The Pace of Change

By Mark Bern, CFA

Artificial Intelligence (AI) is advancing at a rapid pace and will change many industries over the next decade.  This will make investing for the long term much more difficult than it has been at any time in history.  According to McKinsey, a highly respected global consulting firm, we are at the early stages of the Fourth Industrial Revolution.  Over the next two decades most industries will change dramatically creating new jobs requiring a whole new set of skills while displacing many low skill jobs in the process. 

Many in the workforce will need to be re-trained in order to adapt and prosper in the new economy.  But many of those whose jobs will be automated will be highly educated, white collar workers in staff and mid-level management positions.  Most of these people will be capable of adapting and learning the new skills that are to be needed.  Unemployment will remain low throughout the transition and wages will begin to rise for those willing to change and adjust their capabilities through training. 

But the robots and machines are coming and AI will lead the way, creating both opportunities and risk.

Adapt and Adopt

Those companies that adapt to change and adopt new technologies will thrive while those that get stuck in the past could fail.  As a result, the average tenure in years that a company remains in the S&P 500 Index has dropped significantly over time, all due to change and the inability to adapt.  In 1965 the average tenure was 33 years; by 1990 it had fallen to 20 years; by 2026 it is forecast to fall to 14 years.  The pace of change is increasing making if more and more difficult for companies to keep up.

This time is different in that is all about to begin to happen at an alarming rate.  I remember thinking back in the 1990s that the rate of change was rising faster than at any time in history.  Today, I believe that the next two decades will see the rate of change that will boggle the mind. 

Those companies able to adapt to the changing environment and stay ahead of competitors by adopting new technologies will grow and consolidate their respective industries.  Those that ignore the need for change will be disrupted as never before and are likely to lose market share.  They will also become less efficient relative to competition and see their margins (and profits) deteriorate as they fall behind.

According to the McKinsey report less than a third of all manufacturers have begun implementing major changes, 41% are still piloting at a single site and 30% have not even started.  So, many of the piloting companies are stuck in pilot purgatory as they test but don’t scale and those that haven’t started yet are at risk of being left behind.  Even those that have already begun the process of change could again be at risk if they do not keep up with the pace over the years.  Change is not a one-time effort; it is a continuous process. 

Many managements are old school and will be resistant to constant change.  It will no longer matter how strong a brand may be if a company cannot adapt in the new world order that will require constant introspection and adoption of the new.  Leaders who are complacent will need to be removed for great companies to survive.  It is going to get messy as the business environment becomes one of evolution, disruption and survival of the most nimble.  Stated differently, size may not provide the comfort and sense of being impregnable that it once did. 

M&A Activity to set a new record in 2018

Companies fall off the S&P 500 Index for a number of reasons including bankruptcy, loss of market share, or being acquired.  The last one is happening at an increasing pace as M&A (merger and acquisition) activity is heating up again.  So far in 2018 there have been more M&A deals totaling more in dollar terms than at this point in 2007, the height of the last M&A record-setting year.  That record was shattered in 2015 and tit appears that the record will again be shattered in 2018 because so many U.S. multinationals have so much cash available due to repatriation under the tax reform bill enacted into law last December. 

The M&A activity may or may not provide an impetus for higher stock prices this year.  Sometimes mergers are ill conceived or executed poorly and investors can send share prices lower for the acquirers.  The potential key to profiting from all this activity is to identify the most likely acquisition targets because the price paid in such deals is generally at a significant premium to the current market prices.

Identifying acquisition targets

The best companies are growing revenue faster than competitors and generating lots of free cash flow.  These companies should be the likely targets for acquisition in the coming year.  The best tool for identifying such companies that I know of is Friedrich.  Friedrich rates companies based on free cash flow return on invested capital, among other ratios, and identifies those companies each month that are consistently growing and generating superior results.  My intention is to use Friedrich to identify those companies that I think will be most likely to be acquired, as well as those with the best track records of integrating new acquisitions into a successful corporate culture.  Of course, I hope to enrich my clients in this endeavor.

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Respectfully and Candidly,

Mark Bern, CFA