The opportunity in 'bits' and 'atoms'
by Amit Lodha, Portfolio Manager, Fidelity Global Equities Fund
In recent years, the importance of technology has soared. By this I mean not just the significance of the technology sector but also the importance of technology in every industry be it be autos, mining, energy or consumer goods. This development offers us with a new way to define the universe of global stocks; it’s to divide them into camps of ‘bits’ and ‘atoms’. ‘Atoms’ companies and industries are those underpinned by something physical – something composed of atoms – such as iron ore miners, luxury brands and food companies. ‘Bits’ companies or industries are those that are underpinned by something more nebulous such as software.
A key part of fundamental investing is analysing the sustainability of pricing power for a company and it appears that the drivers of sustainable pricing power for bits companies are different from those determining the pricing power for atoms companies. For atoms companies, pricing power is based on some form of scarcity value; a miner such as BHP Billiton can raise prices when demand outstrips supply, a luxury-goods company such as Louis Vuitton has pricing power because of the perceived scarcity value of its handbags. However, bits companies such as Facebook or Google achieve pricing power by giving away their intellectual property. By increasing the accessibility of their services, these companies increase participation and, via the networking effect, drive up the value of their business offerings. The more people spending more time on Facebook, for instance, the higher the value of advertising or promotional space on the website.
Often the best investments these days are when atoms companies use bits businesses to their advantage. Take, for example, the atoms company Estée Lauder, a French-based cosmetics business that has created an array of valuable brands. I own this stock and met with company management recently. They told me how the company’s MAC Cosmetics brand had used its contracted US fashion model Kendall Jenner (of Keeping up with the Kardashians fame) to effectively attract the millennial dollar. All Jenner did was Instagram a selfie of herself wearing a new MAC lipstick to her 51 million followers (a reach that is more than twice the population of Australia). The photo of the 20 year-old swiftly received over two million ‘likes’ and Estée Lauder was then able to track the sales of this lipstick in the following weeks and restock distributors accordingly. This anecdote provided a number of insights that underscored findings made by Fidelity analysts. What were the key learnings?
1. Estée Lauder, like all luxury retail companies, spends a significant percentage of revenues on advertising and promotions annually. However, for many companies, knowing which part of the marketing budget is working has always been difficult to judge. In this case, however, Estée Lauder could see directly the benefits of its promotions spend via its contracted celebrity and Instagram. As a consequence, it is choosing to skew its marketing budget more towards promotions and away from advertising. This example also raises questions about the pricing power of old media companies reliant on advertising that does not offer the same transparency when measuring results.
2. Estée Lauder could track the lipstick sales inspired by Jenner’s selfie and re-stock swiftly because of the SAP enterprise, including distribution-tracking, software it installed a couple of years ago. This gives me confidence on the embedded value proposition of the bits company SAP. Atoms companies need the Germany-based SAP to enhance their returns by making their distribution networks more efficient.
3. Facebook owns Instagram and plans to monetise this platform within three years. My confidence as an investor in Facebook has grown as key customers like Estée Lauder praise how important the platform is for them to reach their target markets.
In summary, by using the lens of bits and atoms, one can always be on the lookout for companies that have sustainable pricing power and use technology smartly to sustain and grow that pricing power. That ultimately leads to growing earnings, cash flows, dividends and stock prices.
One final observation, wearing my accountant’s hat, is that the rise of bits companies makes valuing and comparing businesses trickier. Our historical accounting principles have been developed over time based on atoms companies, where assets are physical and the value of such assets and asset turnover are tangible. Accounting principles have failed to keep pace with the development of asset-light industries and thus valuing bits companies becomes more of an art than a science because the intellectual capital of the company walks out of the door every day. Measures such as price-to-earnings ratios, price to sales or enterprise value/earnings before interest depreciation tax and amortisation tend to give spurious results.
However, the one measure that holds true is the oldest one of all – free cash flow. As investors, ultimately the free cash flow a business generates either comes back to us as dividends or is reinvested for growth. Measures of free cash flow thus allow investors to apply a single ruler across bits and atoms companies and thus they remain my preferred valuation tool.
Yours sincerely,
Amit Lodha
A key part of fundamental investing is analysing the sustainability of pricing power for a company and it appears that the drivers of sustainable pricing power for bits companies are different from those determining the pricing power for atoms companies. For atoms companies, pricing power is based on some form of scarcity value; a miner such as BHP Billiton can raise prices when demand outstrips supply, a luxury-goods company such as Louis Vuitton has pricing power because of the perceived scarcity value of its handbags. However, bits companies such as Facebook or Google achieve pricing power by giving away their intellectual property. By increasing the accessibility of their services, these companies increase participation and, via the networking effect, drive up the value of their business offerings. The more people spending more time on Facebook, for instance, the higher the value of advertising or promotional space on the website.
Often the best investments these days are when atoms companies use bits businesses to their advantage. Take, for example, the atoms company Estée Lauder, a French-based cosmetics business that has created an array of valuable brands. I own this stock and met with company management recently. They told me how the company’s MAC Cosmetics brand had used its contracted US fashion model Kendall Jenner (of Keeping up with the Kardashians fame) to effectively attract the millennial dollar. All Jenner did was Instagram a selfie of herself wearing a new MAC lipstick to her 51 million followers (a reach that is more than twice the population of Australia). The photo of the 20 year-old swiftly received over two million ‘likes’ and Estée Lauder was then able to track the sales of this lipstick in the following weeks and restock distributors accordingly. This anecdote provided a number of insights that underscored findings made by Fidelity analysts. What were the key learnings?
1. Estée Lauder, like all luxury retail companies, spends a significant percentage of revenues on advertising and promotions annually. However, for many companies, knowing which part of the marketing budget is working has always been difficult to judge. In this case, however, Estée Lauder could see directly the benefits of its promotions spend via its contracted celebrity and Instagram. As a consequence, it is choosing to skew its marketing budget more towards promotions and away from advertising. This example also raises questions about the pricing power of old media companies reliant on advertising that does not offer the same transparency when measuring results.
2. Estée Lauder could track the lipstick sales inspired by Jenner’s selfie and re-stock swiftly because of the SAP enterprise, including distribution-tracking, software it installed a couple of years ago. This gives me confidence on the embedded value proposition of the bits company SAP. Atoms companies need the Germany-based SAP to enhance their returns by making their distribution networks more efficient.
3. Facebook owns Instagram and plans to monetise this platform within three years. My confidence as an investor in Facebook has grown as key customers like Estée Lauder praise how important the platform is for them to reach their target markets.
In summary, by using the lens of bits and atoms, one can always be on the lookout for companies that have sustainable pricing power and use technology smartly to sustain and grow that pricing power. That ultimately leads to growing earnings, cash flows, dividends and stock prices.
One final observation, wearing my accountant’s hat, is that the rise of bits companies makes valuing and comparing businesses trickier. Our historical accounting principles have been developed over time based on atoms companies, where assets are physical and the value of such assets and asset turnover are tangible. Accounting principles have failed to keep pace with the development of asset-light industries and thus valuing bits companies becomes more of an art than a science because the intellectual capital of the company walks out of the door every day. Measures such as price-to-earnings ratios, price to sales or enterprise value/earnings before interest depreciation tax and amortisation tend to give spurious results.
However, the one measure that holds true is the oldest one of all – free cash flow. As investors, ultimately the free cash flow a business generates either comes back to us as dividends or is reinvested for growth. Measures of free cash flow thus allow investors to apply a single ruler across bits and atoms companies and thus they remain my preferred valuation tool.
Yours sincerely,
Amit Lodha
Portfolio Manager, Global Equities
