More than half of today’s S&P 500 constituents are expected to be replaced in the next decade as technological disruptors erode profit margins. Here we ask: how can long-term investors in the US market ensure that their returns are not diminished by disruption?
The composition of the S&P 500 index is evolving rapidly. Today, a typical S&P 500-listed company survives on the index for an average of 18 years, compared to a life span of 61 years in 1958. By 2027, it is estimated that more than 50% of today’s index constituents will no longer exist on the S&P 500. And these are not minnows: industry heavyweights have been jettisoned from the index in recent years. Eastman Kodak was replaced in 2010 by a cloud computing firm, while the New York Times was usurped in the same year by Netflix.
Figure 1. S&P 500 constituent turnover, 2002-2017
Source: Hermes Investment Management, S&P Dow Jones Indices as at September 2017
For investors, the current zeitgeist in the US market is characterised by a large uptake in passive investing. The long-running bull market has created a mentality that investing in index funds is low risk. It isn’t.
Index funds are exposed to disrupted industries, and thereby the consequent disruptor-induced loss of market value. A popular approach adopted by disruptors today is the ‘winner-takes-all strategy’, where the disruptor cuts prices and boosts investment in order to build a wide moat through scale economies. In an attempt to remain competitive, industry incumbents also reduce prices, resulting in falling margins and profits across the affected industry. For example, Amazon’s retail unit reported second-quarter sales of $34bn yet posted a loss of $300m.
By investing in an actively managed fund, long-term investors can have exposure to publicly-listed disruptors, including Facebook, Amazon and Google – and avoid companies that are at risk of digital disruption and thereby reduce their exposure to diminishing market values.
Furthermore, index funds do not have exposure to America’s ‘unicorns’ – private companies valued at more than $1bn. Uber is the most valuable unicorn in the US, with a valuation of close to $70bn, while Airbnb is worth around $30bn.
The Hermes US All Cap Strategy holds stocks that provide essential products and services, such as aggregates and water, which are unlikely to face disruption in the future, as well as arch disruptors. We look for companies with economic moats and proven business models that generate attractive returns over time – a strategy that has delivered net annualised outperformance of 0.8% since the Strategy’s May 2015 inception.
Disrupt, or be disrupted
The major cause of disruption is the rapid advancement of technology and the accelerating pace of its adoption by consumers. Research by Gartner suggests that the rate of technological change is exponentially faster than the speed at which most businesses run. To survive, companies need economic moats – defensible franchises that make it difficult for new competitors to gain strength. Otherwise, there is a material risk that technological progress and business-model disruptions will lead to an increased rate of business failures over the next 10 to 20 years.
A recent Amazon Web Services summit, “Scaling up to your first 10 million users”, serves as a reminder of the magnitude of the threat facing incumbents. The ability to rent extra server capacity from cloud providers has effectively levelled the playing field for new technology start-ups. As such, all you need is a laptop and a good idea to become a disruptor.
Today, a number of S&P 500-listed companies are exposed to technological disruption. For example:
- Exxon Mobil, Chevron, GE: The transition from fossil fuels to renewable energy has impacted energy and industrials firms
- IBM, Intel, Cisco: The emergence of cloud computing has resulted in the commodification of systems infrastructure
- Pfizer, Merck, Johnson & Johnson: Breakthroughs in drug discovery have reduced the period of competitive advantage benefitting leading medications
- Verizon, Comcast, Walt Disney: The upsurge of digital advertising and streaming services have put traditional content and distribution models at risk.
- Wal-Mart Stores, Nike: The penetration of ecommerce is transforming consumer services. Today, ecommerce accounts for 15% of retail sales in the UK, compared to only 7% in the US
The valuations of some incumbents, however, have been supported by attractive dividends and buybacks. In 2009, 60% of S&P 500 companies’ earnings were spent on dividends and share buybacks. That ratio passed 100% in 2015 and surged to 131% in the first quarter of 2016.
Companies that are structurally challenged are often the most active in share buybacks. For example, Hewlett-Packard (HP) has invested $47bn in stock buybacks over the last decade – almost double its current market capitalisation. During this time, HP faced existential threats from disruptive competitors, as consumer tastes shifted from PCs and notebook computers to smartphones and tablets.
Meanwhile, other blue chip companies are paying dividends that are no longer covered by their free cash flow. One such example is GE.
The trend of attractive dividends and share buybacks will likely provide short-term support for share prices, but at the risk of increasing long-term financial risk.
The Hermes approach
Active investors can provide exposure to companies that are immune to digital disruption and disruptors that have adopted a winner-takes -all strategy. The Hermes US All Cap Strategy aims to invest in high-quality stocks bought at a discount to intrinsic value. We look for businesses where there is good visibility of revenues and profitability sourced from a durable competitive advantage. Over time, we believe that companies exhibiting these characteristics should outperform the S&P 500 index – in no small part because they are less exposed to technological disruption and as such, disruptor-induced profit erosion.
For example, aggregates company Martin Marietta, a holding in our portfolio, is appealing since its products – asphalt and cement – are likely to still be used when building roads in 10 years’ time. Due to the monopolistic nature of aggregates companies, which tend to dominate access to local quarries, it also has relatively little competition within a 50-mile radius of its operations.
We also hold a position in American Water Works, a utility company serving 15m people. It earns attractive returns and is immune to obsolescence risk.
Alongside companies that provide essential products and services, the Strategy is also overweight arch disruptors, such as Amazon. The “Amazon flywheel”, an economic engine that uses growth and scale to improve customer experience through greater selection and lower cost, is creating a widening moat.
Hindsight is a wonderful thing – but foresight is better
Disruptive technologies are shortening the lifespans of companies listed on the benchmark S&P 500 index, as they erode profit margins. Rather than invest passively until 2027, when half of the current S&P 500 constituents may no longer exist in the index, long-term investors must actively manage the risk of disruption now.
We believe that the Hermes US All Cap Strategy is well-positioned amid the changing composition of the S&P 500. Its portfolio of high-quality stocks is far less exposed to the risk of disruption than the benchmark index.
Since its inception 28 months ago, the Hermes US All Cap Strategy has achieved net annualised outperformance of 0.8%. And we believe that our sector-neutral approach to investing in companies strengthened by enduring competitive advantages should deliver attractive long-term returns for investors.
Figure 2: Net performance of Hermes US All Cap Strategy, since inception
Source: Hermes as at 31 August 2017. Performance shown is the Hermes US All Cap Strategy in USD, net of all costs and a 50bps management fee, since its inception on 31 May 2015. The benchmark is the Russell 3000 Index. Past performance is not a reliable indicator of future performance.