Companies are having a much harder time producing earnings growth. Those that are positioned on the right side of change should be better placed to increase profits—and deliver investment returns—in a growth-constrained world.
Corporate profit margins today are much higher than their average since the early 1950s (Display). These profitability levels are very high, even when taking into account that the mix of US economic activity has shifted toward more capital-light business models (e.g., services and technology), which inherently generate higher margins.
But not every company or industry is facing the same squeeze on earnings growth. In particular, changes triggered by technology, regulation or structural shifts in specific markets are excellent sources of growth potential—even in an earnings-constrained world. Finding companies that are on the right side of changes like these is one of several ways that active investors can capture excess returns over long time horizons.
Using Technology Right
Technological change isn’t only about the Internet or social networks. Consider the retail sector, where new technology and information systems allow companies to take advantage of massive amounts of available data on customer behavior. Companies that recognize this potential and invest accordingly are using these tools to deepen relationships with customers—and are capable of doing better than rivals who haven’t.
Manufacturing is another case in point. Companies that are at the vanguard of manufacturing innovation have greater flexibility in managing their businesses, which provides a powerful way to boost profitability.
For example, when we researched Nike in 2015, we discovered innovations that looked likely to significantly improve the company’s earnings growth potential. Nike may be adding sophisticated chips to some of its sneakers; this will allow it to deepen its relationship with customers by offering personalized deals that bypass retail outlets, bringing more profit to the shoemaker. It’s also using a new automated manufacturing technology called Flyknit that lets customers customize their orders with minimal labor, allowing Nike to shift its production closer to consumers—in the US and around the world—and save costs on shipping, duties and tariffs. Our research suggests that innovations like these are transforming Nike’s business model and could potentially trigger a leap in its profitability.
Why the wide gap between our view and the street’s? It’s because most analysts aren’t evaluating how new technologies and processes will filter down to the bottom line over several years; the potential payoff is a couple of years beyond their horizon. In a short-term world, building thoughtful, independent models like these can make the difference in choosing stocks that stand out from the crowd.
The Innovation Factor
It’s not only giants like Nike that turn innovation into investment opportunities. It’s becoming easier every year for people to change the world because traditional barriers to innovation—such as capital and time—are falling dramatically.
Today, new ideas can be transformed into businesses for only a fraction of the prior cost thanks to continued exponential declines in the cost of computing. For example, the required costs of a typical tech start-up have fallen by roughly 95% since the dot-com era of the 1990s (Display, left). And the disruptive potential is enormous, as seen in the shift in advertising from print newspapers toward the digital world, which has had a profound impact on profits for both traditional media companies like the New York Times and new media leaders like Google (Display, right). For investors, the challenge is to get an early grasp on how unfolding changes will transform the profitability outlook for a wide range of companies.
Transcending Traditional Industries
This often requires an understanding of broad themes that transcend traditional industries and sectors. For example, increasing environmental awareness is spurring global efforts to address challenges that include carbon emissions, clean water, food availability and sanitation. Policy support and technological progress are making the shift to decarbonized energy inevitable, in our view. And the costs of renewable energy such as solar or lithium-ion batteries for electric cars are falling dramatically (Display). We believe that many investors have underestimated the disruptive potential of exponential cost improvements to drive faster and broader adoption.
Changes like these are opening up big investing opportunities. Over the next 15 years, we estimate that $4 trillion will be invested in new solar and wind capacity. Industries like these are highly fragmented, and offer strong growth opportunities for winners.
But identifying investment targets requires a substantial research effort in order to understand the technological and business dynamics of many public companies operating in nascent industries. By searching for businesses that are on the right side of changes like these, we believe investors can find companies that should be well positioned to grow their earnings—even when broader business conditions are stagnant.
Frank Caruso is CIO US Growth Equities at AB and Daniel C. Roarty is CIO Global Growth.
