'New economy' stocks are one of the main reasons behind Wall Street and main street divergence. They led stock market recovery during the Covid-19 crash. They bring the S&P500 index (not to mention Nasdaq) to a new high when the world is still suffering from the pandemic effect. FAANG is part of the new economy, and so with other 'tech' stocks, or 'fourth industrial revolution' stocks.
The term ‘new economy’ has been around for decades. Time magazine’s cover in May 1983 captured most of the points. It described the transition from heavy industry to a new technology-based economy. Peter Drucker in Post-Capitalist Society (1994) made an interesting point:
in the new economy, knowledge is not just another resource alongside the traditional factors of production (labor, land, and capital). It is the only meaningful resource. There is no definitive definition for the new economy, but we believe most people agree, knowledge is one of the critical properties of new economy sectors.
Research by Viktor Shvets of Macquarie Group, an investment bank, captures the new economy’s feats very well and analyzes it through a Dupont lens. The study surveyed about 10,000 non-financial listed companies globally from 2011-2019 and classified them into new and old economy sectors. The classification uses the GICS (Global Industry Classification Standard) Sub Industry, which may not accurately describe the new economy population. Nevertheless, it is sufficient to point out the difference between the new and old economy.
Shvets highlighted that new economy sectors exhibit better feats vs. old economy sectors. First, the new economy sectors have been gaining significant shares in revenue and profit. Second, revenue and profit growth rates have been higher. Third, ROE and ROA were higher in the new economy sectors.
With the Dupont analysis framework, Shvets identifies the driver of the new economy. First new economy sectors have better asset efficiency that is driven by intangible capital. As it turns out, R&D drives intangible capital. Second, new economy sectors have higher and more stable net profit margins. Third, since 1990, old economy sectors consistently exhibit higher leverage.
The first and foremost is intangible assets, such as goodwill, brands, patents, trademarks, copyrights, software, customer lists, recipes, capitalized R&D costs, etc. About 32% of new economy sectors’ assets are intangibles, higher than 13% intangibles in old economy sectors. Expectedly, the new economy sectors spent 5.5% of revenue on R&D, while the old economy spent less than 1%.
Such a rosy picture, isn’t it?
The Caveats
Investing in new economy stocks has caveats. First, identifying and measuring the intangibles of these companies are tricky. For example, market capitalization of Apple is $2 trillion. Do we think investors pay so much money for $90 billion book value? Do we think its $90 billion book value can generate $40-50 billion annual free cash flow for the foreseeable future so that we buy it at $2 trillion? Compared to other hardware manufacturers, Apple is expensive, unless we examine its intangible assets, which its peers may lack. But how do we measure its intangible assets if there is no such thing in its balance sheet? Various methods have been proposed, for example, adding S&GA and R&D expenses to book value. But this doesn’t rightly measure intangibles too. It’s tricky.
Second, intangible assets can suddenly lose their value. The starkest consequence of the hype in the new economy is that an image of contenders can cost the incumbent value dearly. When potential entrants challenge the incumbent by offering superior products, market may punish the incumbent without waiting for the results. For example, Grubhub in late 2018 lost more than 50% of market value because the market was afraid of stricter competition from Uber Eats or Door Dash. The jitter was justifiable. Quarters after that, Grubhub seems to pay more to defend its market share, and its share price has not recovered yet.
Our Strategy
While finding stock opportunities in new economy sectors is an intriguing idea, we should balance the optimism with professional skepticism. After all, investing is buying future, uncertain cashflow.
At Christmas Corp, we don’t blindly flock into the hype. We still hold our classic wisdom, that a company’s worth is its competitive advantage; and the consequences are consistent performance. However, with rapid technology innovation, a company’s competitive advantage is under constant pressure. If the competitive advantage is one of the physical factors (land, labor, or capital), we should be more worried. If the competitive advantage is intangible, then we should examine how such intangible assets are created. Strong brands take a long time to build, but a swift shift in consumer preferences will make them obsolete in a short time. Moreover, strong brands are not about how well-known is the brand, but to what extent people are willing to sacrifice themselves to get that brand. If the intangible assets are created from advanced tech, we should watch for more advanced tech possibilities.
As closing remarks, we would like to recall Michio Kaku’s Cave Man Principle: whenever there is a conflict between new technology and human desires, the desires win. This principle may help us determine which new economy stocks will survive.
