Evenlode’s Yarrow: How tech disruption affects steady dividend payers

Yarrow Hugh Evenlode 2014The term ‘disruption’ has become a buzzword in investment circles over the past few years. It is generally taken to mean any innovative technology destroying the economics of a mature industry by rendering established products and services inferior, normally to the point of obsolescence.

Rise of the internet economy

One of the clearest examples of disruption over the past decade has been the online retail sector’s assault on physical retail, with Amazon leading the way. The newspaper and music industries have also seen profound change driven by digitalisation.

More generally, the rise of the internet and its ability to support new, innovative business models is creating change in most areas of the economy – for example Airbnb, Uber and Netflix. In start-up legend Marc Andreeson’s words, software is eating the world. Cheaper and more convenient server power, super-fast broadband, data analytics, artificial intelligence, interconnectivity and mobile device growth are all driving this trend. Other industries such as biotechnology, energy, automobiles and banking/payments are also facing interesting changes as genome sequencing, battery storage, electric cars and blockchain technologies rapidly develop.

Many of the start-up companies in these fields have gone on to list on the stock market, often trading on high multiples, reflective of future potential. But as dividend growth investors, the key question for us is not so much whether these fashionable shares are appropriately valued – but how much the innovation from these new companies and industries might change the long-term economics of the more mature, stable, dividend paying businesses we invest in.

Beer, soap and nappies

In our view the challenges are more than offset by opportunities for most of the businesses we invest in, for two main reasons. Firstly, many products sold by these companies remain broadly unaffected by new technology, particularly low ticket consumer branded goods. Think of products such as Dove Soap, Guinness or Pampers. Society is likely to want, need and value these products in 10 or 20 years, just as it has over the past 50 years or more.

Even for a very durable franchise, times do change however, and business models need to keep adapting. Unilever, for instance, was mainly in the business of selling tea, soap and margarine to developed market customers 40 years ago. It has since evolved into areas such as personal care, while consistently investing in emerging markets. This change has been essential. Margarine, for instance, is now Unilever’s poorest performing category, but makes up only a small portion of sales – while emerging markets are now its growth engine. Likewise, consumer goods are not completely immune from the rise of the internet, with online sales a small but growing part of overall revenues.

Brand strength remains strong online, but these businesses need to adapt. Unilever’s partnership with Alibaba and JD.com in China is a good example of this adaption – with Unilever’s online sales in China nearly doubling over the past year.

Harnessing new technology

This leads on to a second point: many of the companies we invest in are already harnessing new technology without being ‘disrupted’. They are helped by market-leading positions in niche industries with high customer loyalty. Interestingly, software franchises have always fared better at coping with disruption than hardware companies, which in my view relates to the strength of the economic moats they develop, driven as much as anything by customer embeddedness. Software franchises – such as Sage, Microsoft, Fidessa and Aveva – are good examples, as they increasingly utilise technology in cloud and data analytics to increase the value and range of products offered to customers.

Other sectors are enjoying similar dynamics. In fact, the idea of ‘software’ as a sector is becoming increasingly outdated. Many media, support services and engineering companies are increasingly utilising software and data analytics.

Innovation is also on the rise in the healthcare sector, particularly thanks to progress in genetics and resultant therapy areas such as immunotherapy. This is transforming the landscape of areas such as cancer treatment, which I believe is a positive for the sector, despite the challenges it often creates for established firms.

Skate to where the puck is heading

Clearly, there is no perfect protection from technological change. However, selling a trusted repeat-purchase brand with longevity is a good start. And more generally, businesses with a strong ‘economic moat’ should be better placed to harness rather than suffer from technology as time goes by.

Also important is a culture within a business to look to the future and adapt. To use Warren Buffett’s ice hockey analogy, you need to skate to where the puck is headed. Organic investment may hold earnings back a little in the shorter-term. But in periods like today, when economic growth is muted and technological change is accelerating, the best response is unlikely to be a sharp slam of the brakes on organic investment and R&D.

In short, the best insulation from what is to come is what has worked in the past. For us it means a defendable business model with a management committed to adapting to and investing in the future.

Hugh Yarrow is manager of the Evenlode Income Fund