We are in the midst of a period of rapid innovation known as ‘the information revolution’ – a third phase of great technical change after the transformative agricultural and industrial revolutions. Cloud computing, the Internet of Things, virtual reality, immune-oncology and genetic testing could be some of the big innovation stories of this age, and should open up a number of opportunities for investors.
Information technology is a booming centre of investment. The NASDAQ and biotech indices achieved new all-time highs in 2015, while the market cap of US tech and biotech businesses recently exceeded that of all listed companies in emerging markets or all public eurozone firms.1 Tech’s share of MSCI AC World Index earnings shot up to new highs last year. But do current valuations warrant caution? This may be the case in certain instances, but there are still plenty of exciting opportunities.
The US is still the leading centre of innovation, but there has been a notable narrowing of the gap with mainland Asia. In particular, investors need to be attuned to China’s rise as a centre of technical development and the opportunities this entails. This is measurable in part by patent applications, led by leading Chinese tech and telecoms firms like Tencent, ZTE and Huawei. R&D spending as a percentage of GDP has increased from 0.5% in 1995 to 2.0% as of 20132 – though this is still below the levels of other Asian and European countries; the equivalent numbers for South Korea and Germany for example are 4% and 2.9%.
Nanotechnology, clean energy and materials, biotech and information communications tech have been the main areas of focus in previous and current Chinese state Five Year Plans. Beijing’s ‘Made in China 2025’ initiative is designed to upgrade the quality of Chinese output, and place it as a leading innovation nation. Among the highlights:
China faces challenges as it attempts to avoid the middle income trap which has ensnared other developing economies. Deregulation and reform of state-owned enterprises and successful anti-corruption efforts will be crucial. But the country has already emerged as a leader in a number of sophisticated technologies, with plenty more innovation investment opportunities likely in the coming years.
The cloud concept has been around for a few years, but commercial applications are burgeoning now. What many technology start-ups increasingly have in common is the use of cloud computing: the networking of remote servers hosted on the internet to store, manage and process data, instead of a local server or company computer. Digital data storage is replacing physical forms to an ever-greater extent, as shown by the rise of Netflix and Spotify. These ventures wouldn’t exist but for the on-demand data storage and retrieval capabilities that ‘the cloud’ enables. Public IT cloud services spending will be worth $127 billion in 2018, thanks to a compound annual growth rate of 22.8% – six times that of the broader IT market. By 2018, it is estimated that public IT cloud services will make up more than 50% of global software and storage development.4
Cloud computing is the latest chapter in a broader trend for the dematerialisation of computing power. In 30 years, the amount of material required to produce one PC has declined by 68%, and each machine now houses 250,000 times more RAM. In 2011, PC makers used, in aggregate, only 54 times more material to create 38 million times more processing power than in 1981.5 This phenomenon of dematerialisation is increasingly evident in other industries and at the macroeconomic level. In the US, the amount of resources extracted per dollar of GDP has decreased by nearly 75% over the past 90 years. The manufacturing of 1.5 gigatons of steel would have used one-fifth of the world’s total primary energy supply in 1900. In 2010, it used only about one-fifteenth.
In computing, the cloud revolution winners will be those companies that can deliver advanced and secure software solutions to businesses, so that the latter have to spend less on hardware. The losers are likely to be those original equipment manufacturers (OEMs) that specialise in selling in-house datacentre equipment to large enterprises. Companies are spending much more on client devices – particularly mobile tablets and smartphones – and cloud services, and less on the middle layer of IT: on computers, networks, servers and storage gear.6
The ‘Internet of Things’ (IoT) is likely to be another significant innovation territory in the coming years. The IoT is made up of billions of sensory objects that can process information and communicate with each other via WI-FI connectivity. An example of an IoT firm would be Nest Labs, a producer of programmable self-learning, sensor-driven Wi-Fi enabled home appliances such as thermostats and smoke detectors. Such was Nest Labs’ promise that Google bought it for $3.2 billion two years ago. More broadly, IoT development is supported by falling hardware prices – in particular, low-powered, ultra-cheap computer chips – cloud computing and rising global connectivity. The hardware producers that make the IoT possible are the most obvious beneficiaries; but second-order winners could exist across all sectors; for example, clothes companies that manage to incorporate internet connectivity into clothing (for example Google’s ‘Project Jacquard’ is a partnership with Levi’s to create ‘smart clothing’).
There has been a lot of excitement in the last few years about the potential of the IoT. But as with all emerging technologies, it is worth considering whether the hype has got ahead of reality. Gartner’s annual Hype Cycle for Emerging Technologies assesses the market excitement, maturity and benefit of more than 2,000 new technologies. This highlights the need for research and careful assessment, but also the importance of a flexible, active approach and a realistic time horizon, as there typically tends to be a lag before these concepts become commercially productive.
Virtual reality (VR) technology is advancing towards significant market penetration. A number of VR headsets are due to come to market this year, with the consumer version of Facebook’s ‘Oculus Rift’ headset expected to be the first. As with all early technologies, it will initially be expensive: the Oculus Rift will cost $599, more than initially expected, having suffered delays in coming to market.
It’s not just gaming which could benefit: VR could be used in healthcare, to provide virtual environments to help treat phobias. Ford uses a VR Immersion Lab to get a sense of how customers experience their cars, while last year Audi introduced Samsung-made headsets at dealerships, to allow customers to take virtual test drives, and to configure car interiors and settings before purchase. VR could be used in an educational context, for example in training surgeons, as well as offering law enforcement and military personnel immersive training in situations which would otherwise be challenging to recreate.
Investment winners are again likely to be split between hardware producers and companies that manage to integrate VR technology into their product and service offerings. Among the former, visual computing firm NVidia could be among the main beneficiaries, along with speech recognition specialist Nuance Communications.
‘The sharing economy’ is another innovation buzzword, which describes firms that allow owners of property and/or skills to share these via online marketplaces. This field now includes start-ups catering to a multitude of life needs – from business advice to pet sitters and peer-to-peer lenders. The growing desire to ‘share’ – or rent – instead of owning could significantly alter how and what we consume, leading to significant (if varied) disruption across industries. Taxi network Uber, now valued at $51 billion, is the most valuable private start-up in the world. Airbnb is another great example of a sharing-economy firm. The latter is now valued at $25.5 billion, with sales growth at an annual rate of 90%,7 and a significant presence in key markets. Airbnb has more than 1.5 million listings, up from 800,000 in 2014, versus 15.5 million hotel rooms globally. It is expected to outpace Intercontinental Hotel Group revenue by 2017.
Those who are being disrupted, however, aren’t staying quiet. Taxi drivers have mounted legal challenges against Uber, while the Hotel Association of New York is attempting to put together a class action lawsuit against Airbnb. Zoning laws and building regulations are rarely conducive to disruptive models, providing plenty of scope for status quo interests to mount legal challenges. Last year, the State of California ruled in Uber vs. Berwick that drivers qualify as employees of Uber, and must be reimbursed for tolls, expenses and IRS admin costs. This has implications for a whole host of asset-light businesses that rely on contractual labour.
Carefully considering the likely legal landscape impacting sharing-economy firms will be as important in the coming years as assessing the viability of their business models. But the success of Uber and Airbnb has clearly set an attractive and impressive precedent that will set the stage for further disruption in other sectors. At the moment venture capital is leading the charge into this sector, but as it grows and more firms go public, opportunities for mainstream investors will grow.
Although the runaway performance of biotech stocks in recent years means investors should exercise caution, the amount of capital pouring into the healthcare sector, means that we could be at the start of a long pipeline of new treatments coming to market. Many of these will be based on human genome research, which has become significantly more affordable for companies during the last decade; human genome’s can now be sequenced for as little a few hundred dollars.
Immunotherapy is perhaps the most exciting innovation opportunity in healthcare. In particular, immuno-oncology has gone from being relatively unknown just a few years ago to being a major area of research. It attempts to use the body’s immune system to fight cancer, by either ‘turning on’ mechanisms to fight tumour cells, or by turning off the mechanism in tumour cells which impede a natural immune system response. Citigroup analysts predict that immuno-oncology drugs could be generating $35 billion in annual sales over the medium term, and will constitute 60% of cancer treatments by 2023 (from 3% today). This would make immunotherapy the biggest market in medicine,8 and transform the face of cancer treatment as we know it.
Healthcare has traditionally been a top-down affair. Governments and health advisory boards issue general advice on healthy living and disease prevention, while doctors provide diagnosis and treatment. Now, however, genetic testing holds out the prospect of more individualised prevention and treatment, based on a person’s genetic profile. Genetic testing can help to:
This technology is still very much in its infancy, and there is much debate about the extent to which such screening is desirable or ethical. Some would prefer to live in ignorance about a genetic predisposition towards certain diseases. But more than 20% of all drugs approved by the US government’s Food & Drug Administration were precision medicines, and it’s estimated that between 12% and 50% of all compounds currently being researched by the pharmaceutical industry are potential personalised medicines.9
Over time, it seems likely that this technology will disrupt healthcare in a significant fashion, leading to more patient choice and improved detection and treatment options.
There are a number of investment opportunities in innovation across a whole range of sectors, with companies of all sizes involved – from start-ups to established large caps. In addition, far more Chinese and east Asian firms are making their presence felt within technology markets, although the US is still (for the medium term at least) the leading centre of information technology innovation.
The subjects discussed above are just a sample of some of the most promising and potentially investable opportunities. Cloud computing is opening up a whole new vista of data storage and download options for businesses and consumers. The Internet of Things, though a longer term prospect, could have a massive impact on the economy and on consumer behaviour.
Virtual reality technology is beginning to make its presence felt in various consumer markets (albeit slowly), while sharing-economy firms are increasingly disrupting a number of incumbent industries. Lastly, healthcare is a sector which, as indicated by soaring biotech stock valuations, holds much promise for innovative and often radical new treatments in the coming years. This fast pace of disruption calls the efficacy of passive investing as market capitalisation indices tend to reflect yesterday’s winners. On the other hand, an active approach based on forward-looking research can reveal the sectors and stocks likely to win and lose from disruption, giving active investors plenty of opportunities for alpha generation.
“Disruptive innovators are set to change the shape of markets in a number of industries. This will transform global equity markets, creating a new environment in which US leadership will continue to thrive. The NASDAQ will be at the heart of this story as it remains best placed to benefit from disruptive forces in information technology and biotechnology, sectors where we continue to see strong earnings momentum.”
Global CIO, Equities
“I think the long-term prospects for health care companies remain attractive, but I do expect some volatility in the coming year. The fundamentals remain good in a range of subsectors, with selected pockets benefitting from strong drivers that should support robust growth over the medium to longer term.”
“Bottom-up credit analysis is increasingly being supplemented with views on the risk profile of potential competitors, and the capacity or willingness of incumbents to react to disruptive innovation in their sectors. Firms that were once sector-leaders could see their profits impaired by disruptive entrants. The latter may not necessarily have the same desire to issue debt. Traditional benchmarks reflect a firm’s issuance size, not market value. So a manager’s ability to allocate off-benchmark and generate alpha by avoiding bonds from companies that are vulnerable from the growing threat of competitors will be key.”
“The overall outlook for the tech sector remains positive and I am continuing to focus on quality companies with sustainable growth prospects, trading at attractive valuations.”
This information is for Investment Professionals only and should not be relied upon by private investors. It must not be reproduced or circulated without prior permission.
This communication is not directed at, and must not be acted upon by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity/Fidelity International means FIL Limited and its subsidiary companies. Unless otherwise stated, all views are those of Fidelity. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes.
Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on an individual's circumstances.
Past performance is not a reliable indicator of future results. Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA.