Opportunity or Adversity? – An Analysis into the Technology Industry June 29, 2018
2017 was an outstanding year for the equity markets. According to Reuters, the World Stock Index added $8 trillion in value that year. This was led by a strong US economy, with various US indices reaching all-time highs. Most notably, the NASDAQ provided a return of 27.24% in 2017, with the FAANG stocks (Facebook, Amazon, Apple, Netflix and Alphabet) leading the pack with an average return of 48%.
The stellar performance of these tech stocks have probably caught the attention of many investors. Despite scares of market sell-off in February and March this year as well as regulatory changes threatening the business models of these tech firms, the FAANG stocks have rebounded to trade in the upper bounds of their historical share prices.
The volatile macroeconomy, coupled with constant threats of regulation, will continue to threaten the profitability of the tech industry. However, disregarding these external growth catalysts, it is also paramount for investors to identify if the tech industry has room for organic growth – the key that will determine if the industry remains attractive to investors.
The Industry Lifecycle Model
According to the Industry Lifecycle, a typical industry undergoes 4 stages- introduction, growth, followed by maturity, and eventually its decline. While the length of each stage of the lifecycle varies across industries, each stage within the lifecycle possess certain characteristics that can provide investors with an idea as to which stage of the lifecycle the industry is currently operating in.
Each stage of the industrial lifecycle may be distinguished by the following characteristics:
- Number of Industry players
- Economies of scale
The introduction stage begins with the introduction of a new product or service being offered to the market. Market leaders typically experience high costs in Research and Development (R&D), Marketing, and the likes to bring the new product/service into the marketplace. This results in high volatility within the industry, and a low profitability that will often turn investors’ attention away.
However, once the product/service reaches a critical mass in adoption, it will spark the growth phase of the industry. During this phase, first movers during the introduction stage would have started reaping rewards from their initial costs. This means better cost efficiencies for existing players and increased profitability. The lowered costs will also attract other players to enter the market by putting up similar product offerings to the market to capitalize on the growing market.
The industry will continue evolving with more sophistication in technology. Profitability will eventually stabilise once the market is saturated. At this point, the industry reaches maturity, and firms will be operating at their optimal level. Firms will then pursue inorganic growth through mergers and acquisitions to sustain market expectations. Dominant players will emerge as market leaders, while smaller players who are unable to compete will eventually be taken over or eliminated from the competition through an industry shakeout.
As more advanced technologies emerge, the industry might decline, giving rise to the beginning of a newer industry. This will mark the end of an industry whereby there is no room for growth, and ultimately risk replacement by newer industries.
Current Phase of the Tech Industry
Within the tech sector, we have experienced an influx of tech services driven by the uprising of the internet since the start of the 21st century. However, the shift from a product-based economy to a service-based economy has created a unique situation for the tech sector. According to the Industrial Lifecycle Model, the decline of an industry is usually indicated with disruptive technologies that render current technologies irrelevant. The inability of incumbent firms to adapt to new technologies often spell their eventual downfall and small but flexible firms will rise to replace market leaders.
The FAANG stocks, however, have consistently been staying at the forefront of technological advancement. Tech companies have capitalized on the evolving technologies to position themselves in the marketplace, becoming leaders of new technologies such as machine-learning, as well as Artificial Intelligence (AI). The potency of such technologies also creates a scenario that seems to hint that they can be ‘the technology to end all technologies’.
If the ‘end-game’ scenario does play out as expected, it will mean that firms who get a first-mover advantage into the late-stage technology of machine-learning and AI will become eventual winners in the race to the top. The current trend seems to indicate that the incumbents are poised to emerge winners by harnessing the full capabilities of these late stage technologies.
Indication of Weakness?
Nevertheless, it is important to understand that even if the current market leaders emerge victorious, there will always be a limit to growth. In this period whereby the possibility of disruptive technologies overturning incumbent firms is unlikely, we should also try to determine the limits of organic growth for these firms.
Without novel innovations, incumbent firms have undoubtedly reached their maturity stage. Furthermore, the proliferation of inorganic growth through mergers and acquisitions (M&A) of smaller firms by incumbent firms and the amalgamation of services is indicative of an industry that may be reaching its growth limit. Some recent examples of inorganic growth undertaken by market leaders include Facebook’s announcement of their plans for dating services, as well as rumours of Amazon’s shopping list for 2018.
Another key indicator that might signal the maturity of the tech industry is the squeezing of profits across the industry. Apart from the FAANG stocks which contributes to the core of growth within the industry, other players within the supply chain have also benefited from the exceptional performance of the FAANG stocks. Hardware manufacturers such as NVIDIA and AMD have been reporting off-the-charts sales figures driven by demand for technological products.
Eventually, the key question most investors will need to answer is whether the industry will be able to continue to provide novelty in their products and services; or is the industry pushing for the last mile simply to match investors’ expectations? The former will see the industry incumbent continuing to flourish in the long run, while the latter may indicate a worrying trend of a stagnating industry at risk of falling from grace.
About the author
Mr. Tay Wee Kuang
Phillip Investor Centre (Toa Payoh)
Mr Tay joined Phillip Securities in August 2017, shortly after graduating from Singapore Management University with a Bachelor in Business Management. Mr Tay majored in Finance and Operations and has developed a keen interest in the equity markets after having undertaken modules in Analysis of Equity Investments back in school, where he was taught various valuation models and ways to conduct Fundamental Analysis.
Mr Tay have conducted multiple seminars at Phillip Investor Centre (Toa Payoh) on the fundamentals of investing. He understands that investing on the stock market may seem daunting for many but believes that there are various tips that can make the trading experience much more enjoyable.