Looking at the number of years it took for different products and technologies to reach 50 million users, one can deduce that the pace of adoption by society has accelerated exponentially. For example, it took 46 years for electricity to be used by more than 50 million households, while Facebook reached the same number of users in 4 years, WeChat in 1 year, Fortnite in 4 months, and Apex Legends, a new Electronic Arts game, only took 1 month to reach 50 million users. But why this acceleration? According to Robert Almeida, global investment strategist at MFS Investment Management, in his presentation during the 2019 MFS Americas Advisor Investment Forum in Miami, this slowdown is due to the considerable reduction in the price of new technologies, which sometimes becomes free, in exchange for consumer data and information. 

Thus, the manager assessed the sectors, industries and companies that have generated a profile of above-average margins that are not sustainable, because they have lost competitiveness and are only achieving growth in their profits through acquisitions and cost cutting.

Excess Supply of Content in the Media

An example of this type of companies are those belonging to the media, whose value proposition has changed significantly in recent years. “Today, Hollywood produces about 500 films a year, about 1,000 hours of film per week. While YouTube, which is a free channel with 2 billion users, produces 48 hours of content per minute. YouTube produces in 20 minutes the same length of content in hours as Hollywood produces in a year. Of course, quality is debatable, but when in economics you significantly increase the supply curve and there is no change in demand, prices decline. And it’s precisely these companies that are subject to price pressures that we want to avoid,” Almeida said.

“For example, SpongeBob has been the most monetized children’s program in cartoon history.In the future, I don’t know if the kids will continue to attend this program, but if they do, they will do it through YouTube or Netflix, for $13 a month,” he added.

In this context, the main issue, according to the manager, is the selection of titles. There will be a number of companies that will not continue to add value and there will be another number of companies that will achieve greater value because of their scarcity. In the next decade, the current abundance of margins will not be such and those companies that cannot offer tangible value to society will decline and become extinct.    

The Retail Sector

We all know that the disruption of e-commerce has had a strong effect on retailing, but that does not mean that department stores will be eliminated. In Almeida’s opinion, there will be shopping centres, but these will have to offer a value proposition or they will be dispensable.

“E-commerce is easier and more convenient, you don’t have to go to the mall, you don’t need a parking space to get there, with just one click, the purchase is done. But what happens when you introduce more offer in the market? A price war begins. The difference now is that retailers have realized the need to build an online sales platform similar to Amazon’s, so they are increasing their capital expenditures rather than their operating expenses to increase their sales. At that point are companies like Macys, Sears, JC Penny and ToysRUs. When will be the next time you go to RadioShack to buy a product? Probably never, you will make your purchase online,” he argued.

“The market tells us that there are survivors and dinosaurs. Among the survivors is Costco, whose profits are growing by 5% while other retailers are experiencing losses by the same percentage. That’s because even Amazon can’t compete with its price-based value proposition. On the other hand, Tiffany, LVMH or Nike are also offering a different value proposition. These companies have recognized brands, intellectual property and pricing power.

The Marijuana Value Proposition

Although only two countries have legalized the recreational use of cannabis, with Uruguay being the first country in 2014, followed by Canada in 2018. In the United States, the situation is somewhat complicated. In 10 states, medical and recreational use is allowed, while at the federal level it is illegal.
“Two-thirds of the U.S. population has access to medical marijuana and one-fifth has access to recreational marijuana. By regularly increasing the legal amount available, the adoption curve is being transformed from an S-shaped curve, as was the case with the electricity mentioned above, which took 46 years to be massively adopted, to a J-shaped curve, like Facebook, which took only 4 years to get 50 million users,” he said.

“Another point of view must also be considered: households have budgets. People often formulate a budget in relation to how much they can spend on vacations, shopping or meals during the week. If the cannabis adoption curve increases, what share of consumption will the budget take? What categories of products could be at risk if the cannabis market grows? In our opinion, the beer, wine and spirits sectors are the candidates to lose market share to marijuana. We are evaluating the model closely and examining the potential results. This does not change our view of Diageo, Philipp Morris or Altria, but it is something we are discussing and observing. That’s what active management is all about,” he concludes. 

At this point in the economic cycle and the market cycle, in the opinion of Robert M. Almeida, global investment strategist at MFS Investment Management, it is necessary to shift from an emphasis on performance to an emphasis on risk. According to the manager, in his presentation during the 2019 MFS Americas Advisor Investment Forum in Miami, the economic cycle of the last ten years has been characterized by being longer in length, but lower than the average growth magnitude. While the market cycle has been markedly higher than the average in magnitude of growth and certainly, it has also been longer in duration. These two premises are the starting point for understanding market expectations and valuations, as well as where to find alpha opportunities today.

Market Expectations

Universally, in all market sectors, a massive transition is being seen as technology is weakening the value proposition of companies at a hitherto unknown pace. This, Almeida said, is important because when a company stops producing or providing services in a competitive way, margins erode and stock prices tend to follow.

“From my point of view, there is only one important issue when valuing the price of an asset in the long term: free cash flows. And what do these cash flows depend on? It depends on the number of items and the price at which they are sold minus the cost of production. If a company cannot sell more items or the price of these items is decreasing because a competitor is doing something similar  or cheaper, then current margin and free cash flow levels will erode. We try to avoid those companies that we think are overvalued, but not simply from the standpoint that market prices have risen by 300% in the last 10 years  but because they have ceased to be useful to society and investor expectations of cash flows are too high. These companies have become dinosaurs, melting icebergs or cubes,” explained Almeida. 

“By avoiding companies that suffer from the innovator’s dilemma, that close their eyes to the potential of technology and disruption, we create performance in the portfolio. In our industry we tend to think about creating alpha, but over the years, I believe that success in active management, like most aspects of life, comes not because of what you’ve done, but because of the mistakes you’ve been able to avoid,” he adds. 
The manager then explained that we are facing a regime change, from a period with above-average returns driven by above-average margins, to a period with below-average returns, driven in turn by below-average margins. This translates into lower returns vs recent years or long-term averages.
In order to assess performance expectations over the next 10 years, MFS Investment Management uses an average reversal model with variables such as sales, pricing power, margins and valuations. In this model, the balanced global portfolio, with 60% equity and 40% fixed income allocation, yields an unsatisfactory return of 4%. This figure is difficult to explain for the pension plan community, advisors and trustees that make up the asset management industry. 

The Level of Valuations

When examining the Shiller P/E ratio based on the average inflation-adjusted profits of the last 10 years, Almeida acknowledged that valuations do not usually predict returns, especially if the previous 12 months or 12 months ahead are taken into account, their level of prediction is almost nil.
However, an examination of the US Shiller P/E ratio shows that, at levels close to 30 times, this is the third highest Shiller ratio in US history. According to Almeida, this is due to the fact that, during this cycle, yields have exceeded the average, because margins have been above the average, but profit growth has remained below.    

“To get out of the global financial crisis, companies laid off workers and refinanced their debt at lower interest rates, then saw the rehabilitation of the market structure. Then investment in fixed assets, consumer spending and the GDP of the economy should have improved, but they did not. I could talk about macroeconomic and political motives, but in my opinion, there is a simpler explanation, dematerialization,” Almeida explained.

The Effects of Dematerialization

As Almeida argued, advances in technology have allowed the world the opportunity to rent rather than own. “Companies that needed to increase their technological infrastructure to expand their business have rented it from Amazon, Google, Microsoft or Alibaba, instead of buying it. Instead of buying music, consumers have rented it from Spotify. Faced with the need to buy a car, consumers have used Uber’s services. And the same when buying a film, that consumers have chosen to rent it on Netflix. The shift from a property economy to a rental economy has had two fundamental consequences. The first is deflation of pricing power and the second has made the price of goods less expensive. From an accounting point of view it has been a shift from capital expenditures to operating expenses,” he added.