In Investing, the Only Constant Is Change

Many of us are creatures of habit. We stick to the same morning routine and frequent our favorite restaurants again and again.

That’s not the way the world of business works, however. People are constantly working to innovate and improve on what we already have. If a company is making too much money, a new competitor will try to take away some of the profits. (As Jeff Bezos famously said, “Your margin is my opportunity.”)

That’s why we like companies that have strong competitive advantages in place to protect themselves. But we like them even more if they are up to the task of operating sustainably in an ever-changing world.

As an analyst, I spend nearly all my waking hours thinking about finding new ideas, which often gets me to thinking about change. If you think about certain changes that happen over a long period of time, you might have your hands on a long-term trend—just to name a few, automation, robotics, and artificial intelligence; digital payments; urbanization; energy efficiency and the resulting disruption to traditional modes of transportation.

I’ve been thinking about one trend in particular of late, and want to share some thoughts on it today.

Data usage is all around us 

The early days of the Internet were a jumbled mess. Data took circuitous paths to get where it needed to go. We connected to the Internet using our phone lines (and, in some cases, rang up unbelievable phone bills). Websites looked terrible and our computers were weak and slow. We would often get dreaded “page loading” errors.

However, the technology kept improving. The dot-com bubble led to tons of capital being disastrously wasted, but it did a lot of good, too.

For one, some of the vast amounts of capital went to accelerate the investment of fiber in the ground. According to telecom services firm NEF, the amount of fiber laid during the tech bubble exceeded even the most optimistic demand scenarios by a factor of 30 in many areas. There’s still a significant amount of unused fiber in the ground, even today. But with each passing year, more of it goes into service.

Today, the Internet functions much better than in the past, and investments are much more efficient. Sure, it can be hard to keep up with the increasing usage each year. But companies are getting better at investing in the infrastructure necessary to make the Internet work. Networking giant Cisco Systems publishes an annual white paper on data traffic with all kinds of interesting projections. This year’s paper predicts mobile data traffic will grow at 46% annualized from 2017 to 2022, with applications like Internet gaming, and virtual reality growing even faster than that.

Now that I’ve set the scene, let’s investigate some themes:

Cloud computing: By now, you’ve likely heard of cloud computing. It’s very easy for everyday users to gain several gigabytes of free cloud storage from one of the tech titans. Companies are also increasingly outsourcing some or all of their functions to the cloud—for example, Amazon (NASDAQ: AMZN) and Microsoft (NASDAQ: MSFT) provide computing, storage, and databases aimed at facilitating the needs of various companies. [Note: All companies mentioned in this report are mentioned for illustrative purposes only, and do not represent trading intent.]

Data centers are required to house the equipment of all these various parties, as well as serving as hubs for companies and Internet networks to connect with each other. Real estate investment trusts such as Equinix (NASDAQ: EQIX) and Digital Realty Trust (NYSE: DLR) own data centers where this can happen.

Chipmaker Intel (NASDAQ: INTC), which once fell out of favor because personal computer usage was falling, has been benefiting from cloud computing for years. Intel has the dominant market share of chips that go into servers. As Internet speeds continue to increase, it’s becoming more and more possible to outsource IT functions to the cloud and not skip a beat.

Wireless Speed: We have to start with wireless networks. What’s going to happen with the T-Mobile (NASDAQ: TMUS) and its merger with Sprint (NYSE: S)? Are they finally going to merge? Can the combined entity compete effectively with the more established telecoms?

Besides the carriers themselves, there are many other interesting things going on in the wireless space. The last time the wireless standard changed, 4G proved to be a vastly better solution than 3G for streaming videos and surfing the web.

By all accounts, 5G will be much faster than 4G. We’ll see much higher speeds and latency, which will unlock a slew of new functionalities that weren’t available before. We’re talking enough speed for self-driving or connected cars, virtual and augmented reality, all sorts of internet-connected gadgets, and even remote surgery.

In addition to things like telematics (a field that combines telecommunications and vehicular technologies) and the Internet of Things, we’ll see plenty of new devices that we haven’t even dreamed up yet. Companies will innovate new products we didn’t know we needed, as they get more familiar with the capabilities of 5G. Finally, getting 5G up and running will be no simple task. How will the coming 5G wireless standard affect the tower companies that provide macro and small-cell towers to house the wireless carriers’ equipment?

Just within these two themes, there are tons of companies worth looking at. Many of the names are obvious winners, but not all of them have been uncovered. We also haven’t even mentioned the networking gear provided by companies like Cisco and Arista Networks (NYSE: ANET), content companies such as Netflix (NASDAQ: NFLX) and Walt Disney (NYSE: DIS), gaming companies taking advantage of the increased speed and performance, and many more.

Long-term implications

Unfortunately, since long-term trends bring about change, that means there will be many losers in addition to the winners.

Faster Internet speeds have enabled gaming companies to deliver games digitally rather than through physical discs, which has hurt sales at GameStop (NYSE: GME), a retailer of new and used games. GameStop’s operating income has declined in each of the past three years as a result. The company still earned $314 million in operating income last year, but this is half the company’s operating profit a decade ago.

The decline of bricks and mortar retailers has coincided with consistent decreases in mall traffic. This trend is supported by both e-commerce and the trend of urbanization. Changing consumer tastes have dented the highly profitable soda sales of Coca-Cola (NYSE: KO), which has been investing in less profitable water and juices to compensate.

Not all companies affected negatively by these trends are dead on arrival, but it’ll require a high degree of agility. Large companies with economies of scale and established brands can still make good money cultivating new product lines, but, to state the obvious, a hit to a company’s growth trajectory due to change or disruption means it’s potentially worth a lot less than it was previously. A company can’t consistently expand profit margins and increase your cash flow without growing revenue.

Without a long-term trend in place, a company might not have a reliable way to grow its profits over the long haul. Standout companies in struggling industries can often only grow by taking market share. This is not something that can be done in perpetuity.

Change is happening faster than ever. We are constantly surveying the landscape, and thinking critically about how change is helping (or hurting) the companies in our portfolio. Funnily enough, companies hurt by these trends can be interesting as shorts, so we like to think about trends both ways.

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—Paul Chi

Disclosure: 1623 Capital research analyst Paul Chi owns shares of Amazon.com, Equinix, and Walt Disney. 

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