The Digital Age

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Transcript:

What is the virus plaguing value?  Why are low book value multiple stocks continuing to lag?  Why are corporate returns not fading?  Why is contrarianism not working?  Why are “value stocks” in the 100^th percentile of valuation versus growth?

The virus plaguing value isn’t really a virus; it’s that we are advancing out of the Industrial Age and into the Digital Age and measuring value in the digital age is different.  Low book to market worked in the Industrial Age and was still the relevant paradigm to describe most businesses in the 1990s.  In the Digital Age, we are gradually replacing the physical with the digital, from communications to consumption, to industrial design to finance.   In our view, this has specifically been catalyzed by broad penetration of connected and highly functional digital devices like smartphones.  This reached critical mass not in the year 2000 but a few years after around 2006.

This means consumers and businesses have an astonishing amount of information available to them about prices, products, and availability.  Products are designed digitally, and supply chains are tightly tuned to end demand based on precise information transmitted digitally.  Tight digital linkages have enabled successful companies to “de-verticalize” themselves, focusing on product design and marketing, while leaving the more capital and labor-intensive manufacturing of key components and final assembly to others.  Customer engagement is not limited to store hours or even normal times of the day, and clever entrepreneurs are continuing to find ways to create digital interfaces for everyday necessities and services.

As we have entered the Digital Age and gone deeper into it with more and more advanced digital devices, physical assets have become less important to business success. It’s software and systems that are needed to make physical devices work and connect.  And increasingly, digital devices can be substituted for physical assets.  The general store and the shopping mall is increasingly a screen.  In 2020, we discovered that much of the office experience can be a screen also.

The electrons on screen as you are viewing this piece don’t have any replacement cost associated with them.  This general tendency towards digitization erodes the “physical replacement cost” definition of value considerably.

Hopefully, this all makes intuitive sense.  Because when you are used to looking through an industrial age financial lens, some of the key sources of value in the digital age are not so obvious.

In the industrial age, decades’ worth of experience have shown that physical scale, distinctive brands, strong product distribution, and attractive locations lead to competitive advantages and more valuable stocks.  These same concepts hold true in the digital age, but they manifest in different ways.

We have identified three key business concepts that superior digital age businesses tend to possess, and which lead to durable profitability and customer relationships.  These are:

• intangible assets, such as brands, patents, and other forms of know-how,
• interoperability which is also known as “the lock-in effect”, and
• liquidity-driven marketplaces.

None of these concepts are unique to the digital age, but they show up much more often and more powerfully than in the past.  The most successful companies in the digital age harness these forces to create monopoly-like profits and market positions, leading to very low fade rates.

The liquidity-driven marketplace concept is as old as the stock market itself.  Buyers could expect to find sellers, and sellers could expect to find buyers in the same location, such as the New York Stock exchange for stocks, or the Chicago Mercantile Exchange for commodities and financial contracts.  For the buying and selling of ordinary goods, location and distribution mattered more.  Now that’s no longer very true.  We are no longer bounded by location, the time of the day, or other physical constraints.  Shopping, searching, socializing, and communication have become standardized on the platforms where there is the greatest liquidity between buyers and sellers.  The liquidity-driven effect explains the success and scalability of entertainment services such as Netflix or transportation platforms such as Uber.  The important point from a competitive analysis perspective is that once liquidity becomes established at a certain venue, it becomes very difficult to compete with.  We will find out in the course of time just how durable some of these digital liquidity-driven marketplaces are.

Interoperability is another old-school business concept that has taken on new scale in the digital age.  The old “razors and blades” approach to pushing customer loyalty is a form of interoperability.  With the rise of operating systems software, business software, digital platforms such as smartphone apps and connected ecosystems of apps, the interoperability concept scales far beyond the bathroom.  With interoperability a nearly constant presence in our digitally-driven lives, monopoly-rents have accrued to companies that can capitalize on this reality.

Intangible assets such as brands, patents, and technological know-how are well understood to be of greater importance in the modern world.  The average S&P 500 company spends twice as much on R&D as a percentage of sales as 25 years ago.  They would not do this if there were not compelling business reasons to spend so much more money.  Ironically, the accounting profession remains rather stuck in the past, and fails to recognize cumulative R&D as a balance sheet asset.  This accounting distortion just further magnifies the challenge of using book value as the most critical evidence of an attractive stock market price.

The world of quantitative and passive investing would just love it if there were a new and improved single variable that would indicate the presence or absence of “value”, but I’m afraid our work shows this just isn’t realistic.  We can look for the liquidity-driven marketplace effect, for interoperability, and for huge moats of cumulative R&D as likely indicators that digital age value drivers are present. It’s much harder to say where on a financial statement these would reside.

Let’s go back to my big question – why has the fade rate for business returns on capital changed, and why has that happened so decisively since 2006?

You probably know the answer if you have made it this far.  The importance of intangibles, the barriers to competition that these create, the amount of interoperability that is a feature of the digital age, and the liquidity-driven effect – when successful businesses are able to capture these, their success compounds and competitive pressure fades.  The ubiquitous nature of digital and connected devices opened this floodgate wide.  The value investor’s behavioral bias to fade outsized success and identify laggards is much less likely to be productive and as for the low book to market value factor, that looks hopelessly antiquated as a predictor of future returns, as antiquated as shopping malls and newspapers.  And NBA big men.