Get ready for more creative destruction: key themes for 2014 and beyond - Heptagon Capital – Production

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the…

Get ready for more creative destruction: key themes for 2014 and beyond

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

The 30-second summary: Thematic investing is a core part of our investment process at Heptagon. We seek to identify long-term secular trends that will only likely grow in importance over time. From this work we also typically discover businesses that look well-placed to benefit. Our best ideas are profiled below. We discuss the impact of the data deluge (key beneficiaries include Western Digital and Telecity), the digitisation of the healthcare and education sectors (McKesson and Pearson), the growth of personalised medicine (Ilumina), 3D-printing (3D Systems), the robot revolution (Duerr) and nanotechnology (FEI). Interested investors can access a range of these ideas via our Helicon UCITS equity fund, or via our Helicon Future Trends product.

The future may be upon us sooner than we realise. Over the last three years we have written in our Helicon Thoughts series about the growing pervasiveness of trends as seemingly disparate as robotics, 3D-printing, personalised medicine and nanotechnology. Yet what they all share in common are exponential growth prospects and inherent disruptive capabilities, serving to challenge established norms and conventional ways of doing business. Investing in many of the pioneers of these industries can therefore be a potentially lucrative strategy.

This trend of ‘creative destruction’ (an idea first developed by Karl Marx but popularised by the Austrian economist Josef Schumpeter) is, of course, not a new one. In the past, developments such as steam power, electricity, telephones, automobiles, aeroplanes and computers among others have been transformational. Each of these advances constituted a new way of doing things; economies correspondingly were able to do more with less, to create additional value with reduced input. However, at the same time, seemingly traditional or accepted ways of doing business were supplanted and rendered much less relevant, profit pools necessarily shifted, and industry structures redrawn.

To gauge how quickly the world is changing, just consider some of the following statistics. In 1975, the world’s fastest super-computer cost the equivalent of $5m; now, an iPhone with equal performance capabilities retails for less than $300. Over 1.1bn people (or 15% of the world’s population) at present own such smartphones. During the next ten years, this figure will more than double. As spectacularly, the Human Genome Project cost $2.7bn and took 13 years through to 2003 to complete. Currently, however, a genome can be sequenced for less than $10,000, but over the next decade, the cost will fall to under $100 with the process taking less than an hour. Elsewhere, the cost of 3D-printers has fallen 90% in the last four years and soon these devices will be ubiquitous in both the workplace and the home. Robots will be too: there has already been growth of 170% in industrial robots in the last three years. Many other such examples abound.

Moreover, as these disruptive technologies combine, they will become mutually overlapping and therefore reinforcing, thereby magnifying their impact. Imagine a scenario, for example, where robots administer targeted medicines to patients with all of their medical records stored electronically in the cloud; or, a setting where replacement body parts are printed easily and customised with enhanced facilities in order to prolong life. Even if not all of these potentially enticing futuristic situations come to pass, it is at least clear that new technologies can act as enabling factors for corporates to sustain already-high margin levels, while consumers will certainly benefit from broader choice in many areas. On the flipside, some workers will inevitably be displaced as a result of some of these developments and firms/ policymakers will clearly therefore also need to think intelligently about the related redeployment of labour.

Irrespective of these observations, there is no doubting that disruption is set to become the norm and many of the trends we have observed are already increasingly prevalent within our everyday world. With your author having begun his career in financial services during the Internet boom of the late-90s, we however always remain mindful of the dangers of hype and hence possible investor disappointment. As a consequence, in writing Helicon Thoughts (we have now published 22 editions) we seek to highlight those trends that we believe are set to grow in importance regardless of what happens to global economic growth and notwithstanding state intervention. Below is a non-exhaustive list of some of the themes discussed as well as a number of businesses that have the potential to benefit.

The data deluge
Data arguably lies at the heart of all current innovation and this is why it was the first topic we discussed in our original Helicon Thoughts note of March 2011. Put simply, the increasing digitisation of the global economy means that all new technologies are effectively becoming information technologies. Smart grids, digital oilfields and electronic healthcare records, for example, are all increasingly commonplace and their importance will only grow. Even today, where over 50% of the world’s population still lacks an internet connection, already some 200m emails are sent and more than 2m search queries made on Google every single minute. The world’s largest retailer (Wal-Mart) handles over 1m customer transactions every hour and these are imported into their databases, equivalent to over 50m ‘real world’ filing cabinets.

Two things therefore seem clear. Not only is data set to grow (Cisco forecasts a 30%+ growth rate in overall internet traffic for 2014 alone) but it also needs to be stored, secured, retrieved and analysed. Improvements in processing power (Moore’s Law) and declining costs underpin these trends. However, according to consultants IDC even today, if every person wanted to store every byte of digital content created, then there would be a shortfall of around 35%. This gap is expected to grow by some 60% through to 2020, implying that ever-larger amounts of data will end up simply not stored.

Businesses that are poised to benefit from these trends include Western Digital and Telecity. Western Digital is the world’s largest provider of digital storage, controlling around 45% of the hard-disk drive market. Around 90% of data is currently stored in this format and it will likely remain the dominant format in the medium-term. The company is also actively investing in new technologies such as solid-state storage. Meanwhile, Telecity is one of Europe’s largest carrier-neutral data centres. Such centres allow customers to warehouse and scale up their data strategies and also transfer their data quickly via a range of service providers. In 2013, Western Digital gained 97% and Telecity lost 8%.

The digitisation of the healthcare and education sectors
Although at first sight these two sectors would appear to have little in common, both have seen major expansion in recent years (healthcare expenditure accounts for about 17% of a typical OECD nation’s GDP and education a further 7%). At the same time that governments globally are seeking to limit further expenditure in these areas wherever possible in order to control budget deficits. Moreover, with both industries being remarkably inefficient in many respects, digitisation is a logical response to managing the twin challenges of necessary expansion and cost control.

Take healthcare first. Consider that nearly 7,000 deaths per year occur in America alone owing to prescription error. Additionally, prescribing faults constitute the largest identified source of preventable mistakes in hospitals. A recent report by the Institute of Medicine estimated that a hospitalised patient is exposed to a medication error on each day of his or her stay, while another study by RAND (a US non-profit health policy research institute) suggests that American hospitals end up spending around $1bn annually on treating some 200,000 ‘drug-adverse events’ in hospitals.

Against this background, there is a strong case for embracing IT within the healthcare industry. Broad and consistent utilisation of information technology would not only reduce healthcare costs but, more importantly, improve healthcare quality and help prevent medical errors. In an ideal world, all patients would have electronic medical records and there would be full computerised physician order entry for prescription drugs and other similar treatments. Wide-ranging estimates have put the benefits from introducing electronic health records and other similar projects at between $80bn and $450bn annually for the US (depending on what is included within the definition of healthcare IT; most, conservatively, average at about $300bn).

Turning to education, given the strong correlation between related spend and economic returns (a college graduate will, on average, earn over their career lifetime, $0.9m more than a high-school drop-out according to the US Government), the case for investing in this area is persuasive. Price-conscious individuals/ households that are increasingly choosing (or having) to fund directly education are doing so on their own terms. As a result, a free market for teaching talent, paid according to the demand for appropriate skills, is emerging. The smart education market – where a range of technologies are being used to transform traditional systems into a more automated virtual learning environment – is already worth $74bn (according to Markets & Markets, an independent research firm), and could be worth $220bn in 2017.

Pearson has made strong inroads into this market and stands out among listed education businesses. Beyond being the largest provider of educational services globally, with over $7bn of sales (more than 1.5x its nearest rival), some 50% of its revenues now derive from digital services, a figure it hopes to grow to 75% by 2015. In the healthcare arena, McKesson is a healthcare technology solutions and service provider with a market leadership position in medical management software (in addition to being a dominant player within the field of pharmaceutical distribution). Its products have been sold into more than 50% of US hospitals and McKesson has over 200,000 physician and 50,000 retail pharmacy customers. The company manages more than 21m patient records and processed over 14bn pharmacy transactions last year. In 2013, Pearson gained 13% and McKesson increased by 66%.

The growth of personalised medicine
While digitising healthcare records and patient prescriptions is undeniably a logical step in the right direction, it should be seen as part of a broader revolution sweeping through healthcare. Put simply, current medical practice is predominantly reactive, with treatment/ medication commencing after the concerning signs and symptoms appear. In the future, medical practice may become substantially more proactive. Although less than 1% of the human genome differs between individuals, understanding these differences holds the prospect for great advances in disease prevention and treatment.

Just a decade ago it cost around $80m to sequence a human genome, based on data from the US body, the National Human Genome Research Institute. It was hence the preserve of specialised academic and government research centres. Even five years ago, the cost remained exorbitantly high, at close to $9m. By contrast, today the cost is only $1,000. Data throughput and the cost of DNA sequencing are currently improving by a factor of 10 every 18 months. As a result, a sequencing machine today would cost a surgery or hospital as little as $50,000, fit comfortably onto a desk, and be able to read 10m letters of genetic code with a high degree of accuracy in only two hours.

Given the availability and cost of this information, patients may benefit in many respects including identifying people with predispositions for a particular disease; detecting whether a person has a disease, often at earlier stages of the illness than was previously possible; ascertaining the effectiveness of a particular drug therapy for an individual; and, describing the precise nature of a disease including its condition severity. Leading diabetes drugs manufacturer Novo Nordisk, for example, estimates that around 30% of people who diabetes are not even aware of it, resulting in significant (more than $60bn) of unnecessary healthcare costs globally. Meanwhile other studies suggest that the total cost of ineffective drugs and their side-effects, resulting hospital admissions, lost productivity and premature death cost the US alone at least $100bn annually.

The molecular diagnostics market is already worth around $5bn and is set to expand to between $15bn and $25bn by the decade’s end, on calculations made by the UnitedHealth Group. At present, around 1,200 genetic tests are currently available for approximately 2,500 conditions, with several new tests being introduced each month. Illumina is in the vanguard with regard to producing tools for sequencing DNA. It has a significant order book (and raised financial guidance twice in 2013) and may also benefit from sector consolidation, with peer Life Technologies having been acquired by Thermo Fisher last year. In 2013, Illumina rose by 99%.

3D-Printing
The production of customised products in the home, workplace or factory will become increasingly commonplace. Even in healthcare, prototype livers and ears have already been produced on 3D-printers. Indeed, the industry is already worth over $1.3bn yet by 2015, this figure could have grown to $3bn (according to Wohlers Associates, a consultancy). The cost of 3D-printers continues to fall and some basic models now retail for just $1,000.

How it works is simple. Typically, thin layers of material (plastic/ metal dust etc.) are deposited from a nozzle and then solidified via tiny amounts of glue (or another substance – sometimes laser, ultra violet or heat) from a tightly focused beam. The spare part is therefore created gradually, in several layers, hence why 3D-printing is often referred to as additive manufacturing. Most items produced by such printers are currently used either as functional models or visual aids, although Wohlers estimates that around 15% of goods manufactured are used in direct part production. By end-market, the consumer industry accounts for 24% of demand, followed by the automobile (17%) and healthcare markets (14%).

Boeing has been using 3D-printers for over a decade to make parts at 10-30% less weight than previously, resulting in cost savings of 25-30%, according to the company. Lightness is crucial in making aircraft with a reduction in 1kg of weight saving the airliner around $3,000 of fuel annually (with the additional benefit of also reducing carbon dioxide emissions). Customised, printed parts are typically considerably lighter, but equally as sturdy as their machined alternative. This is just the potential tip of the iceberg: General Electric has said that it plans to use 3D-printers to make up to half of all parts used in its energy turbines and aircraft engines within ten years, while General Motors, believes that over the next decade, additive manufacturing could allow it to be producing its own car.

Two companies currently dominate the 3D-printing industry, 3D Systems and Stratasys. The former is market leader by revenues and has around 20% of the market. The company has been a serial innovator and consolidator and its scale is currently reflected in its range of print engines (underpinned by a book of more than 1100 patents) retailed a global dealer network. Its wide range of customers includes Airbus, Apple, Ford, GE, Mercedes, Nike and Samsung. In 2013, 3D Systems gained 161%.

The robot revolution
The growing ubiquity of robots will be as significant as that of 3D-printers. Already today there are over 1.1m robots in service, equivalent to one for every 6,000 people. Robots are typically classified as either industrial or service-based. The former account for the majority of today’s installed units, used in production and other such processes. Service robots, by contrast, are typically for professional or private use. Within the professional space, robots that can perform surgery are on the rise, while domestically, robots that are able to carry out tasks such as lawn-mowing and vacuum cleaning are becoming increasingly popular. Newer applications on the horizon include handicap assistants (that could administer medicines to the elderly), robots for personal transportation and also for home security.

Many companies have already begun to see the clear gains that the introduction of intelligent robots into the workplace can bring. Within the car industry, around 60% of the manufacturing process in now automated, with robots involved in the welding, gluing, painting and final assembly processes. Correspondingly, some car manufacturers now produce twice as many cars as they did a decade ago, based on research from Berenberg Bank. Elsewhere, robots used in warehouses, for example, are poised to boom. Labour accounts for around 80% of the cost of operating a forklift truck at present. Correspondingly, Seegrid Corporation, a private manufacturer of robotic industrial trucks believes that around 30% of all such vehicles could be robotic within the next decade.

Against this background, the International Federation of Robotics, a leading body within the industry, forecasts industry growth of at least 6% a year compound for the next five years, while Daiwa Capital Markets believes the industry could double in value, to $40bn, by 2030. German-listed Duerr looks to be among the best-placed companies to benefit from the growth of this industry. It is a leading player in the provision of robotic equipment to car manufacturers and has recently begun expansion into other areas such as weighing and measurement and also clean air filtration. Duerr is currently market leader in around 90% of its product portfolio and has an order book equivalent to around one year of sales. In 2013, Duerr gained 92%.

Nanotechnology
If 3D-printers and robots constitute highly visible markers for how quickly the world is changing, then nanotechnology stands at the opposite end of the spectrum. Put simply, nano means very small (a nanometre is to a metre what a marble is to the size of the earth) yet it is also very important. Nano-materials will, in the future, appear not only in printers and robots but in an ever-broadening range of products.

The reason why is that when atoms and molecules of any substance are manipulated at a small scale, they can assume different, often superior properties which can influence the design, characterisation, production and application of structures, devices and systems. The size of the nanotechnology industry is notoriously hard to calculate given the multitude of applications to which the technologies can theoretically be applied. Oxford Instruments, a high-tech producer of nano-tools, estimates that the market for quality tools used by researchers in their studies for nanotechnologies is worth around $4bn. The market value would then grow to $17bn if the processes and products that are developed using nanotechnology tools were included (an example being graphene, a lightweight form of carbon). Much more contentious is the scale of applications for which a substance like graphene could be used. However, conservative estimates suggest that the current size of the market for nanotechnology-enabled products could be $250bn.

The largest area in which nanotechnologies are currently being deployed is with regard to ‘smart’ materials. Within the car industry, for example, a shift towards lightweight substances such as high-strength steel and carbon fibre can help improve auto efficiency and reduce pollution. Consultants McKinsey estimate that the lightweight market (also including aviation and wind turbines) is already worth €70bn and could reach €300bn by 2030. Elsewhere researchers have, for example, developed a nano-fabric paper towel woven from tiny wires of potassium manganese oxide, which is able to absorb 20 times its weight in oil. Such a product would be particularly effective in clean-up operations such as disasters. Consumers may also find zinc oxide nano-particles within sun cream (making it more resistant) or silver nano-particles in food packaging (increasing durability). Within the medical arena, nanotechnologies could help enable drug-delivery targeted at specific sites within the body, and enhance molecular imaging, while embedded sensors within the body could allow both patients and practitioners to monitor temperature, heart rate and blood pressure more effectively.

Nano-tool manufacturer, US-listed FEI, with a market cap of over $3bn is a leading producer of focused ion-beam workstations and transmission electronic microscopes that are critical for viewing and manipulating atomic level material. Yearly bookings have grown at a rate of over 10% annualised over the last decade, and the company points to an installed base of more than 8,000 instruments, currently growing at a rate of at least 500 new systems a year. With these retailing for between $750,000 and $6m, FEI sees a $4bn opportunity for its products by 2016. In 2013, FEI added 61%.

Other topics on which we have written include global power and water shortages, the US freight rail renaissance, the potential for both liquefied natural gas and fracking to revolutionise the energy industry, what the home of the future may look like in terms of smart materials as well as LED lighting and, how a global obesity epidemic is emerging. Over 2014, we will look to add selectively to this list of topics.


Alexander Gunz, Fund Manager

Disclaimers 

The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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