Technology in the 2020s

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Contents

Introduction 3

1 Technology in the 2020s 4

1.1 Backdrop 5

1.2 Key investor questions 7

2 Technology shifts through the ages 8

2.1 ICT as the fifth industrial revolution 9

2.2 Revolutions have stages 10

2.3 The importance of the turning point 10

2.4 Are we entering the deployment phase? 11

3 Top-down implications for the decade 12

3.1 Impacts on productivity and growth 12

3.2 Impacts to the way we work 14

3.3 Impacts on climate change 18

3.4 Impacts on capital markets 22

4 Industry implications for the decade 24

4.1 The new industrial juggernauts 25

4.2 Growth likely to remain strong 26

4.3 Mega cap not without risks 26

4.4 Sector preferences 28

5 How are we investing? 30

5.1 Bottom up wealth creation framework 31

5.2 Profit pool shifts 32

5.3 Exceptional companies 33

IntroductionAs we begin a new decade, one thing is undeniable: technology bears a far greater influence on our daily lives and investment portfolios than it ever has.

The impact has been so spectacular that the dispersion between companies, individuals, and investors embracing technology and those who haven't has never been wider. It is unsurprising therefore that understanding where we are in this cycle, and how best to navigate it, dominates company boardrooms and investment forums alike. In this feature-length report, we review the technology landscape from multiple angles. From a top-down perspective, we find that technology's influence will likely be even greater this decade in relation to areas such as how we work and our ability to tackle climate change, versus the 10 years just passed. Industries such as healthcare and education are set to be some of the most transformed by

technology, having been among the slowest to ride the adoption curve thus far. On the other hand, we find that some trends are already beginning to mature, while a number of companies will face increasing scrutiny from regulation and growth may succumb to the gravitational pull of the law of large numbers. With a recession bearing down on the economy, and indexes increasingly dictated by a few large companies, we believe continuing to deliver strong risk-adjusted returns will not only require a more targeted approach, but also differentiated holdings. Some of the most attractive ways to invest in the next 10 years are likely to be found in specific technologies, profit pools, and industry verticals that are generally less well understood – but where many of the strongest competitive advantages and structural growth stories are to be found. All this considered, individual company fundamentals matter more than ever before.

Andy GardnerInvestment manager, global equities, AMP Capital

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Technology in the 2020s1.1 BackdropWe start the current decade with technology permeating our everyday lives in ways many wouldn’t have imagined not so long ago. Following the launch of the iPhone in 2007, we now spend more time on our mobile devices than we do with any other medium including TV and PC. The smartphone sparked off a period of near exponential growth in the adoption of new consumer applications, by most metrics the fastest in history (Exhibit 1).

As consumers have shifted their time, engagement, and spending towards products and services that are born of the internet and enabled by the smartphone it has left a trail of destruction in its wake for many companies and technologies born of the old era (Exhibit 2).

While the transitions that have taken place in consumer technology are most relatable and often dramatic, the transitions within the enterprise are no less profound. Much like the smartphone, the cloud has provided a new platform upon which new applications and companies have flourished, capturing an increasing portion of business investment.

Exhibit 1: Years to hit 50m users

Exhibit 2: Impact of smartphones on camera industry

Source: BAML

Source: CIPA, statista.com

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Whilst technological innovation never stops, and there is still much to be excited about, there are also notable signs of maturity and slowing in some areas of the industry that best exemplified the most recent boom. According to a Bernstein report, the number of Facebook logins and Google searches increased only incrementally in 2019, and for the first time the number of active social media accounts a user has (between 6-9) has been to fall (Bernstein). There are even signs of a slight moderation in the record pace of growth in enterprise IT spending.

In financial markets, the past 18 months has also seen increased volatility and mixed returns (Exhibit 4). The past decade, where some of the largest technology stocks in the index had been some of the best performers, has been a dream scenario for passive investors. The decade ahead may be less smooth sailing. Ultimately, the long-term outcome will be determined by the aggregate fundamental performance of individual companies. Empirical evidence shows that anything between 80 and 110% of total return are explained by fundamentals over a 10-year period (Exhibit 5). In order to help us navigate the decade ahead, in the following sections, we look at the potential path of fundamentals from multiple angles by firstly reviewing the historical context and top-down perspectives before leading into the all-important bottom up framework.

1.2 Key investor questionsWhere are we in cycle?

History doesn’t repeat but it often rhymes. We review a popular historical study on technology cycles and conclude that we are likely at the end of the turning point and into the synergy stage of a tech revolution which began in the 1970s, evolved into the internet age in 2000s, and was followed by the digital age (mobile/cloud) in 2010s, and will likely evolve again in the 2020s (AI/blockchain/loT) before potentially maturing.

Will mega cap tech be disrupted?

Full blown disruption or displacement is very unlikely in this stage of the revolution where typically a handful of ‘juggernauts’ continue to dominate for a prolonged period. However, competition between these companies is increasing and it is our view that they will at some point, long before they are disrupted, begin to show signs of maturity given the law of large numbers and the spectre of regulation.

What are the top-down implications?

A confluence of new technologies beginning to work together in combination has the potential to spur a range of transformative shifts at an economic and societal level; productivity benefits of technology may finally begin to accelerate at a crucial time given the growth dampening effects of a shrinking labour force, technology will undoubtedly play a crucial role as critical enabler in tackling climate change, and will dramatically change the way many people work and build businesses, impacting wealth and income inequality in multiple ways.

How are we investing?

As patient, bottom-up, long-term fundamental investors, we follow our wealth creation framework in assessing investment opportunities. We seek to identify a range of exceptional companies that profitably participate in structural growth tailwinds across a diversified range of technologies and end markets. Examples include robotic assisted surgery, industrial automation, simulation of product development, and biological drug manufacturing to name just a few.

Given these massive profit pool shifts that have occurred, it has been an equally spectacular decade for technology investors too. Technology stocks have significantly outperformed the S&P500, and within that it has been some of the largest companies (the so called FAANG stocks) which have done particularly well. However, one meaningful difference between the most recent decade and the late 1990s is the evidence of real and sustainable fundamentals underpinning performance. From 2010 to 2019 revenue growth of the technology sector was twice that of the broader market, and operating margins expanded by an additional 525bps, resulting in technology stocks accounting for 32% of the growth in S&P 500 earnings over the past decade1. The margin differential has widened to such a degree that now $1 dollar of revenue growth that the technology sector delivers is at least twice as profitable as growth in the rest of the market and requires considerably less capital investment to boot2.

Exhibit 3: Significant price and fundamental outperformance of the technology sector

Words to the wise

“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10.”

– Bill Gates, Microsoft co-founder

Price Performance (indexed to 100 at 2010)

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Source: Credit Suisse

Source: Credit Suisse

Source: Credit Suisse

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Exhibit 4: Cumulative relative performance of internet stocks equally weighted (%)

Exhibit 5: Long term shareholder returns are explained by the compounding of cashflows (%)

Source: Bernstein

Source: CS HOLT

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1 Credit Suisse equity strategy, January 20202 Credit Suisse equity strategy, January 2020

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2.1 ICT as the fifth industrial revolutionAccording to Perez, we’ve had a technology revolution every 40 to 60 years (Exhibit 6).

1. the industrial revolution beginning in 1771

2. steam and railways starting in 1829

3. electricity and heavy engineering starting in 1875

4. oil, automobiles and mass production starting in 1908

5. our present age of information and communication technologies (ICT) starting in 1971.

Each one was typified by a rapid pace of economic and technological, spawned entirely new business models, and generated a new batch of entrepreneurs. Equally, the arrival of a new age saw old industries being displaced, featured speculative bubbles, losses in private savings, and quite often instances of social and political upheaval.

One of the most interesting, and relevant, observations of these revolutions is that each new era is founded upon, and enabled by, entirely new infrastructure which allows new companies to take the lead from incumbents who are built upon the old infrastructure. Secondly, a confluence of new technologies are then developed on top of the new infrastructure, and eventually converge.

For example, the revolution at the turn of the 20th century saw several major innovations combine to radically change the world: transport was revolutionised by combining oil and the combustion engine, and the ensuing development of cars and roads, electrification, and aviation resulted in the radical transformation and growth in the distribution and logistics industries for example.

In a similar fashion, the latest ICT revolution has involved the convergence of several technologies; semiconductors, computers, software, networking, and mobile phones are just a few of them, with the release of Intel’s microprocessor in 1971 being seen as the defining product of that era – at the same time that Silicon Valley was born. It has been said that San Francisco is to the ICT age what Pittsburgh was to the age of steel or Detroit was to the age of the automobile.

Although trying to characterise cycles is of limited use in assessing individual companies, it would be ignorant to suggest we cannot learn from the past. What we tend to find is that very few things are truly unprecedented, and it is not always different this time. It can provide useful context to aid (or indeed challenge) our understanding of the current environment and provide clues as to what we should be looking out for as companies and industries evolve.

For this we draw upon the work of Carlota Perez, a Venezuelan economist who teaches at several European universities, whose seminal work included “Technological Revolutions and Financial Capital” published in 2002.

Exhibit 6: Technology revolutions throughout history

Source: Carlota Perez

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Technology shifts through the ages2

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2.3 The importance of the turning point

2.2 Revolutions have stages

2.4 Are we entering the deployment phase?

Exhibit 7: The phases and turning point of a revolution

Source: Carlota Perez

Crucially, between the installation and deployment phase there is something she terms the ‘turning point’. The speculative frenzy of the installation phase leads to bubbles and crashes in the sector and the economy. What is important about this process is that financial bubbles play a critical role in facilitating the necessary over-investment in new infrastructure.

This has happened in each of the five revolutions. The dotcom boom resulted in a mass of cable and fibre being laid that allowed todays internet giants to reach widespread scale and mass adoption extremely quickly. In other words, they have created huge economic value benefitting from the massive capital expenditures, and indeed losses and bankruptcies, that occurred in creating the infrastructure

According to Perez framework, each technological revolution is divided into two very distinct phases.

1. The first, called the installation phase, is a time of “explosive growth and rapid innovation” and experimentation where grass roots innovation begins life as an idea, is nurtured in the lab, becomes financed by venture capitalists, and is eventually launched into the marketplace. She even likens it to a “frenzy” period characterized by “new industries, technology systems, infrastructures, intensive investment, and market growth.” This is very symptomatic of the period leading up to the dot com boom which peaked in 1999.

Perez recently tweeted that she believes we are likely still in the recovery phase of the turning point which is when the industry reassembles itself post a bust (she counts both the dot com and GFC together as the bust period). However, there is also plenty of evidence pointing towards the deployment phase and the most likely scenario is that we lie somewhere along this spectrum. But one thing is quite certain – we are past the installation period, and this has several important implications discussed in series 3 and 4.

For what it’s worth, we suspect most technologies are within the synergy phase. It is quite feasible, in our view, that a dawning of transformational technologies such as the smartphone (in consumer) and cloud computing (in enterprise) which emerged post the dot com and GFC busts, were in retrospect the initial phase of the recovery period. There was a reassembling of innovation and investment towards these platforms. The result of this recovery was an explosion of new things being built on top of them – for example there are now over 2.6M Android and 2.2M iOS apps available for download. However, very few of them leverage the rest of the technology ecosystem, and fewer still would be described as anywhere close to intelligent.

network. As the old joke goes in Silicon Valley – the cable companies provided all the capital and the internet companies took all the profit.

Again, this is no different from previous revolutions which saw a boom and bust in the initial ‘overbuilding’ of railways and canals, which allowed for future corporations to capture most of the economic value by taking advantage of that prior investment.

In this, history provides an important lesson. Investing in new technology per se does not necessarily generate high returns, and private savings are rarely appropriate for funding ultra-long-term economic infrastructure where the payoff is super long dated, and the value widely distributed to users.

2. The second major phase is called the deployment period, when the technology finally achieves widescale adoption and use, social behaviours change in response to the new paradigm, and results in clear winners and losers. Perez also divides this period into two sub-phases (1) synergy – the continued growth of the technology, where the technology and the market expands into its full potential (2) maturity – the market for the new technology begins to become saturated, social structures have completely adapted to the new technologies, and opportunities for investment are decreasing. Speculative financial capital moves on and begins to hunt for new sectors and new regions which may lay the foundation of the next great surge.

Hence the promise of the synergy stage, which is widely expected to bring about the convergence of several recent technology developments. This could be the combining of wearables with voice and artificial intelligence for personal assistants for the consumer or the combination of AI and IoT and Edge computing in industrial automation for the enterprise. All of this will be wrapped up and connected by software which provides the glue that sticks it all together.

Most intriguingly it will become both ubiquitous yet largely invisible – it will be ‘always on’ operating in the background, constantly gathering data and making decisions on our behalves (yet according to rules we have designed).

BAML call this the “Datafication” of everything and speculate that by the end of the decade we will have 500bn connectable devices vs. “only” 30bn today (Source: Cisco). By 2030, they calculate that autonomous vehicles (AVs) could generate more data than the earth’s entire population does today. And one smart city will generate even more data than all the AVs combined. Three billion more people will go online, and we will interact with an online device every 18 seconds by the middle of the decade – compared to every 6.5 mins today.

Installation period Deployment period

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3.1 Impacts on productivity and growth

In 1987 Robert Solow posed a now famous paradox: “a technological revolution, a drastic change in our productive lives,” had curiously been accompanied by a slowing down of productivity growth in the economy. “We can see the benefits of computers everywhere except in the productivity statistics.”

A recent study by MIT believes this is potentially explained, in whole or part, by the fact that new technologies (particularly revolutionary ones based off new infrastructure) require significant investment upfront in intangibles before the rewards (economic outputs) can be harvested. This causes a J-curve effect, where productivity initially dips before rising again. For example, the report suggests that up to 0.55ppts of 2017 GDP could have been impacted by investments in intangibles related to AI alone.

They estimate that investment in software has the most powerful J curve effect of all the main types of investment (greater than labour or capital). Aside from brief periods following the dot-com bust and the financial

crisis (incidentally periods when productivity increased) investment in software has grown significantly, and its level is sufficiently large to suggest that productivity growth has been under-measured throughout the history of software investment. Indeed spending on software now captures 15% of total investment dollars, up from 5% in the 1980s, and is reflective of an ongoing structural shift in business spending trends3.

While we do not see software investment slowing down any time soon, the nature of software delivery has been transformed: with the shift to software as a service (SaaS) business models, it is now much more efficient to implement and integrate, easier to operate, and it results in quite meaningful labour and capital efficiencies.

This is important because of the significant slowdown in labour force’s contribution to growth. Labour force growth is about a percentage point less than in the 1960s when real GDP growth averaged 4.3% annually (Exhibit 8 and 9). Today US GDP growth is stuck around 2%. Growth in the civilization labour force has been slowing since late 1970s, which is unlikely to change given ageing populations and slowing birth-death rates, and this will continue to put a brake on economic growth. Further, unemployment is already structurally very low. One of the reasons for this is for the increased mix of spending on services and entertainment, industries that are typically

Exhibit 9: US labour force (%)Exhibit 8: US productivity growth (%)

Source: AEIdeasSource: AEIdeas

2018 Q4/Q4

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3 Bernstein Report: Software in Downturn4 FRED Economic Research, https://fredblog.stlouisfed.org/2017/02/slow-labor-productivity-growth/5 https://howmuch.net/articles/price-changes-in-usa-in-past-20-years

quite labour intensive (restaurants and hotels struggle for reduced labour intensity, or logistics supporting ecommerce etc).

Hence, productivity will have to do the heavy lifting. The good news is a small difference in productivity growth can lead to a dramatic difference in the standard of living over the long run. At 2% productivity growth living standards would double every 35 years compared to every 99 years at the current rate of 0.7%4.

Moreover the productivity benefits of technology have not been evenly distributed throughout the economy. Sectors such as manufacturing, media, retail have been much faster to adopt technology. Prices of white goods, clothing, and even cars have become more affordable in real terms over the past 20 years. On a like for like basis, the cost of a TV has fallen a whopping 97% since 1998. You get substantially more for less.

In contrast, sectors such as healthcare and education have been much slower to adopt technology and at the same time have had to deal with the burden of increased regulation and state control. Healthcare is now over 225% more expensive, and higher education 183% more expensive, than 20 years ago5. Even college textbooks now cost almost 150% more than they used to. Essentially, discretionary goods have gotten cheaper but essential goods have gotten more expensive. It is imperative that we bend the arc of the cost growth in these sectors before they cripple our household budgets, and reducing the digital deficit by embracing technology will provide our best chance.

Top-down implications for the decade3

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While robotics and automation are not new concepts and have been used in virtually all industries for decades, it is the confluence of many technologies within the synergy stage (such as sensors, machine vision, and artificial intelligence) all coming together at once which is expected to cause a step change in the capabilities of automation.

As the graphic shows, this is not confined to industrial industries such as manufacturing or construction by any means. Not all robots have physical arms! Indeed, various other ‘bots’ such as chatbots, data miners, and web crawlers are really just software-based algorithms and will put numerous process orientated office jobs at risk across many sectors. While all this may sound depressing and dystopian, increased automation does not necessarily translate into fewer jobs if productivity increases, thereby supporting growth by expanding existing markets and developing new ones. For example, healthcare is an area where increased productivity is desperately needed to improve patient outcomes, whilst a sizeable reduction in environmental pollution will have a significant economic/standard of living impact.

Augmentation rather than automation

Our view is that too much debate has focused on “human versus machine”. Rather than it being about one “or” the other what will most likely transpire is how do we “augment”. A good example could be in healthcare where there is perhaps the greatest potential for societal as well as economic benefits. Ultimately, we want the highest quality medical decisions being made as efficiently and cheaply as possible.

Capturing all medical records electronically will allow patient histories, test results, and relevant information to be available for analysis. Applying big data and machine learning to these data sets will enable a patient to compare his specific condition more precisely to thousands if not millions of other patients who have experienced the condition before, allowing more accurate and precise treatment. Previously, treatment may have been prescribed based on the narrower experience and mental model of the GP.

It will also allow for changing roles, enabling the nursing workforce to be more effective in frontline delivery and providing physical and emotional assistance to patients, and gives highly trained and (higher cost) GPs, doctors, and physicians the time to focus on more complex and specialised care needs where their impact can be greatest.

Similarly, telemonitoring technology will allow patient consulting and monitoring to be done remotely, in the comfort of your own home, freeing up highly valuable hospital beds for serious acute care and even allowing patients in emerging markets to benefit from the specific skills of experienced doctors in developed markets.

The gig economy

Within the business environment technology is already having a major impact. Most companies today are embracing remote work and flexible work, which has been a game changer to anyone with young children! But the most dramatic impacts are unfolding outside of corporations entirely. It has given rise to the “gig economy” – a dramatic rise in the number of contract, temporary and freelance workers where people and jobs are typically matched through platforms such as TaskRabbit, Upwork, GitHub, or even Uber.

It is estimated that around 40% of the US workforce is involved in the gig economy, rising steadily each year and expected to reach well over 50% by the end of the decade. The main motivations are for wellbeing: 84% of freelancers are living their preferred lifestyle compared to just 54% of those working in traditional jobs; 78% of gig workers say they’re happier than those working traditional jobs, while 68% say they’re healthier. It is also about autonomy – 81% of full-time freelancers work as independents in order to be their own boss. Interestingly, a better lifestyle does not appear to be at the expense of lower incomes: 72 percent say they make the same amount or more money than they did before when fully employed678.

3.2 Impacts to the way we workWith labour productivity needing to improve in order to sustain our standard of living, it will inevitably bring changes to the way in which we work. Much of the debate has focused on the anxiety inducing aspects of this transition such as the prospect of robots replacing humans.

But there are many positive and liberating aspects too, including the increasing freedom that comes with the rise of the so-called gig economy. This is related to a phenomenon that Laetitia Vitaud describes as the rebirth of craftmanship in the economy. She argues that the kind of repetitive routine work which was originally designed for the automobile age is less relevant in the digital age. According to Laetitia, mass standardisation and mass

Automation

The anxieties around automation are not without merit. A recent OECD study believes that 14% of jobs across 32 countries are highly vulnerable, defined as having at least a 70% chance of automation. A further 32% of jobs were slightly less imperilled, with a probability between 50% and 70%. At current employment rates, that puts 210m jobs at risk across the 32 countries in the study (Exhibit 10).

production of the “Fordist era" are giving way to an age of customisation and personalisation with increasing rewards for creativity, responsibility, and autonomy – transforming work and management as we know it. The same thinking is being applied to the future of education, where the concept of a teacher standing in front of a room full of students – all of the same age, who are forced to listen and respond to direction, at the same time and pace, 7 hours a day, 5 days a week, for 12 + years – is being turned on its head. Customised and collaborative learning, which can be done almost anywhere and anytime, enabled by technology are some of the ways in which education is set to change in the coming decade.

Exhibit 10: Automation risk by job type

Source: Economist, https://www.economist.com/graphic-detail/2018/04/24/a-study-finds-nearly-half-of-jobs-are-vulnerable-to-automation

Food preparation

Construction

Cleaning

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Garment manufacturing

Personal service

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Information technology

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0 10 20 30 40 50 60 706 https://www.smallbizgenius.net/by-the-numbers/gig-economy-

statistics/#gref7 nation1099.com8 https://nation1099.com/gig-economy-data-freelancer-study/

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Golden age of entrepreneurialism

With all the media attention focusing on the extraordinary wealth of the CEOs of the tech giants (quite right too), we should not forget there are two major and interrelated structural trends that are having an enormous positive impact on the growth of entrepreneurship in the global economy.

1. Firstly, it is the number of people online. There are roughly 4.1B people (~53% of the global population) online as of 2019, and that number continues to grow at around 5-6% per annum10. Back in 2000 this was number was close to 10%, and the biggest delta in terms of number of people has been in emerging markets, which is home to 2/3 of the world’s population (Exhibit 12. China and India now use more mobile data than the rest of the world combined11.)

2. Secondly, the cost of starting a new business has fallen dramatically in the past two decades largely on account of technology. Again, the biggest delta has been in emerging markets where it has reduced by over 70% in many countries (Exhibit 13)

Hence it is not surprising that some of the most positive impacts have been felt in emerging markets, with many countries reporting that 20-40% of working age adults are entrepreneurs versus around 15% in the US12. From a technology perspective, emerging market countries are unencumbered by traditional infrastructure from the previous revolution. For example, in China mobile is used for over 80% of payments versus 27% in the US13.

While this is all quite exciting from an economic or entrepreneurial standpoint it has a number of high-level considerations for investors too.

• Firstly, barriers to entry for start-ups are substantially lower, both in terms of start-up costs and the barriers to access to talent (which can be sourced from around the globe), and once established they can scale more quickly.

• Secondly, some of the fastest growing companies in recent years have come from countries that have been borne outside of Silicon Valley. There are thriving tech hubs across the globe, most notably Tel Aviv in Israel, Shenzhen in China, and Bangalore in India which has risen rapidly to become the world’s third largest start-up ecosystem after San Francisco and London.

While the above provides a plethora of opportunities to the truly unconstrained global investor, there are of course risks that emerge too. It does mean that there is the potential for new disruptive business models, products, and innovations to emerge from nowhere.

The area where we find the risks greatest are in the consumer sphere. Consumers are notoriously fickle sources of demand, much more so than enterprise customers which can be quite sticky. The competitive advantages of brands are being eroded by the ability of innovative and agile direct to consumer (DTC) businesses to quickly launch a website on Shopify (and/or sell on the likes of Amazon, Alibaba, eBay), ship their product through third parties, and yet are able engage more

intimately with their customer base with highly targeted digital marketing campaigns and text message style chat, motivated by a shared alignment to a common philosophy (Exhibit 14).

The highly competitive nature of consumer retail is a reminder that successful long-term investment in innovation requires sustainable competitive advantages that are genuinely hard to replicate. Further, it requires a management team that constantly reinvest in the economic moat to maintain or even grow that advantage. These advantages can take on many forms, from intellectual property to network effects.

Exhibit 11: The office of a digital nomad

Source: International Telecommunications Union

Source: World Bank

Digital nomads

A special subset of the gig economy is the concept of ‘digital nomads’ – essentially freelancers who are location independent, either moving from location to location or even travelling the world while working. The ‘office’ is anywhere with a Wi-Fi connection. According to Upwork, “Digital nomads are people who are living life as an adventure, empowered by technology to break free of the constraints of the physical workplace.” It has proved extremely popular with millennials typically operating in the design, writing, photography, and marketing sectors. Upwork believe that around 40% of freelancers describe themselves as digital nomads. As Naval Ravikant, founder of Angel List says “The smart people have already figured out the internet enables this. They’ve already started to work more and more remotely, on their own schedule, on their own

time, in their own place, with their own friends, in their own way. That’s actually how we’re most productive. The information revolution, by making it easier to communicate, connect and cooperate, enables us to go back to working for ourselves9.”

Exhibit 14: An example of a DTC retail brand

Source: Twitter

Exhibit 12: Internet user penetration has risen dramatically...

Exhibit 13: ... While the cost of doing business has fallen

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9 https://twitter.com/coryjss/status/1186736716096266240?s=1110 Bernstein Report: US Internet, January 2020 11 Ericsson, https://www.ericsson.com/en/mobility-report/

reports/november-201912 CNN, http://edition.cnn.com/2014/05/13/business/numbers-

showing-africa-entrepreneurial-spirit/index.html13 Daxue Consulting, https://daxueconsulting.com/payment-

methods-in-china/

1918

Clean energy and energy efficiency

Investments in renewable energy have been compounding for decades. The best thing about compounding effects when applied to technology is that it can result in exponential declines in costs given rapid scaling and efficiency improvements. This has reduced unit costs almost precipitously to the point where now they have become much more economic than fossil fuels in most regions and end markets. And it isn’t going to stop here.

Michael Liebreich, founder of Bloomberg New Energy Finance, summarises this game changing development:

BNEF has concluded that around two-thirds of the world’s population now live in countries in which wind or solar are the lowest-cost ways of generating power. The world records for low-cost wind and solar are both now down to around $17/MWh. That is around a third of the cost of new gas-powered generation – even in the U.S., where there is a glut of cheap gas.

By 2030, I have no doubt whatsoever that the world record for low-cost onshore wind and solar will be below $10/MWh. It will probably be set in China, Morocco, Mexico or the Gulf states, who have been vying for leadership for the past decade. However, there is a chance it could be in India, Brazil, the U.S. or even Australia.

The cost of distributed renewables too will have reached new lows, far below retail costs of electricity in most parts of the world. By 2030 erecting a new building without integrating solar power, without equipping it with battery and a heat pump, without capturing rain water, will be an act of deliberate economic self-harm.

As we approach the final days of 2019, wind and solar are generating around 8.5% of global electricity. BNEF estimates that figure will be nearer 25% by 2030.

Battery prices, which were above $1,100 per kilowatt-hour in 2010, have fallen 87% in real terms to $156/kWh in 2019. BNEF’s 2019 Battery Price Survey, predicts that as cumulative demand passes 2TWh in 2024, prices will fall below $100/kWh. This price is seen as the point around which EVs will start to reach price parity with internal combustion engine vehicles (Exhibit 16).

3.3 Impacts of climate changeThe ability and willingness to arrest climate change has never been greater, and we believe it will be the dominant narrative across politics, business, and investing in the current decade. The devastating impacts of climate change in recent years have not only captured the hearts and minds of the general public, but it has increasingly captured the hearts and, most importantly, minds of the technology industry. From a narrow technological perspective (the scope of this paper), there is much to be positive about. It is undeniable that technology has and will continue to play a major role in decarbonising our economy.

We look at three themes where technology is playing a vital role in tackling climate change:

1. The production of energy, which is the largest opportunity for carbon emission reductions, with a quarter of global emissions released by the power sector (MS.)

2. The global food system, which contributes 25-30% of greenhouse gas emissions (Source: Ellen MacArthur Foundation, IPCC 2019.)

3. The fashion industry, which although smaller at 10% of annual global carbon emissions, is still more than all international flights and maritime shipping combined (Source: World Bank.)

Source: International Telecommunications Union Source: BloombergNEF

Exhibit 15: Solar installed cost reaching parity on LCOE basis

Exhibit 16: Lithium-ion battery pack price – real 2019 $/kWh

US coal Oil LNG SolarHenry hub

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0

20

00

20

02

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Pri

ce in

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Real)

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1,183

917

721663

588

381

293

219180

156

22%

21%

8%11%

35%

23%

26%18%

13%

2120

Whilst the economics are now incredibly compelling, supply side behaviours have been much slower to change given vested interests and the amount of capital stock that has been built. Unfortunately, carbon taxes and subsidies have not always been effective in shifting energy producer behaviour either. New policies being put forward include the proposal to place legal and financing restrictions on fossil fuel capex. UBS estimates that between now and 2050 there is an expected $15 trillion of global fossil fuel capex that is to be spent at the current trajectory. To achieve net zero carbon, they claim that it is required that 2/3 of that ($10 trillion) fossil fuel capex would need to rotate into clean energy.

However, it is on the demand side of energy consumption where some of the biggest incremental gains could come from this decade – again, it is the convergence of technologies that are now making this possible. Artificial intelligence, IoT, and 5G/6G connectivity are just some of the technologies that will allow previously ‘dumb’ things to become incredibly ‘smart’. BAML calls these the “Smart Six:” and it includes Infrastructure, buildings, homes, safety, energy, mobility.

1. Smart infrastructure: Smart infrastructure investments can transform traditional infrastructure. The global smart city ICT infrastructure market is projected to reach US$1.7tn by 2025E, 17.5% CAGR vs. 2017 (Source: Verified Market Intelligence).

2. Buildings: We spend 90% of our time in buildings which account for c.40% of energy, 25% of water, and 40% of resource use, and a third of GHG emissions. However, just 10% of US buildings have basic smart technologies (e.g. efficient lighting or monitoring). The global smart building market is to grow from US$61bn in 2019 to US$106bn by 2024E (Source: Markets and Markets, 11.7% CAGR).

3. Smart homes: Smart Home devices can control, automate and optimize household functions like lighting, heating, cooling, entertainment, safety and voice assistants. The global market for Smart Homes is projected to grow to US$405bn by 2030E, at a 25% CAGR from US$14bn in 2015 (Source: AT Kearney).

4. Smart, safety and security: Smart Cities are integrating an increasing number of ICT-enabled devices and measures to improve

safety and security. The Safe City market will see US$226bn in revenues in 2015-21E with opportunities in CCTV, incident detection, adaptive lighting, emergency alerts, environmental monitoring, disease surveillance, epidemic monitoring, and smart/assisted care14.

5. Smart energy: Smart Grids – digitalized and connected electrical grid comprising cleantech – could grow to US$169bn by 2025E (Source: Allied Market Research,12.4% 2018-25 CAGR). New global investments in zero carbon electricity generation capacity are expected to be US$3.8tn cumulative in 2021-30 vs. US$656bn for fossil only (Source: BNEF NEO 2019). Solar/Wind power, smart meters, and electric vehicles could all be key catalysts for smart energy take-up.

6. Smart mobility: The US$7tn mobility market is inefficient, expensive, and highly polluting (>20% of global emissions). The biggest shifts in urban transport and mobility will be in the next decade. Electric cars will gain share vs gasoline cars in the 2020s15. A shift towards Mobility as a Service is a viable option to city car usage while digital capabilities (sensor data, diagnostics, analytics) can help improve efficiency and reduce costs (accidents, repairs).

Innovative agriculture

Agriculture primarily contributes to climate change by the simultaneous impact of conversion of carbon reducing fields and forests into carbon emitting farming and livestock land. According to BAML, mass expansion of vertical, urban and greenhouse farming are just some of the technologies that could provide part of the solution, alongside changing consumer preferences, that could increase land productivity while reducing resource use and the impact on the environment.

The Netherlands is a remarkable example of this in action (Exhibit 14). Despite being 270x smaller in size than the US, it is the second-largest exporter of vegetables, beaten only marginally by the US, and is the largest exporter for potatoes and onions by value. In fact, the country accounts for over a third of vegetable seeds traded. It achieves this sustainable food production through greenhouse farming and lighting crops throughout the night (Source: National Geographic 2017).

Vertical farming (the growing of plants on shelves) can be substantially more land

efficient than open field and even greenhouse farming, albeit currently it is quite energy intensive given the lighting which would need to be powered renewably. But given the potential for greenhouses to be placed closer to urban areas, it can reduce the cost (and carbon impact) of transportation quite considerably. Taken one step further, the growing of food products directly within urban spaces has been growing in popularity. Paris is set to open a 14,000m2 urban farm, the world’s largest, in early 2020. The rooftop site will grow over 30 different plant species and produce 1,000kg of organic fruit and veg every day during its high season (Source: The Guardian 2019).

Sustainable fashion

At the current pace, the fashion industry is on track to consume 25% of the world’s carbon budget by 2050 (from 10% today). While the gluttonous over-consumption of apparel by humans is a necessary behavioural shift that needs to take place in order to arrest the unsustainable growth in waste (apparel consumption is on track to increase from 62mt to 102mt by 2030, the equivalent of 500bn t shirts)16, the industry is finally beginning to seriously invest in a number of technologies related to sustainable materials, recycling, digital/3D printing, and RFID tracking.

Importantly, the industry’s largest companies are getting on board. In September 2019, Amazon announced plans to become net zero carbon across their businesses by 2040, which is a decade ahead of the Paris Agreement’s goal of 2050. Along the way, it expects to reach 100% renewable energy by 2030 and 50% shipments net zero carbon by 2030. Shipment Zero packages will be transported in one of AMZN’s 100k newly ordered electric delivery vehicles, an electric bike, or an electric rickshaw in India. (Source: MS).

Whilst outside retail fashion, only a few months later in January 2020 Microsoft announced its pledge to become “carbon negative” by 2030 and, by the year 2050, it aims to remove “all of the carbon” from the environment that it has emitted since the company was founded in 1975. Unsurprisingly it plans to achieve this through a variety of technologies, some currently unproven such as direct capturing of carbon dioxide from the air.

Exhibit 17: Greenhouse farming at scale in the Netherlands

14 BAML Report: Transforming World, November, 201915 BAML Report: Transforming World, November, 2019 16 Barclays Report: Global Fashion, January 2020

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3.4 Impacts on capital marketsAs the title of her book suggests, Perez believes that technological revolutions are tightly coupled with financial cycles. One of the implications of the framework is that as we progress through the deployment phase there is incrementally less need for the kind of highly speculative capital that was prevalent in the installation phase – a time when visionary venture capitals were required to back pioneering entrepreneurs off to explore the great unknown.

The share of capital being invested shifts more towards ‘production capital’ and away from speculative capital as technology shifts more towards incremental than disruptive innovation. Significantly, as its name suggests, production capital is also increasingly provided for by the major companies of the new paradigm. This would seem to the case today, as the majority of investment dollars for the critical technologies which will likely define the 2020s (such as artificial intelligence) are being provided for by the likes of Google, Amazon, Microsoft etc int heir capital expenditures and research and development budgets.

Taken to its logical conclusion it may suggest we have reached the peak this cycle in terms of the volume of ‘blockbuster’ size VC deals and funding rounds that catalysed the current round of technologies and companies which have been established in the past 10 years (Exhibit 18).

emergence of a new disruptive car company (Tesla) to come along and threaten the existing incumbents by going all in on the new technology rather than the old technology (the combustion engine).

The internet as we know it was ‘discovered’ in the very early 1990s, Amazon was founded in 1994, and Google founded in 1998, some 20-30 years ago and as we have outlined this is likely to be the prevailing paradigm for at least another 10 years.

That is not to say that financial speculative capital goes away by any means, but it may take pause, as the ‘heat’ around valuations and exits (IPOs) starts to cool. Moreover, it becomes incrementally less interested in backing the “nth” similar business model in an increasingly crowded space and instead begins the early hunt for the “next big thing”. These include technologies which could potentially lead to the emergence of a 6th revolution, based on completely new infrastructure that has the potential to displace and disrupt the current one.

As an example, there is a lot of debate whether the amount of speculative financial capital that has gone into blockchain and crypto could foretell the basis of a new revolution, a version of the internet that is truly decentralised and democratised with the potential to undermine the current centralised structure of today’s internet. Others point to quantum and even biological computing as potential new eras.

Whilst this may or may not be the case (we have no strong view), we should remember how long it can take for a new infrastructure paradigm to firstly establish itself, then attract a critical mass of entrepreneurs and financiers, before finally changing behaviours. For example, it took many decades of advancements in an alternative platform – battery technology – to finally allow the

Source: crunchbase

Exhibit 18: Number of VC rounds of $100m or more

US

China70

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Words to the wise

"Any sufficiently advanced technology is equivalent to magic."

– Arthur C. Clarke, author

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4.1 The new industrial juggernautsThe tech industry is starting to look like every other industry that has been through a revolution. According to history, in the beginning there is an explosion of new companies in the installation phase, but what you end up with by the time of the deployment phase is a handful of dominant large players, followed by a long tail of specialist companies up and across the value chain.

It is important to note that the deployment phase does not imply that innovation stops by any means. But by this point, the new infrastructure is now firmly embedded, such that most new products and services are built on top of this architecture. This is certainly what appears to be happening today, whereby new companies and start-ups are launching on top of AWS (Amazon Web Services) or Azure (Microsoft equivalent) and leveraging open source software applications that often partner directly with these platforms.

Indeed, whilst many studying Perez have likened Amazon, Microsoft, Apple, and Google as being the GM, Ford, and Chrysler of the 21st century, General Electric might be a better analogy given that it was the backbone to so many industries. The three large cloud providers (Amazon, Google, Microsoft) are providing much of the infrastructure to the tech industry through storage and compute.

We should add that we believe there are several material differences between these eras from an investment standpoint. For one, internet companies have a vastly superior business model to car companies. In general, relative to heavy industrials, internet companies benefit greatly from:

• Network effects

• Low capital intensity

• Low/zero marginal costs

• Rapid scalability

• Potential to be everywhere (not just one industry but permeate all industries)

In addition, if there is one feature that has the potential to be a game changer compared to previous paradigms, it would be the self-reinforcing positive feedback loop of data and artificial intelligence.

As Azeem Azhar writes data and AI create a virtuous flywheel whereby “data begets AI, begets better products, begets more data, begets better AI, begets better products. In traditional operating models, scale inevitably reaches a point at which it delivers diminishing returns. But we don’t necessarily see this with AI-driven models, in which the return on scale can continue to climb to previously unheard-of levels (Exhibit 16). Now imagine what happens when an AI-driven firm competes with a traditional firm by serving the same customers with a similar (or better) value proposition and a much more scalable operating model.” In a recent report, HBR call this kind of confrontation a “collision. As both learning and network effects amplify volume’s impact on value creation, firms built on a digital core can overwhelm traditional organizations.” Taken to its logical conclusion – this theory (not one we necessarily subscribe to) states that whichever company, or indeed country, leads the AI race will lead the world for the decades ahead.

Source: HBR

Exhibit 19: How AI driven companies can outstrip traditional firms

Number of users

Valu

e

Traditional operating model

Digital operating model

Industry implications for the decade4

2726

4.2 Growth likely to remain strong

4.3 Mega cap not without risks

The large technology companies have a multitude of growth opportunities which they are exploiting. However, there are perhaps three major ones that account for most of the growth and each of them are very large and significant profit pools in their own right.

1. Digital advertising: estimated to be around 50% penetrated today, currently growing at around 15-20%, with potential to reach 70% penetrated over the next 4/5 years. It is the most mature of the three major profit pools17.

2. Ecommerce: estimated to be around 10% penetrated today, with potential to reach 30% penetrated by the end of the decade, currently growing at around 10-15%. Given the physical investments required (distribution centres, logistics) this could be a longer and slightly slower burn.

3. Cloud: estimated to be around 25% penetrated today, with potential to reach 70% penetrated by the end of the current decade, currently growing at around 20-25%. Growth in the cloud and the software applications which are built on top are likely to be the biggest drivers of profit pool

While digital advertising continues to take share from physical advertising and as ecommerce continues to take share from physical retail, we shouldn’t forget that both advertising and retail spend in aggregate have historically been quite cyclical.

However, given that digital continues to take share of the overall advertising pie, the cyclical impact may be dampened in the event of a downturn, similar to the experience during the financial crisis. Back then, while spending on traditional advertising and physical retail fell by 12% and 9% respectively, spending on digital advertising and ecommerce did not decline but the pace of growth slowed (from 20-30% pre crisis to mid-single digit growth at the bottom). But at some point, the structural becomes the cyclical as digital penetration matures, which may occur within the next 5 years. At that point, rivalry would increase as participants ‘fight’ for lower rates of incremental growth.

shifts within the technology sector itself, taking share of wallet away from spending on hardware.

Whilst all the companies participate in all these profit pools in some form or another, Amazon is quite unique in being a major player in each. It dominates US eCommerce with 38% market share but capturing nearly 60% of all incremental online spend. It is roughly 6x bigger than eBay, the number two player. Similarly, it is the number one Cloud provider in the US, with close to 40% market share and nearly twice as large as Azure. And whilst only a distant number 3 in digital advertising with around 5% market share (some way behind Facebook and Google which account for 70% combined), it is the fastest growing among the three18.

Amazon/AWS is penetrating an incredible number of industry verticals in the unique position as both a service provider and a competitor to existing large incumbents as well as early stage start-ups. In perhaps its most famous example, AWS provides all the back-end cloud infrastructure hosting for Netflix despite the fact it competes head on with Prime Video.

We are more concerned with the potential structural impacts of increased competition and regulation within and between the big companies. Mega cap tech are increasingly battling it out between each other across content, advertising, payments, cloud, and the home (such as smart speakers and gaming).

It may come as a surprise to those reading the press in recent years that technology has been one of the least regulated sectors. Up until recently it has been a difficult one for the Government and lawmakers to tackle based on traditional metrics given that, in general, technology results in lower prices which benefits the consumer. And, at least in theory, consumers are easily able to switch web browsers, search engines, and shopping sites.

Where technology is pushing the limits, if not certainly balancing a fine line, is in the areas of anti-trust (monopolistic behaviour stifling competition and innovation), and privacy (rights to use personal data). Whilst fines and settlements are now frequently running into the billions, the numbers have paled in comparison to the profits the technology companies have made by capitalising on these advantages over many years, explaining why the market so far has rewarded stock prices more on the news of a settlement to an investigation than on the initial negative headline.

However, we cannot be complacent for two main reasons (1) costs to comply with regulation are increasing, not just in fines but also in terms of prevention (2) M&A is almost certainly more difficult to do today than 10 years ago. Some of the large cap technology companies would be struggling for growth if it wasn’t for the transformative deals of recent years. Instagram and YouTube are the fastest growing business within Facebook and Google and may account for around one third of their respective valuations.

Ultimately it is fundamentals which drive the stock performance, hence the concern for regulation would be whether it can negatively impact margins or place limits on growth. At this point, there hasn’t been meaningful evidence of its impact other than to Facebook where the cost to comply with regulations is expected to continue compressing EBIT margins. CEO Mark Zuckerberg said on the

third quarter 2017 earnings call “I’ve directed our teams to invest so much in security on top of the other investments we’re making that it will significantly impact our profitability going forward” and that appears to be precisely what is happening (Exhibit 21).

On the flipside, it is important to recognise one of the major unintended consequences of regulation is that because it increases the cost of doing business, it commonly results in the shutting out of smaller players, thus increasing the barriers to entry to competition. It is no coincidence that sectors which have seen an increase in regulation in recent decades, such as finance or healthcare, have also seen big increases in consolidation with the largest companies increasing their markets share.

This can be said of previous revolutions too, where increasing regulation arguably contributed to an eventual handful of companies dominating the period following the introduction of each new industrial technology, from the railways to the automobile to the aircraft.

Exhibit 20: Technology has been one of the least regulated sectors

Exhibit 21: How costs to comply with regulation can impact margins – Facebook (%)

Source: BAML Source: Bernstein

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17 Bernstein Report: US Internet18 Bernstein Report: US Internet

Words to the wise

"Privacy is dead, and social media holds the smoking gun."

– Pete Cashmore, CEO of Mashable

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Look beyond the ‘technology’ sector

Investing in technology extends well beyond the list of companies as defined by traditional sector classification standards. Despite significant structural shifts in the economy, global industry classification standards (GICS) classifications have largely remained unchanged for 25 years. Today, the leading companies across all sectors, industries, and end markets are not only embracing technology but are pioneers of technology in their own right.

We believe some of the most attractive opportunities for investing alongside technological trends fall outside of the technology ‘sector’ itself. Healthcare would be a prime example. Not only are there numerous structural growth tailwinds to be found in the healthcare industry, but it also offers some of the strongest and most sustainable competitive advantages and relatively more certain demand. As such, healthcare technology is a major area of focus for us. Some examples include:

• Intuitive Surgical is the global leader in the rapidly emerging field of robotic assisted minimally invasive surgery. There is substantial room for growth given that robotic surgery today accounts for less than 2% of all surgical procedures and is less than 15% penetrated in the US. Crucially, Intuitive has built significant competitive barriers over past 20 years with over 5k robotic systems installed, over 6m surgeries performed, over 18k peer reviewed clinical papers, and 2 decades of accumulated R&D investment, data & analytics that is far ahead of competitors. Intuitive operates in a

highly regulated segment of the market and has a conservative customer base who have invested substantial training and experience into the platform19.

• Idexx is a leading provider of diagnostics and IT products and services in the pet and animal health market. Idexx accounts for 80% of total industry R&D spend and enjoys a strong pipeline of industry leading innovation which is well ahead of peers. Idexx’s business model is very sticky as there are high switching costs involved; clients have committed significant capital to purchase the specialised equipment and rely on Idexx’s market-leading knowledge and support, reliability, and reputation. Customer retention is around 98%. In addition, it operates a relatively defensive business model where recurring product revenues (consumables) represent over 70% of total sales and more of profits.

• Edwards Lifesciences designs, develops, manufactures, and markets products and services to treat late-stage cardiovascular disease. The Company’s products include tissue replacement heart valves, heart valve repair products, and patient monitoring systems. Edwards is a dominant, best-in-class provider with significant market share. Highly focussed cardio specialist backed by substantial R&D, intellectual property (IP) and years of experience. Constant innovation has kept Edwards ahead of competitive offerings. High barriers to entry and exit also exist in the form of clinical data, performance, training, scale and reputation.

Favour software over hardware

Within technology, we expect a continued profit pool shift from hardware to software. We estimate that software now captures close to 40% of revenue dollars, compared to just 5% in 1980 (Exhibit 23). This is expected to continue as hardware increasingly becomes commoditised and as the ‘smarts’ migrate towards the software application layer at the top of the technology stack. This is evident in the relative growth rates and outlook between software centric and hardware centric companies in the technology sector. There is still a substantial amount of revenue that is still to shift. When ranking the technology and communications sector in order of revenues, we find that most of the largest companies are still hardware or infrastructure centric, where growth rates and margins tend to be lower and capital intensity higher.

Higher rates of growth and margins are in part attributable to the pervasive nature of software, penetrating almost every industry

vertical and its very low marginal cost. As Marc Andreessen presciently titled in his 2011 essay ‘software is eating the world’. In your car for example, software now oversees everything from the engine to the infotainment.

In addition, software spending has proven to be far more resilient to economic and business cycles. Indeed, Bernstein estimate that investment spending on software has a beta to GDP growth of only 0.4 vs. a beta of 2.4 for the broader capital investment category and a beta of 0.6 for consumer spending. Some of the reasons for this include the fact that software can help drive automation and cost reduction. The transformation to a subscription-based revenue model should further help support the stability of cashflows. According to Bernstein over the past 10 years, software revenue models have shifted materially towards durable recurring revenue sources (~80% of total revenues on average in 2019, up from 50% in 2008) with strong renewal rates (average >90% amongst their coverage).

4.4 Sector preferencesFavour enterprise over consumer

We have a tendency to favour enterprise technology rather than consumer focused technology, as it tends to exhibit greater barriers to entry/exit, longer and more predictable product cycles, lower regulatory risk, greater potential to upsell/cross sell, and is increasingly moving towards a recurring revenue model which helps improve the stability of cashflows. In contrast consumers tend to be incredibly fickle, more transactional in their relationship, and commonly switch from one brand or fad to another.

Switching has long been a feature in consumer hardware (cameras, TVs, printers etc), and arguably we are now seeing the same occur in consumer applications such as content, social

Source: Bernstein

Source: FT.com

Exhibit 23: Split of revenue between hardware and software companies ($m)

Exhibit 22: New social media apps can scale faster than ever before

1980 2020

100

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60

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0

SoftwareHardware

WeChat WhatsApp

Instagram Twitter

Snapchat Facebook

TikTok2,500

2,000

1,500

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(m)

0 5 10 15

Years after launch

Words to the wise

“When I first started using the phrase software engineering, it was considered to be quite amusing. They used to kid me about my radical ideas. Software eventually and necessarily gained the same respect as any other discipline.”

– Margaret Hamilton, mathematician and computer science pioneer

19 Information sourced from company and broker reports

media, and gaming as our attention moves skittishly from Facebook to YouTube to Spotify to Instagram to TikTok to Netflix and so on (Exhibit 22).

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5.1 Bottom-up wealth creation frameworkInvesting in “disruption” has become topic de jour in equity markets in recent years. However, as we have shown in this series the concept of disruption is not new – it is simply a modern-day term for a long-standing phenomenon that has underpinned economic development for centuries.

Even Jeff Bezos, the CEO of Amazon, the poster child of disruption in the 21st century had this to say:

“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two”

What Jeff is saying here is that business strategy should focus on goals which are eternal truths regardless of which technology or trend comes by along the way. Within retail he says that customers will almost always want lower prices, better selection, and faster delivery. Technology is merely the medium of delivery of this outcome.

We apply a very similar principle to investing. We call it our wealth creation framework. The wealth creation framework speaks to the timeless characteristics of a company that empower it with the best possible chance of compounding cash flows at a higher rate and with a more stable trajectory.

• Competitive advantage: from pricing power to IP, a company must have an edge over the competition that will stand the test of time.

• Runways for growth: we look for companies that benefit from enduring growth tailwinds that won’t be held up by market cycles.

• Capital allocation: it takes skill and commitment to reinvest wisely for the long-term benefit of the business and shareholders, whether that be to reinforce the competitive advantage or give back to shareholders. Capital discipline and good governance is very important to wealth creation.

• Predictability: we prefer companies with stable cashflows that can reliably and persistently create wealth over a long period of time.

Runways for growth is one of the key characteristics we look for in a company, but it is not sufficient in isolation to create wealth. Far from it – it is perfectly possible to be an unprofitable disruptor with disastrous outcomes for shareholders. The most important requirement of all is to generate high and sustainable returns on capital over a long timeframe. This is a function of possessing a substantial competitive advantage, strong capital allocation decision making, and certainty of demand. We believe that when all these components align with a structural tailwind to growth, then the magic of compounding occurs and a genuinely great investment is unlocked.

How are we investing?5

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5.2 Profit pool shifts 5.3 Exceptional companiesNevertheless, for every winner of a profit pool shift there must also be a loser, and this is why it is crucial to understand structural shifts in the economy. Being on the right side of the shift can be a useful tailwind to profit growth and value creation, while being on the wrong side can be very painful – as many offline retailers and consumer staples companies (and their shareholders) have discovered to their cost.

We only invest in 25-35 exceptional global companies that combine a structural growth opportunity with an enduring competitive advantage and solid stewardship. They have been carefully selected from an unconstrained global universe, enabling us to build a portfolio which benefits from profit pool shifts across a diversified range of end markets. Technology is at the core of many of these shifts, including but not limited to:

• The continuing displacement of laparoscopic surgery with robotic technology.

• The rapid growth in single-use systems in biopharmaceutical manufacturing.

• The increasing application of simulation software in product design and development.

• Increasing industrial automation in factories.

• The demand for increasingly complicated technology advice.

• Digital transformation.

• The volume of sensors and connectors used in an increasingly connected world.

• Growth in companion animal care and sophisticated diagnostics and treatment.

• Transition to electro-mechanical and software enabled security systems.

• The need for environmentally friendly hygiene products and improving water efficiency and cleanliness.

• The transition from synthetic to natural ingredients and colourings.

• Increasing use of high-end camera technology to support smart cities and safer environments.

• Transition from cash based to electronic payment technologies.

• Shift from on premise computing to off premise computing.

• Shift from offline retail to online retail.

Exceptional companies are rare, and we want to leverage all the tools we have at our disposal to find them and nurture them. We believe we can improve our changes by having a global opportunity set and being unconstrained in how we identify those ideas – not wedded to any benchmark, sector or country.

We also manage to a capacity which is optimised for risk adjusted returns, which we believe is significantly lower than where many large managers operate. Once funds under management runs into the tens of billions the fishing pond quickly becomes limited to only the vary largest stocks in the index.

It means we do not have to compromise by owning a mega cap where our exposure to its core competitive advantage becomes diluted over time as it expands into new markets in order to sustain growth. That means we can be highly targeted in finding the most attractive companies in the most attractive profit pools.

Most importantly, the main advantage to leverage as an investor is to think longer than the marginal buyer and hold these

companies for the long term to unlock their compounding potential. Finally, when investors find exceptional companies, they should back them with conviction by investing in a focused and manageable number of holdings.

The wealth creation framework outlined above explains the qualities that we seek in companies as part of a strategy that prioritises investment returns derived from the long term compounding of earnings and cashflows. For the companies we invest in, technology is at the heart of two of the pillars of the framework. It provides long term structural growth opportunities and competitive advantages in the form of research and innovation leadership. To help bring this to life with some examples, we feature two companies: Ansys, a global leader in the provision of simulation software and Intuitive Surgical, a pioneer in robotic-assisted, minimally invasive surgery.

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Ansys (ANSS: US) Intuitive Surgical (NASDAQ: ISRG)We believe ANSYS empowers the world’s leading companies to design and deliver transformational products and is a mission critical partner offering best of breed simulation solutions.

Fundamental OverviewIn our opinion Ansys is the leader in the provision of engineering simulation software. The Company provides a pure business to business solution, with high recurring revenue, consistent free cash flow generation and strong competitive advantages. We believe Ansys is well positioned to benefit from structural growth in simulation software driven by businesses recognizing the return on investment from cost savings and reduced product lead times the technology provides.

On a mission to disrupt surgery with a robotic-assisted surgery platform. We believe ISRG offers a compelling value proposition for patients, hospitals, and surgeons.

Competitive Advantage

• 49-year history of technology innovation and commitment to engineering simulation:

• Unique & powerful Multiphysics (broadest/deepest physics solutions)

• Common platform from cloud to edge and leading partner ecosystem (e.g. SAP, Nvidia, PTC)

• Embedded into universities & industry training

• Technology leadership and reputation for simulating products across multiple physics with the highest accuracy has meant:

• Very high ROI for customer,

• Pricing power for Ansys,

• Sector leading margins (45%)

• High recurring revenue (80%)

Competitive Advantage

We believe ISRG maintains a

strong competitive advantage:

• 20Yrs+ R&D, with 2,250 global patents

• Vast clinical and surgical data amassed from 1mn+ procedures

• Installed base approaching 4K and 1,400 training simulators

• Over 10K academic papers written using Da Vinci

• Highly regulated market and conservative customer base

• Scale - R&D, customers, manufacturing, marketing, data

• High switching costs – training, experience, risk, capital, throughput, patient acceptance)

• Multiple procedure types per device

Fundamental OverviewWe believe ISRG is the global leader in the rapidly emerging field of robotic-assisted minimally invasive surgery. The Company strives to make surgery more effective, less invasive and easier on surgeons, patients and their families. The Company’s Da Vinci Surgical systems and advanced instruments and accessories bring enhanced vision, dexterity and precision to minimally invasive surgery.

Runway for Growth

• We believe Ansys has a significant opportunity to expand the company’s existing footprint and drive broader adoption

• New applications (modules on the Ansys platform)

• Additional users (80-85% of business is deeper penetration from existing customer)

• Higher consumption of simulation

• We believe Ansys is positioned well for major new industry trends driving long-term secular growth opportunities

• Digital revolution making product design and delivery harder

• Faster, cheaper computing power

• Autonomous, Discovery Live, Digital Twin less than 5% of revenue today

Runway for Growth

We believe ISRG is positioned for

a multiyear growth opportunity:

• Robotic surgery < than 2% of surgical procedures

• US addressable opportunities less than 12% penetrated

• New specialist applications (hernia and colorectal)

• Huge opportunity in General Surgery

• Overseas – 30% of sales (60% more typical).

• Surgeon demographics (increase in trained surgeons)

• Higher utilisation

• New products (single probe)

• Low to mid teens procedure growth

• Low macro sensitivity

We believe robotic surgery is cost neutral vs convectional procedures, but total healthcare costs are substantially reduced as a result of:

Better outcomes

• Faster recovery• Less secondary complications• Lowe infection rates• Lower readmission rates

Better care team experience

• Greater dexterity• More reach• Better visuals• Less surgeon fatigue

Capital Allocation

• Ansys has a high cash-to-market value for its peer group, which we believe will continue to support steady share buybacks and acquisitions. The company’s healthy operating margin has helped to consistently generate excess cash flow. Further, the company has steadily maintained annual share buybacks in the last three years.

• In our view the company may use more tuck-in deals, such as its acquisition of Optis, to expand product capabilities.

Capital Allocation

• Significant reinvestment back into R&D (US$500mn) which provides a scale advantage backed by significant know-how

• Excess cash over an above R&D and capex is returned to shareholders

• Focus on core expertise, not interested in expanding into adjacencies

1 Source: Ansys presenation 2019. Total addressable market (TAM) and compound annual growth rate (CAGR) information throughout presentation is based on third party study completed by Evalueserve Inc. in 2019 commissioned by ANSYS. Study was based on customer and industry expert interviews and review of industry analyst reports and com mentaries. Refer to Cautionary Statement for a discussion of factors that could impact future financial results.

2 Source: Ansys 2019 Presentation. Peer average based on Autodesk, Cadence, Dassault, PTC, Synopsys, Altair Engineering and Aspen Technology. Average based on non-GAAP operating margin obtained from company financial reports except for Aspen Technology and Altair Engineering which do not report non-GAAP operating margin. Aspen Technology margin was calculated by dividing 2018 non-GAAP operating income by GAAP revenue. Altair Engineering margin was calculated by dividing adjusted EBITDA by GAAP revenue. Peer companies may use different methods for calculating non-GAAP financial metrics such as operating income and EBITDA. Readers are encouraged to reference peer disclosure for calculations which may impact comparability across peer group.

Image Source: Intuitive Surgical press resources

1 Source: Intuitive Surgical, Investor Presentation Q4 2019

The ANSYS Total Addressable Market ForSimulation Will ~Triple In The Next 7 10 Years1

Maintaining Industry-Leading Operating Margins - Actual Non-GAAP Operating Margin2

2026

$15.8B –$20.6B

~$6.6B

$9B –$9.5B

2022

New Adjacencies

Foundation

Emerging -HighGrowth Solutions

2018

~3X

0%

5%

2016 (ASC 605) 2017 (ASC 605) 2018 (ASC 606) Peer Average (2018)

50%

45%

40%

35%

30%

25%

20%

15%

10%

Wealth Creation Framework

Wealth Creation Framework

Cumulative

1500+ peer reviewed articles published

18,000+ peer reviewed articles published

6,000,000+ procedures performed

900 da Vinci

1,000,000+ procedures performed

systems placed

4986 da Vinci systems placed globallyUrologyGynecology

Worldwide Procedure Trend1

Other General Surgery

0

250,000

500,000

750,000

1,000,000

1,250,000

2013 2014 2015 2016 2017 2018

18% Growth2018

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Important Note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (AMP Capital) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.

This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.