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Focus on Innovation Target market segments poised to help shape a post-pandemic future
The COVID-19 pandemic has created a new trend line for our society. Amid enormous suffering and loss, social norms have been upended and the global world order has been materially changed in less than six months. Longer term, second derivative ─ or butterfly ─ effects of the pandemic have the potential to materially change technological, medical, social, manufacturing, policy and geopolitical trends. Not just for this generation, but for generations to come.
Given the global effort to improve testing, create treatments, find vaccines and practice social distancing, we hope that the apex of the curve is behind us. As reopening and rebuilding begin, new industries will be created and current ones will work to adjust to a new sociological paradigm. This inflection point may present opportunities that are not currently well represented in traditional market exposures.
Innovation Inflection Point
Technological innovation will be at the forefront of reshaping our way of life. It will touch every industry and be the catalyst for new ones. We are likely to see demand for advanced medicine, improved structural health care processes, and remote access capabilities to support reduced-contact interactions. There is likely to be a tectonic shift in our daily routines and how we consume media. Digital payments will become more standard, while video games, streaming networks, virtual reality, social media and interactive home workout equipment will likely move from being “discretionary” items to “staples” in the future.
While the potential for innovation will be broad-based, these four themes in a post-COVID-19 world may be the most transcendent:
Software Solutions to Support Daily Life
Remote access, cloud storage, and internet-based solutions were strong secular trends before COVID-19. During the pandemic, however, the use of internet-1 and software-2 based solutions significantly increased for some platforms, and IDC expects that even with a decline in spending on IT solutions, the persistent need for storage will fuel an 18% post-COVID-19 annual growth rate of installed storage capacity through 2024.3
A more digitally connected world, however, will require software to function. We see software as the backbone of our new society, just as the highway-building public works project coincided with the broad-based adoption of the automobile and transformed post-World War II America. As a result, software and service firms are likely to benefit from this seismic shift in corporate and consumer behavior across a variety of dimensions: video conferencing, e-learning, telehealth, project and document management, closed-system social communication tools, cloud technologies, digital payments, and cyber security.
This generation-defining shift is one reason why earnings for software firms are expected to grow at 18% per annum over the next three to five years ─ compared with a 10% growth rate for the broader market. And, software firms are not expected to see material declines throughout the rest of 2020 and 2021. In fact, as shown below, while the S&P 500 is projected to have negative sales growth over the remaining three quarters of this year, software and services firms are projected to continue to grow their top line each quarter. Valuations are a bit above their long-term average for the industry,4 but with a lack of growth in our current environment, the premium for a growth industry with the potential to reshape society is warranted.
Advanced Health Care to Respond to Pandemics
Biotechnology stocks have traditionally offered higher growth potential as a result of their ability to create lifesaving medicine or advanced treatments to improve the quality of life. Given this profile, coming out of this period of uncertainty, biotech is one potential bright spot for three reasons:
- Solutions: One fifth of the industry is working on critical COVID-19 health solutions, including treatments, vaccines and antibody testing5
- Growth: In the wake of massive downside growth for the broader market, as shown above, 2020 earnings growth is projected to remain positive for biotech relative to the S&P 500 (1% vs. -20.5%) with the 3–5-year outlook nearly double the market rate (19% vs. 10%)6
- Innovation: An estimated 30 to 35 biotech companies, raising about $3.5 billion in capital,7 are expected to go public this year ─ evidence of biotech companies being less impacted by any consumer demand-shock, as their products and services have a longer lifecycle (i.e., firms that are pre-revenue and in clinical trials)
Beyond the current need for advanced medicine, an aging population, the need for cancer treatments and genetic therapies, and new technologies to improve the efficiency of what has now been exposed as a susceptible global health care system may act as additional tailwinds for the industry. And with the pandemic response likely to be a US presidential campaign topic, funding for research will gain more attention. The last tailwind for biotech is that valuations are slightly below their long-term median, based on our four-factor composite metric,8 as shown below.
Cyber/Future Security to Defend Against Global Risks
The COVID-19 crisis has also resembled a global security event for many as a result of domestic and international travel bans, compromised video-hosting platforms and a near-total transition to digital payments. While many uncertainties loom large, a shift toward virtual goods, services and employment for a myriad of industries will undeniably increase the economic implications of unfettered cybercrime and cyberterrorism. Accenture estimates that $5.2 trillion globally will be at risk of cyberattacks from 2019 to 2023.9 But we may not have to wait that long, as the FBI’s Internet Crime Complaint Center (IC3) saw daily cyber complaints increase from 1,000 to almost 4,000 a day during the pandemic.10
Additionally, traditional cybersecurity protections are likely to also lose efficacy with application and use-cases expanding significantly, prompting opportunities for specialized innovation and development in this space. Lastly, the second-order effects of COVID-19 may result in an even greater increase in nontraditional defense spending than what had been previously anticipated. Tightening security restrictions at borders, airports, train terminals and sporting events ─ similar to what occurred during the years following the 9/11 terrorist attacks ─ may lead to more tracing/scanning technology, drone usage and facial recognition technologies.
Intelligent Infrastructure for a Digitally Connected but Physically Distanced World
Home networks, improved power grids, robotics/automation to replace physical labor, safety equipment for nonremote jobs, as well as automated transport systems are all likely innovations to support the systematic change in how we will work, live and travel. These trends will compound the growth already expected for “smart cities,” where global spending was already estimated at $124 billion in 2020 ─ a 19% increase over 2019’s figure.11
Legislative efforts may accelerate the trend toward more smart devices or “the internet of things,” a market where global spending is already likely to reach $1.1 trillion by 2022.12 Congress has discussed a $760 billion package13 as part of a recovery proposal, in which portions of the money would be spent on rebuilding roads, bridges and transit networks, in addition to investing in water and sewer infrastructure and broadband internet. Infrastructure bills have long been discussed but never enacted. Perhaps the COVID-19 pandemic will provide the reason to act, spurring investment in a new world of connectivity.
Implementation Ideas
When targeting thematic trends where idiosyncratic or firm-specific risk can be elevated, since not all firms innovate successfully, a diversified investment approach that is non-market-cap weighted is optimal. These non-market-cap-weighted funds may allow investors to participate in one of these generational themes without shouldering sizable single-stock risk.
To target the broad-based innovation impacting a variety of industries throughout the economy, consider:
To overlay specific thematic exposures covering segments and trends, consider:
1“The Virus Changed the Way We Internet”, The New York Times, April 7, 2020.
2“Zoom, Microsoft Teams usage are rocketing during coronavirus pandemic, new data show”, MarketWatch, 4/1/2020.
3 International Data Corporation, 05/13/2020.
4 Current Price-to-book, Price-to-Earnings, Price-to-Next-Twelve-Month-Earnings, and Price-to-Book for the S&P Software & Services Select Industry Index were analyzed relative to their historical valuations from 2011, as of 05/15/2020 per FactSet based on SPDR Americas Research calculations.
5 Bloomberg Finance L.P., calculations by SPDR Americas Research as of 05/15/2020 based on the constituents of the S&P Biotech Select Industry Index.
6 FactSet as of 05/15/2020.
7 Bloomberg Finance L.P. as of 04/30/2020, calculations by SPDR Americas Research.
8 Current Price-to-book, Price-to-Earnings, Price-to-Next-Twelve-Month-Earnings, and Price-to-Book for the S&P Biotech Select Industry Index were analyzed relative to their historical valuations from 2011, as of 05/15/2020 per FactSet based on SPDR Americas Research calculations. The average is across all four metrics reflects a 6% discount.
9 The Cost of Cybercrime, AccentureSecurity, 2019.
10 “FBI says cybercrime reports quadrupled during COVID-19 pandemic”, ZDNet.com 4/18/2020.
11 International Data Corporation, 2/4/2020.
12 Statista 04/23/2020.
13 “Lawmakers look to infrastructure spending to help economy recover from coronavirus”, Washington Post 4/1/2020.
Price-to-Earnings
Share price divided by earnings per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested. A higher number indicates that a company's stock is overvalued.
Price-to-Book Ratio, or P/B Ratio
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company or that its accountants have undervalued it.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
S&P Biotech Select Industry Index
The S&P Biotechnology Select Industry Index is a modified equal-weighted index that represents the biotechnology sub-industry portion of the S&P Total Markets Index.
S&P Software & Services Select Industry Index
S&P Software & Services Select Industry® Index is a modified equal-weighted index that represents the software sub-industry portion of the S&P Total Stock Market Index.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended May 21, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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