The Australian Sharemarket represents just 3% of global market capitalization, yet many Australian investors have a domestic market bias in their portfolios. This misses 97% of global opportunities and creates a bias that is a serious potential growth impediment for both Australian index and active investors.
Australian investors have overweight positions in resources and local financial services and are underweight in innovation and technology enabled businesses. As shown in the Sector Exposure graph below, the IShares Core S&P ASX 200 ETF (which is a proxy for the Australian market) has large weightings to the basic materials and financial services sectors. A traditional diversification strategy to include exposure to a broad-based global index, such as the MSCI World, doesn’t solve for the underweight exposure to innovation and technology enabled businesses. An allocation to a future focused portfolio is required to appropriately reweight the typical Australian investor’s portfolio.
The future-focused portfolio should have exposure to:
The world is now divided into two types of businesses: ‘old world’ and ‘new world’. Last century’s old-world organisations needed to be big to be global, with large teams of people in international office networks. They took years in waterfall style, steady and sequential development to bring products to market.
The local and linear old-world businesses, that often form the bulk of many Australians’ investment portfolios, face serious disruption if they are incapable or unwilling to transform. Kodak is an infamous example. Kodak invented the digital camera, but the leadership team did not have the risk appetite to take the digital camera to market and disrupt their existing, profitable product lines. The rest, as they say, is history.
Australia’s local banks are particularly ripe for this disruption. They were designed last century with bricks and mortar presence and are now crippled by ever increasing risk and compliance overheads. The banks tell us they are modern, but other than online banking, what product or service innovation has any incumbent bank delivered this century?
By contrast, with the power of computing, the cloud and mobile technology, ‘new world’ businesses can expand at near zero marginal cost, virtually overnight, and capture a global market.
“Instead of thousands of employees and large physical plants, modern start-ups are small organizations focused on information technologies. They dematerialize what was once physical and create new products and revenue streams in months, sometimes weeks. It no longer takes a huge corporation to have a huge impact.” Peter Diamandis, futurist and founder of Singularity University.
COVID has accelerated the transformation to new world businesses, which are digitally enabled and global. They are the ‘global and exponential’ platforms we live and work on today (e.g. Zoom, Amazon, Netflix) that continue to deliver huge profits and returns.
Australian investors need to significantly ramp up their exposure to ‘new world’ companies to broaden their opportunity set, ensure participation in new “game-changing” economic propositions and lift potential returns.
The future focused portfolio solves this underweight with three key building blocks:
The future focused portfolio must have a core exposure to the infrastructure providers of the digital world. These are the companies that enable the development of e-commerce, and distribution of digital entertainment and gaming, the infrastructure on which much of our digital lives are based. These massive companies such as Amazon, Tencent, Alibaba, Alphabet, Facebook, Microsoft and Apple are dubbed ‘Mega Caps’ and technologists refer to these companies and their networked platforms as Web 2.0 based entities.
Many investors believe technology enabled businesses are risky. That view assumes that many of these companies are unprofitable. But that view ignores the value propositions, the balance sheets, and in the case of the Mega Caps, the network advantage of billions of growing customers. The chart below shows the exceptional levels of operating cash flows that are generated by the Mega Caps. For example, in FY 2020 Amazon generated an operating cash flow of approximately AUD $100 billion.
The truth is that most of the companies that would be considered for a future focussed portfolio are highly profitable. And if they are not, they are deliberately so as they expand rapidly to exploit the opportunity to capture their global market share.
The Mega Caps are benefiting markedly from the centralisation and scaling of data globally, creating near unassailable network economics and competitive advantages. The strength of the Mega Cap business models was clearly recognised in Q1 2020 when they fell substantially less under the quickest sell off in equity market history.
Post pandemic, the digital infrastructure provided by the Mega Caps is looking more essential than ever. We believe that the structural digital transformation already underway has accelerated.
The future focussed portfolio should also have core holdings in companies that use the technology provided by the Mega Caps to scale globally and generate exponential growth.
Typically, these companies will be in sectors such as e-commerce, entertainment, technology hardware, internet of things, gaming and the shift to renewable energy. Companies such as Tesla, Xero, Megaport, Meituan and Xiomai are good examples.
The Mega Cap stocks, and those that can be global and exponential, are fantastic businesses leveraging technology at scale, with incredible margins and global customer bases. It is difficult to contemplate where the competition might come from.
The future focussed Australian investor should have a third kind of ‘new world’ investment: Web 3.0.
The decentralisation movement (AI, Blockchain, Distributed Ledger and related technologies) of Web 3.0 is ushering in a new era of core technology infrastructure and innovation enabling a shift from the ‘internet of communication’ to the ‘internet of value’. This new Web 3.0 technology platform is reflected in digital asset markets.
The picture below depicts the shift that is underway. Many readers will remember the companies that dominated the Web 1.0 landscape, the original search engines and email that allowed us to find information and communicate, a very static environment.
The arrival of Web 2.0 allowed the growth of transactions, e-commerce, data storage and networking. Many of the brands depicted in Web 2.0 below have become some of the largest companies in the world and were, and still are, at the forefront of disruption and innovation. Web 3.0 decentralised digital protocols now threaten the Web 2.0 businesses.
A prime example is Bitcoin which provides a solution to governance over our money. Further examples are Filecoin, which is providing a decentralised cloud solution for privacy and security over data and Ethereum, which provides a technology layer for verifying and recording transactions.
Web 3.0 will enable the global digitalisation of financial services. Australia is particularly exposed to disruption from Web 3.0 as the local equity markets are substantially overweight financial services.
In addition, the decentralised platforms and public networks of Web 3.0 solve the privacy and security issues currently facing Web 2.0 companies today. We therefore believe the key threats to Web 2.0 companies and many traditional ‘old world’ companies are likely to come from Web 3.0 solutions in the future. Furthermore, many of the public open network solutions of Web 3.0 are likely to be many times larger than platforms solutions of Web 2.0.
The future focussed portfolio should have an allocation to Web 3.0 because this new technology is likely to be the potential disruptor of today’s Mega Caps. Investors need to look beyond the volatility of a digital asset and understand the use cases and what the blockchain technology that underpins the digital asset enables. Without understanding the technology, it is easy for an investor to dismiss digital assets as “vapor ware” or to suggest that they have no value.
An understanding of Web 3.0 and the potential threat it poses to existing businesses is a key tenant of the future focussed portfolio. There is increasing adoption of digital assets and the infrastructure underpinning them by many large global companies that have identified the threat to their business models and are looking to implement strategies that incorporate the infrastructure in order to future proof their businesses.
Well known examples include Visa and Mastercard, enabling payments via digital assets and incorporating blockchain technology in their businesses. Web 3.0 is likely to spawn a whole new breed of innovative organisations that will have significantly lower cost bases with no legacy systems or business models. Investors need to be aware of these competitors enabled by blockchains and what they could do to incumbent businesses.
If you walked out your front door and took 30 ‘exponential’ steps (let’s say west), where would you land? Would you be in NSW? In Perth? South America? You would, in fact, travel 26 times around the planet… hard to believe.
Exponential growth may sound scientific, but it is a simple doubling, that is, 1, 2, 4, 8, 16, 32 and so on. This simple anecdote illustrates the power of ‘exponential’ to drive explosive growth, and which is at the heart of ‘new world’ companies.
To grow and protect their wealth in the years to come, Australian investors should be building a future-focussed portfolio. That means shifting from disruption-prone ‘local and linear’ investments to the exciting world of ‘global and exponential’.
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