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Mastering megatrends

Trying to make money from a megatrend is loaded with risks. Daniel Liberto spells out what could go wrong and how investors can get it right
January 19, 2018

When I tell people I write about investing for a living, they occasionally ask for my opinion about the latest hot prospect being hyped up by the press. As a sceptic, I’ll often start by listing all of the potential flaws in the company or asset I’m being questioned about. Many don’t take kindly to such responses, preferring instead to hear feedback that’s more in tune with what they want to believe. Nine times out of 10, they’ll answer back telling me the subject of our discussion will revolutionise the world and make its investors a fortune in the process.

Megatrends, a term coined by American author John Naisbitt to describe major shifts in the way society functions, tend to have that kind of dizzying effect on people. Most will agree that developments such as climate change, robotic workforces or ageing populations are already starting to take shape and are understandably keen to make money from them.

Some investment publications capitalise on fantasies about getting rich off the next Amazon by feeding readers information on the companies apparently best placed to generate the most profits from these megatrends.

What many of these media outlets often neglect to mention is that there are several risks associated with chasing the next big innovators. And by the time they are plastered all over the internet, and you are being urged to invest before it’s too late, chances are the disruptor will already be priced to effortlessly achieve all of its lofty ambitions.

Priced for perfection

Aside from a ridiculous amount of luck, investors hoping to make fortunes betting on the next big sensation ideally need to take a position before the rest of the world starts talking. Once word spreads about what the company could one day be capable of, hype can quickly spiral out of control, regardless of whether or not the company has made a profit yet.

“Everyone is buying it, so it must be a winner,” is what people often say to me when I shoot down their investment ideas. What they fail to realise is that it’s precisely that mentality that makes investing in future trends so dangerous.

 

High valuations make even greatcompanies risky investments

When flocks of people buy into a story, valuations get inflated to such an extent that even a temporary setback can no longer be tolerated. Suddenly investors pay the going rate – that’s already achieved the company’s wildest ambitions – rather than an acceptable price for an up-and-coming brand that has yet to make a profit, is draining cash and is placing all its bets on a technology that has yet to be commercialised and might easily be bypassed by something bigger and better at any point in the future.

These days, companies clamouring to be at the forefront of emerging trends tend to attract a ridiculous amount of attention even before they go public. By the time some of them list on major stock markets, they are already valued higher than companies that have been successfully doing business for many years.

The US tech industry, home to some of the most talked-about innovators, is littered with such examples. For instance, Roku’s (US:ROKU) initial public offering in September 2017 valued the streaming device specialist at $1.3bn (£0.94bn). The shares have since surged more than 200 per cent, giving it a market cap roughly the same size as the biggest FTSE 250 constituents, even though the company has never been profitable, sells a commoditised product and operates in a saturated market where it competes with the likes of Amazon (US:AMZN), Apple (US:AAPL) and Google (US:GOOGL).

Is history repeating itself?

Roku isn’t the only company to get caught up in megatrend euphoria. Promises of new technologies capable of transforming lives and industries have led share prices in many other unproven stocks to rocket to questionable highs over the past few years.

Valuations are now so detached from fundamentals that some commentators reckon we are on the brink of experiencing another dot.com bubble. Back in the late 1990s, investors were so desperate to cash in on the internet boom that they willingly bought shares in anything associated with the trend. Eighteen years later, only a handful of these names, including Amazon and eBay (US:EBAY), are still standing.

What the dot.com bubble taught us is that only a few companies out of hundreds of valid contenders will survive and prosper. New technologies can take decades to deliver and until then require endless piles of cash to develop and commercialise. Setbacks should be accepted as part and parcel of the journey. However, in many cases, investors end up bidding up share prices to such an extent that failure is no longer considered an option.

“When you are paying for blue sky you have to be prepared for hope to disappear,” says James Henderson, a fund manager and director of UK investment trusts at Janus Henderson Investors. “In a good, strong market people are happy to take on more risk. The trouble is, something totally external to the trend could happen, such as a real slowdown or investors needing to raise cash. And then people won’t pay a premium for that. So regardless of how the company may be progressing, you can have the share price weakening because the valuation is so high.”

 

Wait for the dust to settle

Given the various challenges associated with the early-stage development cycle of companies, it’s often best to err on the side of caution and wait for a better buying opportunity to emerge further down the line.

Rather than worry about potentially missing the investment of the century, investors should remind themselves that many of their predecessors achieved higher returns by waiting for the smoke to clear. After all, it took less than 10 years for the dot.com bubble survivors to prove that the internet is a big money-making opportunity.

Unfortunately, buying an already established company with a decent foothold in one or more megatrends isn’t particularly easy, either. Investors can take comfort from knowing that the company isn’t likely to go under any more, but also have to accept that their peers in the current bull market generally prefer to fixate on future earnings potential, rather than the challenges threatening to derail those prospects.

Amazon: Cheap or expensive?

Some say Amazon survived the dot.com bubble by raising lots of money right before the crash. That fortuitous injection of capital gave it the cushion it needed to survive the ensuing turmoil. Nearly 20 years later, Amazon, now a market-leading force famed for shredding its competition and catering to a number of different megatrends, trades on a forward PE ratio of 213 times.

Bulls are confident that the modern-day conglomerate can finally start to bulk up its bottom line after years of sacrificing its profit margins to drive revenue growth. If you mention that there’s a lot of risk priced into its current valuation, they’ll quickly fire back: “Based on what? We’re in uncharted territory and Amazon has a proven track record of breaking new ground and accomplishing its goals.”

Bears, on the other hand, reckon it will be extremely difficult for the company to live up to its potential without running foul of antitrust regulators – perhaps a good a reason as any to invest in Amazon’s out-of-favour rivals. Both arguments make valid points, leaving investors with a tricky conundrum, especially as Amazon has a strong foothold in some of the most exciting developments shaping the globe, including ecommerce, cloud computing and artificial intelligence, and has pretty much colonised its entire supply chain.

 

Don’t settle for second best: Buy on the dips and use different valuation metrics

“If it’s an industry that is tending towards oligopoly, or even monopoly, you will only have two or three big winners,” says Frances Hudson, global thematic strategist at Aberdeen Standard Investments. “The others will plod on in a fairly pedestrian way and maybe their best hope is to be taken over.

“You don’t invest in an Amazon subsidiary that’s using artificial intelligence or big data, because all of Amazon uses that. The transformation has happened. The company has moved from being an online retailer through logistics, distribution, to renting space out on the cloud and hosting that.” 

Ms Hudson adds that investors worried about paying over the odds for Amazon’s many exciting prospects should consider buying on the dips. She also urged investors to use a variation of valuation metrics, rather than just the “backward looking” PE ratio, to determine if the company’s shares are fairly priced or not.

 

Picks and shovels: Look further down the supply chain

If you don’t fancy forking out $1,305 per share for exposure to Amazon’s seemingly endless potential, you could always look elsewhere. Amazon’s monopoly status means it has weeded out many companies in its supply chain. However, it does still rely on one or two other companies to help power parts of its operations, including its booming e-commerce business.

Companies still in Amazon’s supply chain include telecom giants AT&T (US:T) and Verizon (US:VZ), the providers of the internet infrastructure necessary to make online shopping possible, and International Paper and Packaging Corp of America (US:IP), a major supplier of the cardboard boxes and containerboard used to send packages out.

In other industries supply chain opportunities can be more plentiful. Aside from often commanding more reasonable valuations, these lower-profile companies also have the advantage of providing kit to several of the companies fighting it out to become the premier brand behind the biggest trends sweeping the globe.

To determine which companies sit in the supply chain, all investors need to do is figure out who makes the components and materials that go into the end products billed as revolutionary.

Avoid overpriced pure plays when possible

“Where possible, we advocate accessing a theme through the value chain,” says Caroline Simmons, deputy head of UBS Wealth Management’s UK investment office. “As an example, one of our themes is water scarcity. So, you could buy utility companies which deal with the transport and cleaning of water. Or you could buy an industrial company which makes some of the valves, or some of the pipes.

“Often there are [more attractive opportunities further down the supply chain], but you often get less materiality. The companies that make the valves for the water pipes in all likelihood probably make a lot of other valves and other things, so the direct exposure to the water theme is usually slightly less. But you can find that the valuation is less as well because it’s not a pure play.

“That’s part of the balance of this exercise. Combining companies that have enough exposure to the theme to make it a driver for the stock, but that are perhaps not just a pure play. Because the pure plays do, in some instances, have higher valuations, particularly around the tech space.”

Companies must generate at least 25 per cent of their revenues from a theme to be considered for entry into a UBS thematic fund. Other asset managers that sell vehicles tapping into certain megatrends impose similarly strict policies.

 

Limited downside, endless upside

For do-it-yourself stockpickers, other options can be considered. By backing a company that only has a small amount invested in a megatrend you are reducing the risk that your portfolio’s value will plummet if the technology never takes off.

There’s also a decent chance that successful adoption will eventually lead the company to focus more in that area. When Amazon first started cloud hosting, it wasn’t even separated out in its accounts. Now it’s a crucial part of its empire.

What was once a minor experiment overlooked by investors can suddenly become a core revenue generator. Only when real tangible demand is there does the company edge towards becoming a pure play.

 

The fastest horse doesn’t always win races

Many investors were left speechless when Tesla (US:TSLA) overtook Ford (US:F) and General Motors (US:GM) to become the biggest carmaker in the US last spring. The automaker, energy storage and solar panel specialist sells considerably fewer vehicles than its peers and has developed a reputation for production hiccups, missing targets and breaking promises.

Some battery experts claim that several of the technologies required to achieve Tesla’s latest goals either aren’t available, or are so expensive that it would be impossible to make a profit from them. Still, the shares continue to surge based on an unwavering belief that the company is best placed to revolutionise the auto industry and become the premier brand behind a future generation of cars.

Value investors might want to challenge that rationale. Now that electric and autonomous vehicles look destined to be a regular fixture on roads, major automakers are increasing their investments in the field. The market values some of these historic car brands as industry dinosaurs, even though they’ve been manufacturing autos and overcoming challenges decades before Elon Musk first showed up on the scene with his Tesla brain-child. For all of Tesla’s merits and obvious strengths, it seems unlikely that the battle for new-generation car sales will be a one-horse race.

Investors keen to bet on the successful adoption of electric and autonomous vehicles could also opt to invest in the supply chain, rather than wager all their capital on one or two car manufacturers coming up trumps.

“With cars, you can look at the whole supply chain,” says Ms Hudson. “So, you can look at the battery technology and then you can look at the commodities that go into the batteries. And if there is a particular company, or a miner that has a commodity sewn up, whether it’s cobalt or nickel, you can invest in the commodities themselves, or you can invest in the company that you think is going to win in terms of being the supplier.”

Some technologies are questionable, others are harder to ignore

Investors can argue for months on end about which technologies are guaranteed to play a vital role in future society. Many companies can be linked to at least one megatrend, although those that cater to numerous structural drivers should command most of our attention, even if they aren’t quite so glamorous.

Cybersecurity fits into this category. Think about how many of today’s biggest innovations are connected to the internet in some way. Already most business assets are completely digital. And with billions of pounds being poured into the ‘internet of things’, odds are that most new inventions are eventually going to be connected and vulnerable to attack.

Chipmakers have also emerged as beneficiariesof several of the big megatrends shaking up the globe. The graphics processing units (GPUs) crafted by companies such as Nvidia in this high-barrier-to-entry industry are able to process vast amounts of information quickly, making them an integral part of autonomous cars, artificial intelligence and even crypto-currencies such as Bitcoin.

Powerful graphics processors are vital to the functioning of blockchain, a digital ledger that records transactions made in Bitcoin or other crypto-currencies. Rampant demand for GPUs, whose primary function is to make computer games more realistic, has already triggered widespread shortages and out-of-the-ordinary price hikes.

Unfortunately, that information is now in the public domain, pushing the share prices of the few dominant chipmakers to all-time highs. For those of you who believe that the crypto-currency boom is more than a passing fad, however, these stocks do represent a cheaper and safer choice than investing in the multiple digital coins competing for supremacy against each other.

Alternatively, there are other options. Some analysts believe supply of GPUs will outpace demand in 2019, which could open up attractive buying opportunities in these cyclical companies.

Otherwise, investors might want to explore more obscure ways to invest in this popular technology. Crypto-currency miners and iPhone maker Apple are rumoured to already be working on ways to develop their own chips, so delving deeper into the supply chain may represent a smart option.

 

Invest across different asset classes

The components used to power the latest breakthrough technologies are made using materials sourced by commodity companies. For example, the circuit boards used in electronic devices require a substantial quantity of copper, a chemical element extracted from ore and processed using iron, sulphuric acid, silica, gallons of water and oil – copper refining is an energy-intensive process.

All the major megatrends being talked about, including population growth and rapid urbanisation, require serious amounts of raw materials, so investors keen to make money from them might want to consider investing in commodity markets. Pretty much every other asset class is affected by the way the world is changing, too. 

Megatrends such as climate change have spawned unique asset classes, including insurance-linked securities designed to cover natural disasters and other uncontrollable events. Even currencies can be longed and shorted to reflect your visions for the future.

When you ponder how society is likely to function in 50 years’ time, remember that investment ideas can be endless and extend well beyond the few companies tipped to do well by some of the press. 

Those willing to think boring and out-of-the-box can craft well-rounded portfolios stocked with reasonably priced assets that cater to various enduring themes and are capable of surviving the shocks that accompany different economic cycles. Investors backing equities priced to the hilt because they are the talk of the town will be envious when the next bubble blows up in their face.