economy. As a result, transformative innovation cannot be categorised into traditional sectors or even geographies. Traditional market cap and style-focused equity strategies are centred around benchmarks and indices that are backward-looking in nature, and do not adjust rapidly to change. As a result, those investment strategies that are built on past frameworks may miss the opportunities and the risk that innovation can lead to. As Amara’s Law protests, "we tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run."