With today’s disruption dynamic unlikely to slow in 2020, companies at the epicenter of technological obsolescence will continue to be negatively impacted. As the number of attractive industries to invest in shrinks, navigating secular risk is critical to success in 2020. Relying on traditional mean reversion for companies is certainly more difficult than in the past.
Companies at the epicentre of technological obsolescence continue to be negatively impacted, including cable television networks, newspapers, retail, legacy tech, and legacy oil. However, the next stage in this economic revolution – which we call ‘Disruption 4.0’ – is not limited to specific sectors but is structurally transforming business models across the entire global economy. In 2018, our T. Rowe Price analysts estimated that 31% of the S&P 500 market cap was threatened by disruption. As of October 2019, the number of at‑risk companies had increased but, due to underperformance, their share of S&P 500 market cap had declined to 29%. Disruption has created a strong fundamental backdrop for its beneficiaries – such as the major technology platform companies – while curbing earnings growth for many incumbent groups trading at lower multiples.
Amazon is probably one of the the biggest factor driving secular changes for other companies – particularly traditional retail, malls and grocery stores. With the emergence of AWS, its cloud‑based platform, tech hardware has come under pressure as well.
Source: FactSet Research Systems; data analysis by T. Rowe Price. 1 June 1 2007 through 31 October 2019 Past performance is not a reliable indicator of future performance.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by T. Rowe Price, and no assumptions should be made that the securities identified and discussed were or will be profitable.
Managements fail to fix fundamental issues Although a number of challenged, or ‘incumbent,’ companies are seeking to meet challengers head on, the track record for these efforts so far has been relatively poor. In our view, too many boards and management teams are – using an American football analogy – throwing ‘Hail Mary’ passes by pushing ambitious acquisition deals to try to fix fundamental problems.
Many, if not most, of these deals have resulted in poor financial returns and have failed to achieve the intended strategic objectives. Because of these bad capital allocation decisions, we believe many challenged companies are likely to be sub-par long‑term investments, almost regardless of valuations. However, disruption also is improving the growth characteristics of some traditional sectors, Utilities, for example, typically have been viewed as defensive yield plays, but the sector has evolved in recent years. In recent years it has demonstrated newfound growth potential, which may not have been fully rewarded by the market.
The three factors powering utilities We see three trends powering earnings growth for some utilities. Firstly, we are seeing a more favourable regulatory climate. Many states are allowing utilities to start earning a return upon breaking ground on new power plants, rather than when the facility comes online.
Secondly, advances in fracking technology have caused natural gas prices to drop dramatically in many US service areas. While much of those savings are being passed along to consumers, utilities also have been able to retain part, boosting return on equity.
Finally, utilities are benefiting from the falling costs of renewable energy, with solar and wind generation now cheaper than coal‑fired power in some regions and at certain times of the day. Operating costs for renewable installations also tend to be significantly lower than for conventional power stations.
The dramatic impact on utility earnings The impact on earnings has been dramatic. While the utility industry saw virtually zero earnings growth from 1986 through 1998— even as S&P 500 earnings rose 150% over that same period—that gap has narrowed substantially over the past two decades.
We believe continued declines in renewable costs and improvements in storage capacity could fuel a sustained, multi‑decade period of above‑trend earnings growth for utilities. Yet, recent valuations have reflected only a small premium over the broad US market.
Careful stock selection is needed to avoid troubled utilities, as well as companies with significant markets in poorly regulated states. However, in our view a utility able to grow earnings at 6% per year, with a dividend 1.5x the yield on the 10‑year US Treasury note, should trade at a higher multiple than on offer today.
Navigating a disruptive future The number of attractive industries is shrinking, so navigating secular risk is critical to investment success. Relying on traditional mean reversion for companies is more difficult than in the past. It is hard to paint a picture of how companies like Viacom, Discovery or General Mills can innovate out of the secular challenges. Even a successful company not exposed to secular risk or disruption can suffer severe multiple compression if the market perceives its problems as a secular risk.
We think the emergence of secular risk could create a powerful tailwind for active investing and poses a significant challenge for passive investing over the next five to 10 years. In our view, it also highlights the importance of long‑term investing on a three to five‑year time horizon. At T. Rowe Price, we try to manage this risk by being structurally underweight secularly challenged companies.