Separating Leaders from Laggards as Technology Changes the World

From agriculture to telecommunications, technology is shaking up the status quo. In all sectors of the global economy, technology is disrupting traditional business models and changing the way we live. Our mission is to capture the growth opportunities presented by tech innovators and avoid businesses that are likely to be left behind, using a combination of fundamental security analysis and active portfolio management to separate the leaders from the laggards.

The Tech Sector Matures

The tech sector has come a long way since the dot-com crash of 2000. It is well established, representing almost a quarter of the S&P’s total market capitalization, and is a primary driver of corporate earnings growth. In fact, if the tech sector is excluded from 2017 results, earnings growth for the index falls from 11% to 6%. In light of these strong fundamentals, we do not consider tech valuations unreasonably high. We also believe that overall equity market valuations, while extended by historical averages, are not excessive, given the corresponding corporate profitability. Corporate tax reform could also have the potential to boost EPS an additional 5%.

Technology is also driving efficiency improvements across the board, from industrials to energy to health care. Our focus is on companies that are using technology as a competitive advantage, either by creating new demand for their products or services or by driving the cost structure down. Since innovation creates wealth, we are looking for technological breakthroughs that cut across all sectors, mainly from well-established technology leaders but also from emerging companies on the cutting edge of innovation.

The Sharing Economy Blossoms

The practice of sharing isn’t new. Consider the tradition of buying health insurance, for example, which is essentially the practice of pooling money and sharing the costs of healthcare, or owning a timeshare for family vacations. But an “always connected” world has also sparked demand for services that allow consumers to share everyday items like bicycles, designer jewelry or even their home Wi-Fi signals. Technology now allows two people to telecommute and share a single job, giving parents more flexibility to raise their children but complicating the science of measuring worker productivity.

Artificial Intelligence Improves Healthcare

Artificial intelligence is a powerful technology that allows computers to perform tasks that usually require human intelligence such as analyzing data, recognizing speech patterns and making decisions. Artificial intelligence is already being used to help medical researchers sort through data to identify diseases and develop new treatments. Developments in digital healthcare could change the way doctors diagnose irregular heartbeats, replacing large, expensive heart monitors with small, waterproof patches that monitor a person’s heart rhythms and send the data back for analysis.

Productivity Gains in Manufacturing

In the industrials sector, connectivity between manufacturing and distribution systems is becoming standard practice. Data is being collected and combined with the power of cloud computing and artificial intelligence to transform traditional, non-tech industries intomore efficient global enterprises. The “smart factory” of tomorrow could lead the world’s economy into a new industrial revolution.

Innovation in the Transportation Business

We have also seen early evidence of what technology is capable of in transportation. Smartphone applications are notifying travelers of train schedule delays, reporting highway traffic and rerouting drivers. Smart transportation grids use artificial intelligence to analyze traffic patterns and adjust the timing of traffic lights during rush hour, and automobile manufacturers are testing systems that can distinguish a police car from a taxi. Robots are being tested in self-driving cars and self-piloting airplanes. Science fiction is moving closer to reality every day.

E-commerce Shakes Up the Retail Sector

In the retail sector, vendors who have traditionally relied on brick-and-mortar locations are quickly adopting technologies that put the shopping experience in the palm of the consumer’s hands. A strong appetite for sophisticated, on-demand services has given rise to experimental distribution methods such as using drones to deliver packages and subscription services that deliver fresh groceries.

E-commerce has been gaining market share rapidly, capturing 9% of all retail sales in the United States (CHART) and more in some markets overseas. We are tracking a number of retailers that are using technology to expand internationally. Challenges include the collection of state sales taxes from online retailers and the pressure to spend more on marketing.

Millennials Are Cutting the Cord

Technology is also making entertainment more convenient, streaming video-on-demand and other content over the internet to mobile devices, which is in high demand by millennials. We expect to see continued weakness in traditional box office sales as digital delivery platforms become more sophisticated and providers expand their à la carte menu offerings for at-home entertainment. We also see the potential for further industry consolidation among leading entertainment content providers in 2018, which should increase their pricing power. We also expect advertising budgets to continue migrating away from TV and toward social media, but internet TV enjoys the same capacity as social media to target audiences with specific demographic characteristics.

Financial Companies Invest in Tech

Technology is also revolutionizing banking and financial services, allowing investors to place stop-loss orders on mobile trading platforms, apply for mortgages online and use algorithm-driven investing methods that were once the purview of professionals. These services increase the need for robust encryption programs and cybersecurity controls to safeguard personal information.

Banks, insurance companies and brokerage firms are all scrambling to keep pace with technology and the expectations of consumers, investing more than $27 billion in fintech and digital innovation since 2015, according to KPMG. Much of this investment has been in the form of mergers and acquisitions, which we expect to continue. Larger banks are allocating more R&D resources to technology than regional banks, which generally wait until a service is adopted and then try to replicate it. We are also evaluating several companies that provide critical back-office technologies for banks.

Fundamental Analysis in Silicon Valley

Across all sectors, we are focusing on companies that are leaders or emerging leaders in technology, with strong management teams and healthy balance sheets. Ultimately, our goal is to find capital growth opportunities that are attractive regardless of geopolitical headwinds, economic cycles or market volatility. When searching for attractive valuations in the tech sector, we think one of our strong suits is the fact that our parent company, Franklin Templeton, is located in the heart of California’s Silicon Valley, so our research team can visit these companies without leaving town.

In this rapidly changing world, we believe keeping our finger on the pulse of innovation is a distinct advantage for our portfolio managers and our clients.