Faster move to digital this year is transforming how the world does business.

In early July, Brooks Brothers, the storied US clothing company that has dressed many American Presidents over its 200-year history, filed for Chapter 11 bankruptcy, a victim, certainly, of the accelerating move towards on-line retail, but more recently of COVID-19 restrictions around non-essential retail. 

Just a few weeks earlier, Neiman Marcus filed for bankruptcy, as did J. Crew (both overseas retailers).

We have not seen the last of these. 

The virus is part of the bonfire of change, but it is an accelerant rather than fuel in its own right. 

The truth is that retailers at a minimum must be omni-channel (have multiple product distribution channels) to survive, if not online from the get-go. The virus is merely a “forcing function”, by which we mean an event that alters previously entrenched behaviour. 

The virus forced store closures as part of social-distancing measures, which in turn meant shoppers had to move on-line when previously they may only have elected to do so occasionally. Shopping in stores was out, contactless delivery in.

The disruption for store-based retail that has been in train since Jeff Bezos sold his first book at Amazon has been accelerated by the virus, while for restaurants and many other services it is very new. 

The theory goes that once the virus is no longer an issue, many people who tried the new delivery options – whether for groceries, clothes, or restaurant meals – will like it, and do so again, at least some of the time.

“We’ve seen two years’ worth of digital transformation in two months,” according to Satya Nadella, Microsoft Chief Executive Officer. 

It took 10 years for e-commerce to hit 19 per cent penetration in the US, and just three months for it to grow to 26 per cent, according to the US Department of Commerce, as the chart below shows.

Disruption is coming to all banks, including those in Australia. Goldman Sachs is a serious contender, in the view of Loftus Peak.

Thus far, we have not seen enough fintech disruption in Australia to make a significant dent in the dominance of Australian banks, which have been strong performers over a long period. But offshore, the story is different. 

Only a few weeks ago, Goldman Sachs announced a tie-up with Amazon. Small business owners who sell on the e-commerce giant’s platform will be able to apply for credit lines of up to US$1 million, funded from Goldman’s retail bank brand, Marcus.

Potential borrowers who follow the simplified two-step process may access credit at rates between 6.99 per cent and 20.99 per cent. Importantly, the data around the borrowing will be held exclusively by the Goldman subsidiary, not Amazon. 

The move by Goldman comes a year after the company launched a co-branded credit card with Apple. The digital Goldman Sachs start-up banking business is now four years old and reported to have more than US$90 billion in deposits and US$7 billion in loans. It would be unwise to ignore this disruption signal.

Local disruption

In Australia, every so often a company such as Afterpay emerges and steals an overlooked segment, in this case millennials who do not like credit cards. 

Separately, many Australian small-to-medium enterprises already know Square, the little white Apple-looking gadget that turns their phone into a cash register.  It already has a market capitalisation of US$50 billion. (The Commonwealth Bank has one too, called Albert. It is not capitalised at US$50 billion). 

There are other fintech players eyeing or already in Australia too, including Klarna, Adyen and Global Payments, while Australian acquirer Tyro Payments is having a red-hot go. 

They are coming because banks worldwide are ceding their traditional value chain (such as parts of the fees on credit and debit cards) in an effort to focus on their easy businesses, or at least those with sufficient regulatory hurdles to make them unattractive to new players. 

After the Financial Services Royal Commission, bank-owned wealth businesses got too difficult, and are being divested or wound back.

This is the classic playbook of disruption. Go into a market that is too hard/small/unprofitable for the big guys to chase, and once established, expand vertically or horizontally.

Disruption rolls differently according to industry, geography, market, and availability of capital. But it would be wrong to say disruption is even close to over. 

Seek, Facebook and Google disrupted advertising, Tesla is making obsolete the internal combustion engine, Uber eviscerated taxis, renewable energy is coming for coal. There is plenty of change still to come for the banks globally and more industries. 

Satya Nadella, quoted above, is talking about Microsoft’s Azure cloud business. The truth is that the majority of large businesses in the world will shut their on-premise IT hubs in favour of cloud-based solutions, using the Microsoft or Amazon clouds, among others.

Disruption opportunities

Investors have a lot of high-quality opportunities to invest in disruption.

The world is transforming as a result of being digital and this is offering up enormous opportunities, provided their value can be assessed. We believe that in 10 years, businesses will shift to on-line as their primary commerce platform. 

This does not mean extractive industries will cease to operate, or that shopping malls will be empty, or that the car factories will not exist – but it does mean everything outside physical operating/manufacturing sites will run on digital rails on which supply, demand and logistics decisions will be executed. 

From an investment manager’s point of view, there is much choice and, unusually, quite a bit of it is high quality – non-banking financial services, health, successful on-line retailers that are targeting the 70 per cent of retail not on-line, 5G in the telco space, manufacturing – the list goes on. 

As a fund manager, Loftus Peak has extracted value for clients in the disruption thematic over the past six years by focusing on companies that are executing their disruptive models well. 

At the same time, and just as importantly, we have controlled risk by sticking to three core principles of portfolio construction:

1. Hold well-run, highly cash-generative companies with strong balance sheets that will not be unduly threatened by an economic slowdown; 
2. Hold liquid investments for protection in periods of market stress; and 
3. Avoid tail risk by investing in companies that are best-in-class, rather than holding a larger portfolio with an eye to benchmark composition. 

Disruption and the Coronavirus have exposed the serious weakness in what convention has assumed to be safe – index investing – a practice that seeks to mirror the existing make-up of the global economy with similarly weighted investment positions. 

Disruptive companies are in indices, but often wrongly classified – for example, Facebook was until 2018 included in the information technology index, when it has been a media company from day one, 16 years ago. 

The inability to properly classify a company leads to inadequate index weighting and sometimes index exclusion, badly skewing returns. How can failure not be the outcome when even the classification ascribed is wrong? 

Disruption will not ultimately be stopped, even by something as powerful as COVID-19 – in fact, as we say, the virus is the accelerant that creates the forcing function that increases the disruptor’s reach, enabling our investors to benefit when it hit. 

But even before the virus, these companies had performed strongly, as we believe will continue to be the case when circumstances eventually normalise.