When Bill Hewlett and David Packard founded Hewlett-Packard Co. in a Palo Alto, Calif., garage in 1939, they planted the technology flag in what is now known as Silicon Valley — an 1,800-square-mile area synonymous with disruptive innovation and technological progress.
While the Bay Area undoubtedly will remain a hub for technological ingenuity, the next wave of technology-driven investment opportunities will not be found at Silicon Valley startups and the FAANG companies. The baton will be passed to technology-using companies from technology-creating companies. The implications for investors are profound: they increasingly will need to look beyond the tech sector's circumscribed borders to understand how rapid technological change is reshaping other sectors and companies globally.
We believe five themes will define the shifting technology frontier for investors.
First, technological innovation has gone global — and well beyond the Chinese tech behemoths. Tightly integrated international supply chains have fostered an era of reverse innovation, with new ideas often stemming in emerging markets. For example, mobile-advertising platforms developed in India have been rolled out globally and mobile health-care delivery services developed in Kenya are being introduced to patients in Europe. Additionally, the pace of cross-country technology transfer has accelerated, given the speed and cost-efficiency with which code and tech intellectual property can be transferred between countries relative to the traditional model of foreign direct investment and large-scale talent transfers to emerging markets. These trends have played out most significantly in China, which, for example, now leads the world in the mass implementation of artificial intelligence-enabled facial recognition.
Second, like in the 1990s, technological change will only truly accelerate global productivity when new technologies are integrated into the real economy, beyond the digital walls of the tech sector. This is happening now, with examples of early adopters giving us a sense of things to come. In the energy sector, leading firms have turned to advanced robotics, automation and big data to drive down production costs. Advanced drilling technologies such as steerable drills and measurement-while-drilling systems now allow operators to pinpoint exact locations of reserves, as well as make real-time adjustments to drilling paths to reach those reserves in cost-efficient ways. In real estate, the unprecedented pace of technological change has meant "future proofing" new assets, with the flexibility to convert them to new uses, has become critical. Parking garages offer a prime example. Given the rise of autonomous vehicles, garages are now being designed with level floors (rather than ramps) and higher ceilings to allow for easy conversion to alternate uses, such as delivery terminals.
Third, investors will need to develop a framework to identify technology-driven leaders, particularly outside of the tech sector. Proactively identifying "winner-takes-all" firms early on will require active decision-making focused on tracking the characteristics demonstrated by companies well-positioned to succeed. These include firms with business models that can capture and defend scale economies and network effects (such as Amazon and Facebook), that disproportionately invest in technology R&D. They also supplement in-house tech development with technology-driven mergers and acquisitions, and consciously structure their business models around the adoption of technology (with a chief technology, data or transformation officer on the senior leadership team, for example).
Fourth, investors need to look beyond venture capital to capture technology-driven investment opportunities. Our research shows venture capital has delivered, on average, both the highest risk and lowest returns among private equity firms — averaging only 3% returns and generating effectively zero net alpha since 2000. As value is increasingly generated by new technologies in mature firms outside of the tech sector, investors will need to widen their lens to source opportunities in the public markets, late-stage private companies, or technology-enabling real assets such as cellphone towers, distribution centers and renewable power.
Fifth, investors will have to position their portfolios for growing obsolescence risk. This is especially true given the unprecedented pace of technological change: it took around 40 years for companies globally to adopt automobiles after they were first invented, only 16 years for personal computers and just seven years for the internet. The economies of scale and network effects embedded in new technologies and cutting-edge companies can rapidly displace incumbent firms (even digitally savvy ones) and devalue established assets in a matter of just one to two years. A good example is New York City taxi medallions, which peaked at $1.3 million in 2014 and now are auctioned off for less than $200,000 due to the rise of ride-sharing apps. These eroding legacy business models are a particular risk when making long-term buy-and-hold debt investments or less-liquid investments in private equity, real estate or infrastructure. It is increasingly important for investors to understand where obsolescence risk resides in their portfolio and how to effectively mitigate it.
While the technology sector might currently be at peak hype, it is undoubtedly true that the current wave of new technologies has the potential to drive incredible societal progress while also posing some grave challenges. Investors will need to take a broad, long-term, cross-portfolio perspective to truly capture the benefits while navigating the risks of this brave, new technology frontier.