CONTENTS

  1. Don't stop moving
  2. Feeling peaky?
  3. Next level up
  4. Schumpeter’s Gale
  5. Missing with Confidence
  6. A Brand-New Ending
  7. Contributors

Welcome to the Adam & Company Outlook 2021. 

At some point in our introduction, we usually reference that we are not trying to make predictions about the future, as it is just too difficult. 2020 was an example of this. Who would have thought, a mere twelve months ago, that our economy and society would have been so profoundly affected by a microscopic bug?

Whilst the initial shocks in the early spring were synchronised and global, as trade collapsed, consumer spending slumped and the labour market wobbled, the recovery from that low has been very uneven. Much of Asia has risen strongly, especially China, whilst the UK and Europe have seen economies opening up and shutting down again. Countries which depend on tourism or oil exports have also suffered disproportionately.

As we wave goodbye to the horrors of 2020 and welcome 2021, we do so to a world which is less global, more digital and more unequal than it was before, with some massive structural changes in the economy. Big cities and offices are largely empty and all the workers and jobs that support them have disappeared. Having been told there is no ‘magic money tree’, governments which can find billions to give us half price meals will surely be under pressure to deliver a whole host of programmes and the principle that household income is underwritten by governments will be hard to loosen.

Many other things have become more important – resilience for example. From company finances to logistics and production plans, it’s no longer about ‘just in time’, but ‘just in case’.

We are of course conscious that when it comes to investing, whilst we need to learn from the past we always need to ‘keep on moving’ and think about what comes next. There’s the hope that vaccines will help us return to a more normal way of life. There’s  a  new US president whose administration has a very different take on economics and diplomacy. And many of the trends which have driven economies for the past few decades, such as globalisation, have come crashing to a halt – now what?

Looking into 2021, clearly so much has changed, and much remains uncertain about the future. As a result, our portfolios also have to evolve. For those who are patient and can look  to the long term, there are surely opportunities. In this issue of Outlook, we discuss the changes we are seeing in such areas, including the world of work, the move to online entertainment and the increasing focus by investors such as ourselves on the sustainability of the companies they invest in.

Whatever happens, we must keep moving and we must never lose our curiosity about the world around us and how it is evolving.

Graham Storrie

Managing Director, Adam & Company

 

  • don't stop moving

     

    It’s a very tempting proposition. White sand and blue skies, only the gentle lapping of the oceanwaves to disturb the peace and probably less dangerous than St Marie, its fictional neighbour in the BBC drama ‘Death in Paradise’.

     

    Usually the Barbados Tourism Board would be looking to lure us over for a week or two in holiday heaven, but in the digitally connected world of Covid-19 they have raised their ambitions – if all you need is an internet connection to do your job, why wouldn’t you go and stay on their new 12-month work visa?

    Covid-19 hasn’t so much accelerated trends in flexible and home working as strapped them to a rocket. Companies have learned that their employees are safe and productive when working from home and, as has been the case since the birth of the BlackBerry phone, are willing and able to work round the clock. For their part, employees have learned that they don’t really miss 6am alarm calls and long, tiring and expensive commutes.

    With just under half of people in employment working from home at the peak (Office for National Statistics (ONS) survey, April 2020), is this a trend which is set to stay?

    Well it’s certainly popular, with a survey from Cardiff University suggesting 9 out of 10 workers would like to work from home sometimes and half wishing to do it often or always.

    One of the main positives for workers is the increased leisure time – less time on a bus, more time doing something they actually enjoy. Some may also appreciate the relative peace and quiet when compared to the distractions of a modern office. Furthermore, they can walk their kids to school and don’t have to speak to their disgruntled neighbours to retrieve the Amazon delivery they missed.

    It may also help level up the country. All the well-paid job creation in recent years has been centred on cities such as London, Manchester and Edinburgh. Telecommuters can live anywhere and skilled workers who can’t afford to move to big cities could benefit. In a September YouGov survey, 36% would consider moving if they could work from home all the time.

    Whilst employees may feel the benefits now, there could also be negatives in the long term. They might drift and lose a sense of belonging. Friendships might fade. Online staff ‘town halls’, quizzes, cocktail mixing and Friday drinks on Zoom are no substitute for in-person contact. We are social animals after all and if we don’t get up, move around and speak to people our physical and mental health may suffer.

    From a business point of view they may find they’re simply in the wrong location – if you’ve set up to serve commuters getting off buses and trains, for example. In city centres, businesses such as coffee shops, restaurants, bars, newsagents and so on have suffered though local high streets should see a pick up. In a similar vein, companies have office space they don’t need or that’s in the wrong place. And new business models may spring up – Greggs and Pret will now deliver lunch to your home.

    Younger workers may not have large homes they can comfortably work in and many may fear they will be replaced if they aren’t seen to be working hard or looking busy.

    This wasn’t helped by comments made by finance industry leaders such as Helena Morrissey, the campaigner and former fund manager, who raised the spectre of outsourcing. “Those who opt not to return to the office through fear or complacency may be in for a rude awakening,” she wrote.

    Perhaps the worry for companies is that if they can’t see you, it becomes more difficult to manage risks. This could be anything from not locking your workstation and allowing flatmates to see what you are working on to committing fraud. There’s also the case of ‘The King of the Slackers’ – a US software developer called Bob, who was finally caught after years of outsourcing his tasks to a worker in China for a 20% cut of his salary, allowing him more time to watch videos of sneezing pandas on YouTube or whatever underemployed software engineers do.

    The home working question therefore causes serious issues for workers and employers if it is to become more deeply embedded. For government policy too – some of the public transport infrastructure is redundant and investment and expanding it may be folly.

    So what’s the conclusion? Stanford professor Nicholas Bloom worries about productivity killers such as having young children around and lack of space, but his pre- pandemic research revealed that the highest gains in workforce productivity come when staff have a choice over their place of work and work patterns. So perhaps the answer is to leave it up to them.

  • feeling peaky?

    The Seneca Native Americans were the first to use the oil bubbling up through the ground beneath their feet. The European settlers took up their use of it as a salve for burns, cuts and sore stomachs, with the more entrepreneurial bottling it and rebranding it as Seneca oil, and later snake oil, a term still in use today.

    However, it wasn’t until Edwin Drake secured financing for his drilling at Pithole, Pennsylvania in the late 1850s that the oil boom started. Legend has it that his first barrel sold for $40, but the price fell sharply as more was easily extracted to fulfil a new use – it could be refined and used as a fuel for lighting, undercutting and replacing whale oil, luckily for them.

    Unluckily for the planet, however, cheap oil opened up other new uses in time, such as fuel for transport and plastics. It still powers 99% of the one billion vehicles on the world’s roads.

    It wasn’t just the price that was key to oil’s success. Its derivatives are incredibly energy dense, which means you needed relatively little of it. Indeed Winston Churchill, as First Lord of the Admiralty, opted to power the Royal Navy’s new ships with imported oil rather than local coal as they could get more guns and men on board. This decision caused Great Britain to secure an adequate and stable supply of oil from the Middle East through buying the Anglo-Persian Oil Company (now BP), and the eternal link between politics and oil was born.

    Given that it has powered the world for the past 150 years, it’s often argued that the oil price is the world’s most important economic indicator. Spikes in the price helped tip the world into recession in 1974, 1978, 1990 and 2007. But with the price now hovering at around the $40 of that first barrel produced in Pithole, Pennsylvania, what does it tell us about the state of the world?

    It fell dramatically in the spring of 2020, as demand slumped by 25% and at one point the future price turned negative – producers were paying people to take it off their hands. In other words, short-term supply and demand is still the major factor in the price; however, long-term structural threats have also come into view.

    The production cartel OPEC has lost much of the control they had over the price, as their market share has fallen with cheap production coming on stream from the US and Russia.

    Whilst there is a correlation between economic growth and oil demand, it’s much weaker than it once was as the world uses less oil for each dollar of GDP because the energy mix is now more diverse. The world has also become more efficient and less industrialised, and if the trend for homeworking and less globalisation remain, any economic rebound may be less helpful for oil use.

    Finally, the concept of peak oil used to be about the idea that the supply of oil produced would one day peak, causing panic and soaring prices as it ran out. However, this idea seems to have reversed. Peak oil now means that demand peaks rather than supply. Until now, oil demand kept rising due to new uses like jet fuel and rising incomes in the emerging world. Now, however, the main use as a fuel for personal transport will see erosion from electrification and environmental measures to reduce emissions from burning fossil fuels and plastic use.

    BP and Total estimate that this demand peak will hit around 2030. BP thinks that it will happen even without aggressive environmental policies but rather as the price of alternatives – from wind and solar power to electric cars – falls away.

     

    WHAT SHOULD OIL COMPANIES DO, FACED WITH THESE ISSUES?

    In the short term, most obviously production and capex have been slashed to get supply and demand closer to balance. There’s no point trying to find oil and extract it when production costs exceed the current price. Some have chosen to diversify in recent years. Shell is now the biggest producer of Liquefied Natural Gas, which will be part of our energy mix for decades to come, and BP has committed to spending at least one third of its cash flows on renewables. They still earn colossal cash flows and so have options.

    However, these are not risk free. They’ll need to spend vast sums to diversify to other forms of energy generation and their finances may be threatened if they’re forced to write off stranded assets – oil assets that cannot be exploited as the price isn’t high enough to justify extraction. Alternative energy also has far lower margins, thus diluting the overall return to these companies.

    Overall, it’s clear that a combination of all these strategies may be needed as the full displacement of oil as a transport fuel is offset by the growth in new end- user markets for carbon-free electricity. At the same time, even the most aggressive predictions about oil demand reduction still require investment in new supply in coming decades to meet demand as old wells will eventually run dry. To reduce our dependence on oil, the world needs a situation where investments in low carbon alternatives are profitable for producers, and where these alternatives are cheaper than fossil fuels for users.

  • next level up

    The origins of what we now consider video gaming can be traced back to the middle of the last century, when computer programmers wrote software to allow computers to compete against humans in traditional games like chess and draughts. It wasn’t, however, until 1972 before a console (as we might recognise today) made its way into the living rooms of consumers.

    The Magnavox Odyssey brought video gaming to the people, pitched as “the family’s best foul-weather friend”. What followed was nearly five decades of console innovation, with the last twenty years dominated by a fierce competition between market leaders Sony and Microsoft with their respective PlayStation and Xbox offerings. Whereas the Odyssey sold in the region of 350,000 units, the most recent PlayStation and Xbox consoles have racked up approximately 175 million unit sales.

    Indeed, video gaming has grown to be the largest global entertainment industry, generating $152bn in revenues last year according to Newzoo. This is significantly larger than the $21bn music industry, which pales in comparison. Already a growing industry, the video gaming market this year received a boost from international stay-at-home measures in response to Covid-19. One thing that has really helped in lockdown is that games became ‘virtual playgrounds’ where school kids could mix online as they were banned from mixing physically. More time at home left consumers looking for activities to fill their time and engage their desire for fantasy and escapism. Video gaming appeals to a broad audience of people, with games and content to suit every taste: from sport and racing, to fantasy, exploration and education.

    In recent years, those seeking to play video games have accessed the games through three major channels: personal computer (PC), console and mobile. Typically, more serious players require the extensive computing power of a PC or at least a console, whilst mobile games appeal to those with some time to kill, such as on their commute to work. However, the growth in cloud computing and ultra-fast internet (something we’ve touched upon in previous Outlooks) has accelerated a disruption to this traditional model of game distribution.

    No longer do you need to have vast computing power in your device to play advanced games. Instead, ultra- fast internet enables the computing to be undertaken remotely, at data centres owned by the likes of Amazon or Microsoft. Using high-speed internet, the image, audio and interactions are then streamed direct to the screen. This enables video gaming to become device-agnostic and much more accessible. This model hasn’t been able to work before because of issues with internet speed. A multi-player game simply cannot work if there’s too much latency (delay) between the interactions of the various players – we’re all familiar with lags and buffering. But 5G is expected to make slow internet a relic of history.

    This new method of streaming is seen as a huge opportunity for large technology companies to capture a greater share of our entertainment spending – the likes of Amazon, Apple and Netflix have innovated to capture our music and TV spend, and now they are looking to tap into the gaming market. There are an estimated 2.5 billion gamers across the globe (source: Newzoo) and this is only set to grow. As with music, film and TV, these companies are moving consumers from a buy-and-own model to a subscription- based streaming model, where gamers will stream a vast range of games direct to their devices (whether that be a TV, PC, mobile, tablet or other) for an affordable monthly fee. This is also good news for the game creators, as these platforms need to be filled with content to play. The UK has a vibrant content development scene, with companies like Frontier Developments and Codemasters producing a range of hit titles.

     

    The other appeal of this model is its inherent scalability. The previous barrier to entry in video gaming was the £400 console cost. With this new model, customers can use their existing devices and stream for a modest sum. This makes it an attractive proposition in developed markets as well as emerging markets. Smartphone penetration is growing across the world, as is investment in high-speed internet, given its importance to economic development in the digital age. Thus, whilst large gaming countries like the US and China will continue to lead global spend, other economies will increasingly be able to access this new and exciting form of entertainment.

    And whilst conventional parenting may say otherwise, there are several studies suggesting that moderate video gaming has many benefits, notably a rise in problem-solving and memory skills. And it’s not just children who can benefit, the average age of a gamer is someone in their thirties.

    Indeed, as video gaming increasingly becomes a mainstream source of entertainment, the words of Mario creator Shigeru Miyamoto ring true:

  • schumpeter's gale

    Whilst Pablo Picasso may not have a great deal in common with economist Joseph Schumpeter, they certainly shared a similar view of the relationship between creation and destruction. ‘Creative destruction’, now an iconic term, was popularised by Schumpeter in his book ‘Capitalism, Socialism and Democracy’ back in 1942.

    Commonly referred to as ‘Schumpeter’s Gale’, he described the process of creative destruction as “industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”.

    When we reflect on the advances that technology and companies have made over the past few decades, and the subsequent impact this has had on industries as a whole and consumer behaviour, we witness the true force of ‘Schumpeter’s Gale’. Industries as we knew them a decade ago have been turned on their head.

    Consider the music industry over the past few decades – from the 8-track tape, the cassette, the compact disc and then the move to electronic downloads, MP3 players and now the domination of web-based streaming services. It’s a remarkable journey of innovation. As ‘Schumpeter’s Gale’ alludes to, the creation of the new order destroys the pre-existing and, left in innovation’s wake, we find a graveyard of former businesses and industries. For long-term active investors, it’s important that investment decisions remain on the right side of this innovation.

    There is no question that the internet has been the most all-encompassing contributor to creative destruction – no industry has been immune – and the evidence of its contribution to creative destruction can clearly be seen in various measures of corporate longevity or lifespans of companies listed on major stock exchanges around the world.

    If we examine the largest 500 public companies in the US over the years (an index referred to as the S&P 500), the average tenure of a constituent of the index back in the 1950s was around 60 years. This has fallen to roughly 20 years today and is forecast to continue decreasing to approximately 12 years by 2027 (Innosight’s Biennial Corporate Longevity forecast). It represents a rapid acceleration in creative destruction and churning over the period, and this acceleration is only set to increase.

    Whilst companies do fall off the index list due to being taken over through mergers and acquisitions, the major driver is simply that a company’s market value deteriorates as an incoming company renders the existing order obsolete.  Often this is due to disrupters utilising new technologies to deliver superior products and services or utilising more effective business models.

    It’s important to note that the above forecast was made long before the Covid-19 pandemic. In just a short period since the outbreak of the virus, we again have seen the world change considerably, as almost all aspects of our lives were forced to shift online – for working, socialising and our entertainment. Industries had no choice but to adapt to interacting with customers online where possible, with significant digital adoption in sectors such as healthcare and medicine to grocery and retail shopping. To quote Microsoft’s CEO Satya Nadella in April of this year, “we’ve seen two years’ worth of digital transformation in two months”.

    Whilst we’re all hoping to return to a degree of normality as soon as possible, it’s safe to say that we’re now moving even faster towards a digitally-driven and enabled world. We can only infer that this will serve to increase the pace of creative destruction and bring down corporate longevity forecasts further. This may be painful in the short term, as for every winner to emerge there is an unfortunate loser, bringing localised unemployment and short-term turmoil. However, as Schumpeter argues, and what we can hopefully take solace in, is that in the long term, the very creativity that stands as the root cause of the destruction will raise living standards and benefit society as a whole – through better products, wider choice and enhanced productivity.

    It is also important not to overlook the fact that, in relative terms, it is still incredibly early in the life of the internet. Whilst the growth we have seen in global internet adoption has been remarkable over the past decade, more than doubling since 2010 (DataReportal), it is estimated that still only 60% of the world’s population has access to the internet or 4.5 billion users (DataReportal). There are large parts of Africa and Asia still without access: for example, 50% of India’s population and significant parts of China’s rural population. As such, we are a long way from reaching global connectivity. Over the coming years, we can expect to see billions of new users take to the internet. As ‘Schumpeter’s Gale’ would suggest, we could be in for quite the creative storm.

  • missing with confidence

    You have to feel a little sorry for economists. Students of the ‘dismal science’ will have spent years studying theoretical rules and relationships, many of which have turned out to be false.

    One such rule is the relationship between unemployment and inflation – the Phillips Curve says that as unemployment falls, the bargaining power of employees rises, wages go up and inflation soon follows.

    The world’s central banks have assumed this relationship will hold despite evidence to the contrary over the last 20 years or so. With the orthodoxy being to keep inflation under control, they raised rates in the US and the UK on the basis that inflation was about to pick up.

    The world’s most important financial institution, the US Federal Reserve, signalled a huge change in policy in the autumn of 2020. The Fed now wishes to run inflation moderately above their 2% target to make up for the years of sub-optimal economic growth. Despite the breakdown in economic ‘rules’ and the fact they’ve missed targets for years, you have to admire the confidence with which they assumed that they’re now in control and that historic relationships will reassert themselves.

    Why the sudden change from worrying about keeping inflation around 2% to hoping it rises? Central banks say they’re concerned about growth, but much of it surely relates to debts. The enormous debts which governments racked up in 2020 relative to the size of their economies can only be dealt with in a few ways. The UK Government debt, for example, has risen to more than £2 trillion or 100% of GDP.

    Governments have to repay these debts at some point and they have a few options – they could default of course but that’s never going to happen in a G7 nation like the UK or the US. They could raise more tax (politically toxic, it slows the economy down, and more difficult to raise significant monies than you would think). They could cut spending dramatically (austerity may be more difficult to implement than tax rises). Or finally, the could try to let inflation rise so they pay back less in real terms. This may be the least painful option if you can keep it under control. You grow GDP in nominal terms by raising inflation a little and these debts shrink relatively over decades. This is the idea behind the 100-year bonds issued by countries such as Austria and Mexico.

    The problem is that the modern world is very different to that of the 1970s, when many economics lecturers learnt their trade, and passed on to their students in the 80s and 90s. The old world model was of closed economies protected by tariffs, unionised workforces with pricing power over their pay and physical products whose marginal costs could not be reduced.

     

    These days economies are fairly open and workers compete globally. If productivity is poor and wages high, your job may move to a country where the opposite is true. In the internet age, many products and business models are infinitely scalable. For example, it costs no more money to make and distribute 10 million computer games as it does one, as they are just digital copies distributed over the internet. Furthermore, ageing populations, as seen in Japan and Europe, tend to be a deflationary force. Maybe the central banks will not be able to get inflation to help, given these structural forces.

    Faced with these, is the idea fanciful? If these structural forces remain, yes. However, the world continues to change and some of the structural forces have been reversing somewhat.

    Globalisation has given the world economy a huge boost and lifted a billion and more people out of poverty in the past 30 years. It has also been hugely deflationary as a vast pool of workers – from Eastern Europe to the east coast of China – has joined the global labour force. It has allowed multi-national companies to grow sales and keep wage and production costs down. However, the trade war between the US  and China has escalated from a dispute over tariffs to ‘Cold War 2’, and protectionism is on the rise around the world.

    Furthermore, the Covid-19 crisis has seen supply chains break down and governments and businesses are concerned about their ability to get their hands on products outsourced to far-off lands from face masks and basic drugs to car parts. Offshoring and lean inventories seem set to fall in favour of onshoring and holding more stock ‘just in case’. These trends are all inflationary.

    These will help governments and central banks in coming years on the one hand, though whether they overwhelm the other trends – technological deflation and demographics – remain to be seen and analysed by the next generation of economists.

  • a brand-new ending

    The events of 2020 have meant a great deal of change, with a lot of rebuilding to be done, and there are increasingly calls to do the rebuilding in the ‘right’ way: to emerge with a stronger focus on equality, resilience, responsibility and environmental awareness, putting sustainability at the core of the way ahead.

    Sustainability is about making the right decisions today that will work and be for the benefit of the long term, so a full range of economic, environmental and social factors need to be considered. In terms of companies, sustainability is usually discussed in terms of Environmental, Social & Governance (ESG) credentials.

    In the 1990s a company that was seen to focus on ESG ran the risk of being viewed by investors as being distracted from the main business of making money. But since that time there’s been a complete turnaround in attitude and increasingly both companies and investors want to see adherence to ESG principles. Part of this is due to external requirements to act, with increasing government regulations and policies in this area. There was a focus on addressing the ‘G’ with the UK’s introduction of the Combined Code on Corporate Governance in 1998. Standards on ‘S’ have been placed in the spotlight by the 2015 introduction of the UK Modern Slavery Act and gender pay gap reporting rules in 2017. The ‘E’ is receiving ever more attention as the awareness of our impact on the environment grows, and global organisations such as the United Nations have been leading efforts to coordinate a response, with broad global support for the Paris Agreement in 2016, aimed at reducing greenhouse gas emissions, a key milestone.

     

    environmental

    social

    governance

    Research has shown there are sound reasons for companies to be good corporate citizens. There are plenty of studies showing that companies who get it right outperform. A 2015 survey of more than 20,000 companies in 91 countries showed that a 10 percentage point increase in female   representation on a board correlates with an increase of 0.7% in net profit margins. A joint UK/US study that paired companies that were measured as having a high regard to sustainability against those with a low regard highlighted both a stock price and financial outperformance of the companies with strong sustainability credentials.

    Of course what’s being measured and how it’s interpreted is one of the key problems at the moment. There are a wide variety of measurements and sources of information to choose from, many of which are difficult to standardise across companies, or indeed verify. Then there’s a question of how you combine the ‘E’, the ‘S’ and the ‘G’. How does a company that’s working on developing a very environmentally-friendly product, but with some questionable corporate  governance practices, rank against a company that has lower environmental credentials but is working on improving them and has the highest social and governance standards?

    At Adam Investments we feel that sustainability, as defined by making the right choices for the long-term, dovetails with our focus on quality companies in structural growth areas. We’ve included our own ESG measures and analysis in our stock research since 2017. However, as with many other investment managers, we are looking to refine and deepen what we do.

    On 21st March 2021 the EU Sustainable Finance Disclosure Regulation comes into force. This says that all firms must have a policy on integration of sustainability risks into investment decision-making processes that’s disclosed on the company’s websites. Further to that, it asks companies to assess the principle adverse impacts of their investment decisions on sustainability factors and provides guidance on sustainability factors to be addressed. We plan to continue to make progress through developing our own internal processes and our engagements with companies, and in addressing the new regulations coming into force next year, all of which means you’ll see more on this topic from us as 2021 progresses.

     

  • Contributors

IMPORTANT INFORMATION

Issued by Adam & Company Investment Management Limited (Adam), which is authorised and regulated by the Financial Conduct Authority. Adam is registered in Scotland number SC102144. Financial Services Firm Reference Number 141831. Registered Office: 6-8 George Street, Edinburgh EH2 2PF.

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