In our previous articles we addressed the investment case and key components of what we call a ‘future focussed portfolio’, and an unpacking of the opportunity we see in global Mega Caps. This solves for the underweight exposure to innovation and technology enabled businesses typical in many Australian investors’ portfolios.
We segue now to a fundamental question that many are asking: why are investors underestimating the opportunities in a global and exponential world?
Technological innovation is occurring at an accelerating pace, this we know all too well, and it becomes even more apparent when we try to project forward 10, 20 or 50 years from now. At the heart of this acceleration is one of the most powerful and transformative forces we have ever witnessed: our collective shift online which has transformed businesses from local and linear, to global and exponential.
This change has thrown up a range of Mega Cap winners; Amazon, Apple, Microsoft, Alphabet (Google) and more. But we believe that investors are still underestimating the size of the opportunity created. It has spawned a core group of companies that use the technology provided by the Mega Caps to scale globally and generate exponential growth – the global and exponentials.
It should be noted that the shift from local and linear to global and exponential is no coincidence. The Mega Caps have laid the foundation of today’s digital infrastructure, infrastructure that is the equivalent of the railway and roads of our physical world, with two key technologies forming the basis of this infrastructure and precipitating the Nasdaq acceleration: cloud computing in 2006 and the smartphone in 2007 (Figure 1).
Cloud computing, pioneered by Amazon, enables businesses to leverage their physical infrastructure to scale their own businesses internationally. The smartphone, led by Apple, allows businesses to reach large cohorts of users at incredibly low costs.
In many ways small businesses can compete with larger players like never before. Organizations are using innovative digital infrastructure to deliver products and services at demonstrably lower costs, disrupting the economics of prevailing business models.
This rapid transformation is comparable to the shift from analogue to digital photos which took place in the first decade of the 21st century (Figure 2), where digitization left analogue in the dust. Even Kodak, the inventor of the technology was caught off guard.
Global digital technology platform models like Netflix, Airbnb and Uber are transforming industries at an accelerated pace, and an all-too-common investor mistake is to underestimate the Total Addressable Market (TAM). Amazon comes to mind as ‘just a bookstore’ but there are examples closer to home as well, such as Xero, the first cloud-based accounting software, now moving global and growing exponentially.
Xero’s founder Rod Drury understood that moving to cloud accounting would change the economics of the SME accounting industry. Xero has been successful, but many investors still underestimate the sheer size of Xero’s global opportunity.
Xero’s platform is currently used in 180 (out of 195) countries globally. They have a direct presence (website, pricing, and people) in 12 countries today that have a combined population of 936 million and nearly 100 million SMEs.
In New Zealand, according to Stats NZ (the national statistical authority), the ratio of SMEs per capita is 1 in 9. Xero however, due to its ubiquitous coverage in New Zealand, and because it has data to verify this through its interactions with nearly all the SMEs in the country, understands that the ratio is closer to 1 in 7.
So, what explains this mismatch in addressable markets for NZ accounting software?
It is a combination of conservative statistical estimates of the TAM and the transformative innovation of cloud accounting that is driving SME adoption. That is: Xero’s value proposition is pushing SMEs to adopt the software at an earlier stage of their business.
By March 31, 2024 we estimate Xero will have nearly 5 million customers (Figure 3) and approximately NZ$1.5bn in revenue. But those 5 million customers would still be less than 5% of the global market it currently operates in today.
If we consider the 180 countries where Xero’s product is currently used, but where it does not have a physical presence (i.e., people, offices, etc.), the number of SMEs exceeds 400 million.
With less than 2% global market share at this point, it would continue to make sense for Xero to reinvest just about all its NZ$1.5bn revenue to capture the global network effect of a platform ecosystem.
In doing so, metrics like P/E ratios are elevated as Xero suppresses earnings to address the opportunity. At a market capitalization of AU$15bn, Xero is still just a start-up on a global stage. This is a common trait for the global and exponential opportunities. A long-term horizon is not just helpful here, it is a prerequisite.
While the adoption of accounting software can take some time for businesses to migrate, digital products have the ability to scale frighteningly fast.
Natively digital products have an unfair advantage in their ability to transverse across the globe. The global digital opportunity is only set to accelerate as 40% of the world’s population remain disconnected (Figure 4). China, for example, had more than 85 million people move online for the first time in 2021, four times Australia’s total population. With penetration in China at just 68% there is still significant growth to come.
While the spread of Covid-19 has given many of us an introductory lesson on exponential movements, the speed of adoption in business can be both exciting and daunting for investors. In less than six years Tik Tok has accumulated a billion users, dramatically outpacing the adoption of any social media application in history (Figure 5).
For investors, disruption at this pace can mean that the fundamentals of a business can change very quickly. But what is the best approach? There has to be a focus on the value proposition – the underlying driver of sales — to understand these changes.
With the digital infrastructure largely laid by the Mega Caps, the ability for businesses to move globally is substantially simplified. Thus, a focus on the value proposition is a key leading indicator to business growth.
Afterpay, another homegrown example, typifies this.
Many Australian investors were puzzled by the growth of ‘just a credit card for millennials’, but they missed the real value proposition, which was driving incremental sales to small businesses, increasing the businesses’ conversion rates. When businesses implemented Afterpay they saw a significant uptick in sales, and in a few short years, retailers were pulling Afterpay across the globe to drive growth for their international stores.
Fundamental value driven investors and conventional funds typically do not invest in global and exponential businesses because these stocks fall outside traditional evaluation parameters, such as price/earnings ratio and dividend yield.
However, for global and exponential models, as the likes of Xero and Afterpay (now Block) illustrate, the scale of their global opportunity may not be captured through a conventional lens.
The speed and size of these markets can be perplexing for investors. Many ignore these models altogether. But that causes real issues for locally focused portfolios that have a lack of exposure to innovation in the first instance.
By blending a component of Mega Caps with a component of global and exponential opportunities in the one portfolio, we believe a future focused portfolio can give investors unique exposure to the certainty and defensiveness of the Mega Caps, coupled with significant growth opportunities that are present in tomorrow’s emerging global leaders.
Looking for some more information on how to build a future focused portfolio? Click here
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