Don’t just take our word for it. Posted in: Featured - At Chevy Chase Trust, we specialize in global research and thematic investing informed by careful planning, and it's working. Forbes and RIA Channel recently ranked us among the highest in their Top 100 list, for 2 years running. Important Disclosures
- Finding Opportunity in Disruptive Change: Retailing and its Supply Chain Posted in: Noteworthy, Video - Today in the retail industry we're seeing that traditional brick-and-mortar stores are struggling despite a relatively healthy economy.
Finding Opportunity in Disruptive Change: Retailing and Its Supply Chain
We’re in the early stages of a revolution in retailing that is creating compelling new investment opportunities.
As thematic investors, we look for phenomena that are transforming cash flows and profitability across multiple industries. Then we seek to identify companies that will benefit, are investable through public equities with ample liquidity, and likely to pay off within three to five years.
Here we discuss one of these phenomena—how the next generation of automation is impacting the retail industry.
See our latest research and what it means for investors.
- Financial Planning and College Savings Posted in: Noteworthy, Video - Every client at Chevy Chase Trust receives comprehensive financial planning.
Smart college planning is the gift that keeps on giving. From UTMA accounts to 529s, Chevy Chase Trust shows clients how to build a legacy of learning through personalized tuition savings strategies that take into account a family’s complete financial picture. Chevy Chase Trust’s Laly Kassa and Leslie Smith share their insights on the best savings strategies for maximizing returns.
- Thematic Investing at Chevy Chase Trust Posted in: Insights, Noteworthy - In some ways, thematic investing is a throwback to investing in a simpler time.
In some ways, thematic investing is a throwback to investing in a simpler time. Before there were 15,000 mutual funds in 115 different fund categories. Before there were over 8,000 hedge funds and 2,000 ETFs traded daily. Before 17,000 new CFAs were credentialed every year, and before sell-side firms had analysts dedicated to specific sub-industries within each sector. Thematic investing doesn’t fit into any of Morningstar’s 115 fund categories or fit neatly into one of its style boxes.
The modern version of thematic investing emerged 15 to 20 years ago in response to the extreme segmentation of the investment industry. It gained greater visibility in recent years, as institutional investors and consultants, having turned to passive investing for larger and larger portions of assets, sought supplementary equity strategies that could generate alpha in a variety of different market regimes with some degree of reliability.
The term “thematic” is used to describe several different investment approaches, from single theme ETFs to portfolios where specific industries or sectors are deemed thematic. Here ‘s our definition:
Thematic investing seeks investable ideas that stem from economic or technological changes powerful enough to influence corporate performance across multiple industries.
It is instructive to contextualize three of the essential terms in this definition.
Today, most Wall Street research, on both the sell-side and buy-side, is organized by industry, with each analyst tasked with being an expert in his or her niche. The result? Few researchers look at the big picture—or even know how to. This creates an inefficiency.
One of the first people who decided to exploit this inefficiency was Lewis Sanders, when he headed AllianceBernstein. In 2003, Sanders tapped Amy Raskin to run a new research group at AllianceBernstein dedicated to studying strategic changes that spanned multiple industries (essentially, thematic research). Broadband internet service was the first theme the Research on Strategic Change group tackled. The team thought about how this new technology would affect media, entertainment, advertising, video games, retail, and telecom services. It asked who would benefit, who would lose, and which industries would be disrupted. The group went on to study many other themes over the next 10 years, each time learning from its mistakes and refining the process.
Chevy Chase Trust adopted a similar investment philosophy when it acquired an investment boutique in 2001. The boutique’s global, multicap, unconstrained equity strategy invested in secular themes influencing economies and markets around the world. In 2014, when Amy Raskin joined Chevy Chase Trust as its Chief Investment Officer, the firm integrated the best aspects of the two processes. One important and fundamental decision was to organize research analysts by theme, not industry. Each analyst was tasked with thinking about his or her themes holistically and uncovering relevant investment opportunities regardless of industry or geography.
Our approach to investing focuses on changes that are most likely to have a profound influence on corporate performance, seeking to buy companies that will be beneficiaries of thematic tailwinds and avoid companies that will be casualties of creative disruption. We think some thematic investors fail to distinguish between a trend and a potentially profitable investment theme. There are many significant changes occurring across the globe. But, in our vernacular, most of these changes are simply trends and not investment themes because they are not likely to create economic advantages that will result in sustainable profits.
Wireless broadband, known as wi-fi, is one example of a disruptive technological change that would not have been a great investment theme. The top left map below is a Manhattan neighborhood south of Central Park in 2001. There were no wi-fi hotspots. The top right map is the same neighborhood in 2011, where the purple dots indicate how wi-fi hotspots had proliferated. The bottom map shows that in early 2018, wi-fi hotspots are almost everywhere.
It’s amazing how this technology took off. Most people have wi-fi at home and would not think of staying in a hotel without wi-fi access. Coffee shops, restaurants, airports and subways provide it for free. A recent consumer survey ranked wi-fi second only to food in its importance in daily living.
While unit sales of wi-fi router equipment boomed, the profitability of the equipment makers was never impressive. Wi-fi is based on a set of a well-defined standards, so barriers to entry were low, and the number of competitors was high. During the decade of explosive growth, average operating margins for wi-fi equipment makers were in the mid-single digits.
Investors focusing on disruptive change must be cognizant of a basic tenet: more often than not, technological change ends up benefitting consumers far more than the companies enabling it, particularly when barriers to entry are low and competition is intense. Consumers have benefited from virtually ubiquitous access to wi-fi, but the companies that manufactured wi-fi routers didn’t profit enough to be great long-term investments.
Other examples of disruptive technological changes that we see as trends, not investment themes, include high-definition and smart television, activity trackers, streaming music, virtual worlds, home meal kits and ride-sharing services. While some of these may be surprising, the last is probably the most controversial. Here’s why we think ride-sharing would be an unsuccessful investment theme.
Introduced by Uber, the concept of a simple, frictionless car-hire platform that matches riders with drivers fills a compelling consumer need. As the concept was embraced globally, business for Uber and Lyft rose from fulfilling rides worth less than $1 billion in 2013 to almost $40 billion in the 12 months ended September 2017.
But a great service is not necessarily a great business. Most of the ride-sharing revenue, roughly 80%, goes to drivers. Some goes to attracting customers. As a result, Uber and Lyft have been losing money at an accelerating rate, and revenue growth has slowed. Their combined losses were roughly $2 billion in 2015, $3 billion in 2016, and $5 billion in 2017. This is not the hallmark of a sustainable business model.
It might be a good business model if, after attracting drivers and riders, the platforms could retain them with fewer incentives. Unfortunately, Uber, Lyft and similar platforms don’t appear to have a strong hold over either group. Drivers around the world are taking advantage of competitive services that give them a larger share of fares, and customers keep switching to new services with lower prices. Google’s mapping app now offers riders direct price and convenience comparisons between ride-sharing platforms, which may dissolve any customer loyalty that the platforms have created.
Gett, Grab, Via, Ola, Didi, Sidecar, Zimride, BlaBlaCar, Carma, Ridejoy, Easy Taxi, Taxify, YandexTaxi and Careem, are all similar services. Over the past three years, Uber has lost its monopoly position in New York City, where its market share has fallen below 75%, with no sign of stabilization.
We seek themes that are “investable,” which includes two traits. First, there must be enough public companies that are beneficiaries of the theme with sufficient liquidity for us to invest at least 5% of our portfolios in the theme. Water as a scarce resource, nanotechnology and space travel may be fascinating trends that could have major impacts on the world, but they are not among our investment themes because we haven’t found sufficient or appropriate investment candidates.
Second, we must believe that other investors will begin to discount the change or disruption into their valuation models within a reasonable time frame, which for us is three to five years. We don’t have to expect the change or disruption to mature within that time frame, just that other investors will begin to expect it. The market is a discounting mechanism, so company share prices reflect investor expectations, not necessarily current reality. For example, the share price of NVIDIA, which manufactures a key component of self-driving cars, is now discounting widespread future adoption of autonomous vehicles, although only about 700 driverless cars are on roads today.
Having noted two trends, wi-fi and ride-sharing, that we think were not or are not investment themes, two trends that meet our criteria for investment themes are advances in molecular medicine and wealth migration in the U.S.
Molecular medicine is the revolution in medical treatment created by the ability to detect tiny variations in the human genome that can cause disease. Molecular medicine is already providing both diagnostic tools and highly targeted treatments for certain cancers and other genetic diseases. Because almost all disease has some genetic component, the ability to pinpoint specific genetic mutations that can lead to disease and potentially alter or prevent the mutation’s impact, will revolutionize healthcare. Millions of people with devastating diseases will be cured as a direct result of the breakthroughs made possible by the sequencing of the human genome. Yet all of this is relatively new. The first sequencing of a human genome was completed in 2003. It took 13 years and cost about $3 billion. Today, complete human genomes are sequenced in little more than an hour for less than $1,000. The chart below shows the extraordinary decline in sequencing cost. If the decline merely followed Moore’s Law, which posited a 50% decline every two years for semiconductor technology, the cost of sequencing a genome would be 360 times higher than it is today.
The modest profitability of wi-fi equipment makers, despite soaring demand for routers, might lead one to conclude that investments in sequencing technology would also be a poor investment. Not so. Genetic sequencing is extremely complicated. Few companies can make this technology, and the number of competitors has actually declined as the market has grown. We estimate that Illumina, the market leader, now produces nine out of 10 new sequencers sold—and its gross margins have been flat to up over the past five years, averaging near 70%. Demand accelerated, the dominant player gained market share, margins improved and the leader wasn’t buying market share with discount pricing. To us, this is what a great long-term investment opportunity looks like.
We expect stronger demand growth for genomic sequencing and related technologies than many other observers. Our view is that the industry is at the beginning of a steep upward climb in demand driven by new applications for sequencing. Most analysts are focused on the number of research labs, existing machines and remaining capacity, to predict growth. We believe they are missing the bigger picture, which will include applications for agriculture, veterinary care, and other uses still on the horizon.How do we invest in this theme? The opportunity set is broader than sequencing equipment. “Big data” investments are particularly interesting. Each human genome contains three billion base pairs and requires 200 billion bytes of digital storage. Genomics was one of the first fields requiring big data storage and processing solutions.
Taking a holistic, thematic research approach can lead to investments that may not be apparent to sector specific analysts. Few analysts covering healthcare or even life science tools were thinking about the investment opportunities in big data, and few semiconductor analysts were focused on the massive amount of data produced by genomics.
Our molecular medicine theme has also broadened to include investments related to CRISPR, a genomic-editing process, and CAR-T, a form of cellular immunotherapy, both of which may disrupt traditional pharmaceutical companies.
U.S. Wealth Migration
Investment themes aren’t always the result of technological breakthroughs. Another current theme in our portfolios is the massive U.S. wealth migration toward urban areas, which reflects new lifestyle preferences, influenced by social changes, secular changes in the economy, and improved urban planning.
Why does this matter to us as investors? Each year U.S. consumers spend $13 trillion dollars, so understanding shifts in spending is crucial. People in cities spend money differently than people in suburban or rural areas. Urban dwellers spend less on transportation, and more on cosmetics, restaurants and travel. Also, denser neighborhoods attract companies and services, such as GrubHub/Seamless, Instacart, Task Rabbit and Via, that wouldn’t be profitable in less dense neighborhoods. The combination of convenience and choice that such companies provide reinforces the allure and advantages of urban living. There’s a virtuous loop of sorts at work. For more on this theme, see our white paper, “Investing in Disruptive Change: The Great U.S. Wealth Migration.”
It’s always possible to miss a crucial flaw in what seems like an exciting theme or get the timing wrong. This leads to considerations of risk management and portfolio construction, which is underscored by some recent research. In early 2017, an economist named Henrik Bessembinder published research showing that since 1926, four out of seven common stocks in a database of listed U.S. stocks had lifetime buy-and-hold returns lower than the return of one-month Treasuries. He also found that when market returns are stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies account for the net gain of the entire U.S. stock market since 1926. All the other stocks collectively matched Treasury returns. Bessembinder concluded that these results “help to explain why poorly-diversified active strategies most often underperform market averages.”
Some people have seized on Bessembinder’s research as another reason to give up on active management in favor of passive. That doesn’t make sense to us. Passive investing requires owning all stocks in the market index all the time. If the future is like the past, passive investors would dedicate virtually all their equity capital to obtain a T-bill like return, to get the upside from the tiny sliver of stocks that do well.
Instead, we conclude that active equity managers need to have a strong basis for selecting stocks with exceptional return potential and to diversify sufficiently to mitigate the impact of being wrong about a theme or an individual stock. We believe that thematic investing informs good stock selection and provides diversification.
The strong basis for stock selection comes from whittling down the thousands of public securities around the world to a manageable group of companies identified through our thematic research. This initial screening process is perhaps the most important part of investing.
Many firms use a quantitative screen, such as low price-to-earnings, or strong return on investment. Most, such as emerging markets growth managers, focus on geography and style. Our investments are largely defined by our themes. We invest almost exclusively in stocks that we think are likely to benefit from disruptive changes, because that’s where we think the risk/reward tradeoff is in our favor.
We don’t need to get everything right to be successful. If the places where we spend the majority our time and energy are even slightly more likely to provide fruitful investments than other areas, our odds of delivering strong performance go up meaningfully. Screening out companies whose business appear likely to be disrupted by new developments also improves our odds of success.
Some thematic ETFs and mutual funds invest in just one theme. But there are often only a handful of companies that have enough exposure to any theme to impact performance significantly. As a result, most single-theme portfolios either have a very small number of holdings, so they lack diversification, or they include every company tangentially related to a theme and, as a result, bear other unintended risks.
Our portfolios, by contrast, typically have about 40 stocks and five to seven themes. Some stocks represent more than one theme; these tend to be our largest positions. We rarely invest more than 25% of the portfolio in any one theme, and we carefully size our positions in each theme, taking into account industry, geographic and factor exposures. Some of our themes, such as molecular medicine, are composed mostly of stocks in classic growth sectors, such as technology and healthcare. Others, like supply chain automation, are more heavily weighted towards value stocks in the industrials and real estate sectors. Our U.S. wealth migration theme is tilted toward consumer discretionary stocks.
Large-caps, small-caps, growth, value and multiple countries are represented both in our opportunity set and in our portfolios. Typically, the largest systematic risk in our portfolios is a skew to the U.S., because, a disproportionate share of innovation and disruptive technology takes place in the U.S. When we put it together, we get a relatively concentrated yet intentionally diversified global portfolio with high active share that generates alpha primarily from stock selection. We’re proud of the results.
- Chevy Chase Trust hosts Spring Reception at the Smithsonian’s Renwick Gallery Posted in: Events, Noteworthy - On April 24, Chevy Chase Trust hosted its annual Cocktail Party and Reception at the Renwick Gallery’s exhibition “No Spectators: The Art of Burning Man.”
On April 24, Chevy Chase Trust hosted its annual Cocktail Party and Reception at the Renwick Gallery’s exhibition “No Spectators: The Art of Burning Man,” based on the maker culture art of the annual festival in Nevada’s Black Rock playa. The Burning Man festival attracts more than 75,000 people each year for a unique celebration of art and music in a temporary man-made city.
Special guest speaker and Lloyd Herman Curator of Craft at the Renwick, Nora Atkinson, introduced the enigmatic exhibition and how she was able to bring it to Washington D.C. “I started off by suggesting it would be just one room and a few pieces of jewelry,” said Atkinson. But eventually, her idea grew into a much larger collection of cutting-edge artwork that takes over the entire building and spills out into the surrounding neighborhood. All 14 installations were either shown at the annual Burning Man festival or were commissioned from Burning Man artists.
Guests at the special event enjoyed interactive installations such as the colorful Shrumen Lumen, large-scale sculptures that respond to human interaction; a 12 seater art deco movie theatre on the back of a red bus; a virtual reality experience; and the transformation of the Grand Salon into a temple of ornately carved wood.
“We appreciated the opportunity to spend an evening with clients and friends of Chevy Chase Trust away from the office and surrounded by the artwork of this exciting exhibition,” said Stacy Murchison, Chief Marketing Officer.
- Investment Update, First Quarter 2018 Posted in: Investment Update, Noteworthy - The S&P 500 Index began 2018 at 2,674. It ended the first quarter at 2,641. After accounting for dividends, the S&P generated a relatively small negative return of -0.76%.
Macroeconomic Outlook — The S&P 500 Index began 2018 at 2,674. It ended the first quarter at 2,641. After accounting for dividends, the S&P generated a relatively small negative return of -0.76%. If you somehow managed to ignore the financial media between January 1st and March 31st and just looked at these numbers, you might think it was a fairly uneventful quarter. Alas, that was not the case. During the first quarter, the S&P 500 saw 23 daily moves of plus or minus 1% or more. This compares to a mere eight in all of 2017.
2018 began with the highest level of bullish investor sentiment since 2010, as tracked by the American Association of Institutional Investors. In 2010, quantitative easing buoyed equity markets. In 2018, tax cuts and strength in the global economy formed the basis for optimism. The quarter began with the best January in eight years, but ended in the red for the first time since 2009. While earnings rose meaningfully, the market’s price-to-earnings multiple fell.
In our opinion, equity market risk has increased in the past 90 days and the risk/reward trade-off for the next 12 months has shifted from favoring risk to a more balanced view. In the near-term, we would not be surprised by more market weakness and higher than normal volatility. Despite our fairly balanced view, we do look for what could go wrong. Below are three near to medium-term risks.
- A peak in global growth coupled with a more hawkish Fed – There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is likely peaking. A more moderate pace of growth, in and of itself, would not be enough to cause an equity market sell-off. However, if it is coupled with a less accommodative monetary back-drop (i.e. continued Fed tightening), equity multiples will likely contract further. In this scenario, the decline in price-to-earnings multiple would likely more than offset positive growth in earnings. Under Janet Yellen’s leadership, it seemed unlikely that the Fed would press ahead with rate hikes if macroeconomic growth slowed appreciably. Under a new Chairman and with several Federal Reserve Board vacancies to be filled, the situation could be different. The Fed, as expected, raised rates in March despite recent financial market turbulence. Federal Open Market Committee participants revised upward their projections for both economic growth and the fed funds rate. Six participants now expect four rate hikes this year compared to only four in December. An overly hawkish Fed is still not our base case. We think when the preponderance of evidence shows economic growth slowing, the Fed will adjust its policy actions accordingly.
- Optimism and financial market instability – As mentioned above, optimism was at an eight year high at the start of the year. A simple word search on the terms “strong global growth” and “weak global growth” illustrates this extreme optimism nicely. Articles mentioning strong global growth shot up in frequency in late 2017, while articles mentioning weak global growth fell to their lowest level in a decade. A picture, or in this case a graph, is worth a thousand words.More recently, euphoria has faded in response to equity market weakness and volatility. Still, a majority of investors and economists seem focused on positive macroeconomic momentum and strong earnings growth, the logic being that bear markets and recessions go hand in hand and leading indicators are not pointing to a recession.While this analysis is sound on the surface, there is a possibility that a sufficient tipping point of financial market weakness and volatility could trigger a recession. Risk assets are now five times greater than global GDP. Causality doesn’t always run from the economy to financial markets. In major downturns, causality can run in reverse. Specifically, the last three economic downturns had their genesis in financial markets. The bursting of the dot.com bubble triggered the downturn of 2001; the large scale mispricing of U.S. mortgages caused the Great Recession of 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession of 2011. We expect volatility to continue to shake out weak equity holders and reduce investor optimism. This will be good for future returns as long as it does not create panic and instability. Again, our base case is that market participants will cope with volatility and avoid a bear market, but the risk that volatility could reach a tipping point has increased.
- Rising protectionism – This risk is harder to analyze. We know President Trump faces few constraints in escalating protectionism. But we do not know whether he will actually pursue what would be a destructive path or if it is simply verbal posturing. A trade war with China would severely damage both countries, and in turn, world growth. Equity markets are likely to continue to negatively react to signs of increasing tensions, and positively react when rhetoric cools.
In conclusion, we expect equity markets to continue to be volatile in the near term. If the Fed recognizes a slowdown in growth and reacts accordingly by slowing the pace of interest rate increases, it is not implausible that the bull market we have enjoyed for the past nine years resumes. However, if the Fed pursues an aggressive trajectory and/or trade tensions escalate, equity markets could drop below the February 9th low of 2,532. This “break” could scare technically focused investors and cause some algorithmic selling. In this scenario, it is possible that the S&P Index could fall 5-7% below the recent low. All other things being equal, we would view this as a buying opportunity.To reflect the increased risks outline above, we have rebalanced portfolios. We trimmed position sizes in several of our biggest winners, mainly technology related stocks, and increased more defensive holdings. This rebalancing has not reduced exposure to our themes and thematic holdings. When volatility rises, concentrating on our highest conviction investment ideas has served us well in the past and we believe it will do so now as well.
The growing importance and systematic undervaluation of intangible assets has been an important and successful theme for Chevy Chase Trust. We have long believed that corporate balance sheets understate intangible investments. For the most part, spending on intangibles is treated as a current rather than a capital expense. In contrast, investments in tangible assets, such as machinery, trucks or warehouses, are capitalized on corporate balance sheets and depreciated over long periods of time. Understatement of intangible investment has led to undervaluation of intangible assets. Many intangibles, like non-public consumer data, research and development and large user networks are increasingly valuable but difficult to measure. These characteristics have provided opportunities to earn excess returns by owning intangible-rich companies.
We recently read an insightful book, “Capitalism Without Capital: The Rise of the Intangible Economy,” by Jonathan Haskel and Stian Westlake. Over the past few decades, the nature of investment in many developed markets, including the U.S., has changed. As shown in the chart below, U.S. investments in intangibles, such as software, research and development, market research and branding, now represent a greater share of economic output than tangible investments.
The authors describe how, in their opinion, intangible assets most critically differ from physical goods.
- Intangible assets do not follow the same set of physical laws as tangible assets. They can generally be used over and over by different people in different locations, often at the same time. They are scalable in a way tangible assets are not. For example, a software package or a drug formulation can be used in offices or labs in multiple countries by multiple users at the same time. The same is not true for a piece of machinery or a delivery truck. Further, once a business has invested in creating or acquiring an intangible asset, it can usually reuse it continually at very little cost. This scalability allows intangible-intensive businesses to grow fast.
- It is hard to recoup money spent on intangible assets if the investment is not successful. Physical assets are often easier to sell or repurpose if things go wrong. In contrast, investments in intangibles often represent sunk costs. This characteristic makes them much harder to finance, particularly with debt.
- Ownership of intangible assets tends to be more difficult to establish legally than ownership of tangible assets. As a result, investments in intangibles are more easily copied by competitors. The company making the investment does not always reap the reward. In economic terms, the original investor may not appropriate the benefits of intangible investment. This characteristic tends to discourage corporate investment spending.
These characteristics of intangibles help explain some perplexing relationships in today’s economy. As the authors explain, “one of the most troubling and widely talked about trends in economics at the moment is secular stagnation: the fact that business investment is stubbornly low despite every indication that it shouldn’t be.” In the past, when interest rates were low, investment spending increased. The greater uncertainty associated with investing in intangibles, and the increased difficulty in funding intangible investments, may at least partially explain the current breakdown in the relationship between interest rates and investment.
Another unusual aspect is that corporate profits in the U.S. and elsewhere are, on average, higher than they have been in decades and seem to be steadily increasing. However, these profits are increasingly unequal. Normally, over time competition levels the playing field between leading and lagging firms, as profit margins regress to the mean and the laggards go out of business. This does not appear to be the case now. In part, this may be due to the scalability of intangibles and the ability of certain very large firms to dominate.
While we value external validation of our thematic research, Capitalism Without Capital and similar articles put a focus on the theme and make it more likely that other investors will begin to fully value intangible corporate assets. When a theme is recognized by other investors, we benefit from being an early investor, but the future opportunity to earn excess returns diminishes. Some of our best performing holdings have been in companies with unique intangible assets. Some have doubled or tripled in price. Today, the valuation gap is smaller than it has been. We still think there are opportunities to invest in companies with undervalued intangible assets, but the opportunities are shrinking.
We often get asked “when and why would we exit a theme?” One of our requirements for a theme is that we believe that other investors will begin to discount the theme in their valuation models within a reasonable time frame, which for us, is three to five years. We would not be surprised if within the next 12-18 months the valuation gap in this theme will have closed and the overall theme will have lost its advantage. Of course, we are always researching potential new themes.
Similar to equity markets, the first quarter of 2018 was tumultuous for fixed income investors. U.S. 10 year bond yields started 2018 at 2.41% and rose rapidly to a high of 2.95% on February 21st. Since late February, equity market volatility and protectionist policies led investors to seek safety in bonds, causing yields to recede about 20bps (0.2%) to close the quarter at 2.74%. Of course, rising yields means falling prices. Interestingly, shorter term bond yields followed a similar trajectory. Two year Treasury yields started the year at 1.88%, rose to 2.34% on March 20th, and receded to close the quarter at 2.26%.
One of the more consensus views beginning the year was that rapid global economic growth would lead to meaningfully higher bond yields. Most economists predicted that 10 year U.S. bond yields would exceed 3.0% or even 3.5% by year-end. We have been more conservative in our estimates (more optimistic on prices), and still believe consensus expectations are too high. That said, a trade war or change in foreign appetites for U.S. debt could meaningfully impact prices. These risks are difficult to handicap.
We continue to view high quality, shorter-term bonds with ample liquidity as the most prudent investment option in volatile markets.
- Q & A with Tap Chibaya Posted in: Noteworthy, People - We recently sat down with Tapfuma Chibaya, an Equity Research Analyst at Chevy Chase Trust, to learn more about his background and what he enjoys most about his career.
We recently sat down with Tapfuma Chibaya, an Equity Research Analyst at Chevy Chase Trust, to learn more about his background and what he enjoys most about his career.
Give us a brief rundown of a typical day for you at Chevy Chase Trust.
I arrive around 8:30 am, before the markets open at 9:30. This gives me time to go through emails and news, and catch up on anything that may have happened overnight. Since we invest internationally, lots can happen overnight.
After that, the first half of my morning is typically research. Checking any new articles that provide new waves of thought that may affect what we are doing here investment wise. Other than these important aspects of my day, it is hard to define a typical day, because there are often many different projects going on at once.
In summation, what is your responsibility for CCT?
To put it simply– my job is to come up with good, investable ideas for Chevy Chase Trust, that will ultimately help our clients meet their investment objectives.
I compile materials to build a case for each idea and then try to convince our research team that it is worthwhile. The best way to do this is just keeping an ear to the ground. I pay attention to all of the trends and have to stay ahead of what’s currently happening.
Tell me a little about your background.
I grew up in Zimbabwe, in a very small community. There were no more than 5,000 people. My dad worked in a mining plant, and that plant was essentially the center of all activity in our town. The plant shut down, but I was fortunate enough to have two working parents, and my mom, a teacher, basically became the breadwinner.
I attribute all of my success to my parents. They made sure to send me and my siblings to great schools, even at a sacrifice to themselves. Education was highly valued by my family, and I benefitted as a result. While still in high school I caught a lucky break, and I was given the opportunity to come to America.
Did you go to college here?
I went to college in Middlebury, Vermont through a program sponsored by the American Embassy in Zimbabwe. The program sought out students who showed promise and assisted us in the entire college application process. They even helped us determine the best schools to apply to, based on tuition assistance knowing that was something we would need. Each year roughly 20-30 students go through the program, and I was fortunate enough to be one of them.
What was college like for you?
Middlebury is a small liberal arts college, and I really enjoyed my time there. I majored in economics, but liberal arts was a new concept for me. In Zimbabwe, you specialize as early as high school, so I had already been on the business track for a few years. In the liberal arts setting, I was taking all kinds of classes… different types of history and music, etc. It was such an interesting experience for me, and if I had to do it all over again, I absolutely would.
I was able to pick up some critical thinking skills that many people may underestimate, and I have an understanding of such a wide range of topics now, thanks to my college studies.
Any courses you had to take that you surprised yourself by really liking?
I ended up taking Spanish to nearly the highest level. There aren’t many African countries that speak Spanish!
What was your first job after college?
My first real job after college was as an equity research analyst at Credit Suisse, which I suppose explains why I am sitting in this seat today. It’s where I cut my teeth in the industry.
Coming out of college I did want to be an investment banker. My finance professor was a former investment banker, and it was such a highly sought after career. I was enamored with the idea of it. But, as an international student, there were limitations on my job opportunities. It came down to finding a company where I fit, but who was also willing to sponsor me as an immigrant.
Did you enjoy the research side more than you expected?
I really did! It is so intellectual and I value that a lot. You can take the research wherever you want. Equity market research specifically fascinates me because it’s all public information—everyone has access to it, so it comes down to piecing together all of these individual parts to establish and support your ideas – i.e. the mosaic theory.
After three years at Credit Suisse, I did test the waters as an investment banker but ultimately decided to come back to research. I personally found it a better fit and more intellectually stimulating for myself.
What do you enjoy most about your career?
Reading and learning new things. I try to learn something new every day or to enhance the knowledge that I already have.
What do you enjoy most about working at Chevy Chase Trust?
The people–especially the team I work on. I can see that my ideas are heard and that my work is valued. Chevy Chase Trust is unlike any place I have ever worked before. There’s also so much room for growth here—career-wise and as a person. It’s really a special place.
What is the best lesson you’ve learned over your career?
Do your work 100%, 100% of the time. Whether you have a small assignment that you feel is a waste of your time, or a big project that you feel will get you noticed. Do your work to the best of your abilities always. Don’t worry about who’s noticing, someone is always noticing.
What is your favorite thing to read outside of work?
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- Amy Raskin, featured speaker at Strategas 12th Annual Macro Conference Posted in: Insights, Noteworthy - At the Strategas 12th Annual Macro Conference on March 1, 2018, Chevy Chase Trust’s Chief Investment Officer, Amy Raskin, presented her views on Thematic Investing.
The conference, which highlights important investment trends driving the economy and markets, featured a panel of eight experts in the areas of Thematic Equity Investing, Cryptocurrencies, Japan and Growth Stocks.
Raskin’s presentation focused on “the modern version” of thematic investment approach which has gained visibility in recent years. While thematic investing is just 15-20 years old, Raskin pointed out that it is a throwback to investing in a simpler time—before there were 115 different mutual fund categories. She defines thematic investing as “an investment style that seeks investable ideas that stem from economic or technological changes that are powerful enough to influence corporate performance across multiple industries.”
Distinguishing themes from trends, Raskin emphasized that of the many profound changes occurring around the world, most are trends, not themes, since they are not likely to add to the bottom lines of investable companies. She offered two examples of current themes at Chevy Chase Trust including molecular medicine – the revolution in medical treatment created by detecting small variations in the human genome that can cause disease, and the U.S. wealth migration toward urban areas –the movement of wealthy people in the U.S. to cities, partially reversing the suburbanization trend of the previous 100 years.
In the end, Raskin said her thematic investing approach tends to result in a broadly diversified global portfolio that doesn’t expose clients to big swings in the business cycle and skews to the US, because, for structural reasons, that’s where a disproportionate share of the most innovative and disruptive technologies is created.
- Investing in Disruptive Change: The Great U.S. Wealth Migration Posted in: Insights, Noteworthy - As thematic investors, we look for phenomena that are transforming economic prospects across multiple industries. Here we discuss one of these phenomena, the migration of U.S. wealth to urban areas, and some of the investment implications.
As thematic investors, we look for phenomena that are transforming economic prospects across multiple industries. Then, we seek to identify companies that will benefit, are investable through public equities with ample liquidity, and are likely to pay off within three to five years. Here we discuss one of these phenomena, the migration of U.S. wealth to urban areas, and some of the investment implications.
For the first time in over a century, more people in the United States are moving to cities than to suburbs. The educated and affluent are opting for walkable cities with restaurants, shopping, schools and parks easily accessible via sidewalks and bike paths. In contrast, moderate and low-income people are leaving cities, often priced out by rising rents.
This wealth migration to cities is the result of lifestyle preferences that are favoring urban amenities over suburban space. This shift is being reinforced by contemporary urban planning and secular economic trends, including the migration of businesses to urban areas with highly educated workforces. We believe these trends will continue for decades, with urbanization spreading outward from city cores, turning many suburbs into urban-like villages.
Urbanization is a centuries-old global trend that has accelerated in recent decades. China’s population is now approximately 50% urban, up from 16% fifty years ago, but it’s still well below that of Western Europe and Latin America. By some measures, the U.S. is the most urbanized country in the world, with 80% of its population living in metropolitan areas. But by another measure, the U.S. is far less urban than most developed countries. More than 60% of the U.S. population lives in close-in suburbs that are part of metropolitan areas. This development pattern is virtually unique to the U.S. and largely the result of government policies.
The American Dream of home ownership was created by the Federal Housing Administration in the 1930s and propelled forward after World War II by the Veterans Administration home loan program. Then, the creation of the interstate highway system in the 1950s, coupled with low gas prices, made suburb-to-city commutes both easy and affordable. A final suburban push came in the 1960s, as safety fears stirred by urban riots dominated headlines and television screens. Rising crime rates prompted people with the means to live elsewhere to leave cities for the safety of the suburbs. The population of most U.S. cities fell in the 1960s and 1970s, leaving cities poorer and more racially segregated. But migration to cities resumed in the 1980s and has sped up over the last 15 years, finally outstripping the slowing rate of net migration to suburbs. Now, urban population growth is being driven by high earners and the highly educated. As city rents rise, lower income people are leaving, priced out by rising rents and rising home prices.
Today, the U.S. is becoming a more urban society and cities are becoming wealthier. These trends are reinforcing each other in a virtuous cycle, with falling crime rates making urban living more desirable, new approaches to urban planning fostering walkable neighborhoods with dining and shopping, an educated and youthful population developing a taste for the new urban lifestyle, and companies, particularly knowledge-based companies, moving to be near pools of talent. The clustering of people, talent, firms and capital has spurred innovation and increased productivity, turning cities into incubators of economic development.
Falling Crime Rates
Cities have become safer. New York City reported 2,000 violent crimes per 100,000 people per year, on average, in the 1980s, but only 600 per 100,000 between 2008 and 2014. Other cities reported similar, though smaller, drops. In aggregate, violent crime rates in large cities have declined by one-third over the last decade. In contrast, crime rates in suburbs have risen 17% on average, with drug-related crimes accounting for most of the increase. Safety improves quality of life. With urban crime rates falling and suburban crime rates rising, suburbia is losing one of its long-held advantages.
The New Urban Planning
For decades, cities across the U.S. have been making concerted efforts to attract young, educated, and higher-income people, and the companies that employ them. In the 1980s, New York redeveloped the South Street Seaport and Boston revitalized Quincy Market into charming old-fashioned shopping and dining districts attracting new residents and more visitors. This trend predates Millennials’ current love affair with cities. We think it is likely to endure for this and future generations.
The new urban planning models focus on being pedestrian friendly. Sidewalks are a priority and neighborhoods are re-zoned so that residential, retail, office buildings, schools, and recreational facilities are within compact areas. According to a study by Redfin of the Washington, D.C. metro area, walkability pays off in higher real estate values. A 20-point increase in a walkability score translates into a $9 per square foot premium in office rents, $7 premium in retail rent, 80% increase in retail sales, a $300 per square foot premium in residential rents, and an $80 per square foot premium in residential housing prices.
Biking, too, has become a priority as it has grown in popularity. Newer urban planning models include bicycle trails and bike sharing systems, which provide another transportation option for young professionals less keen on driving. Chicago saw its investment in biking correlate with its rise as a global startup destination. “You cannot be for a startup, high-tech economy and not be pro-bike,” Chicago Mayor Rahm Emanuel has said.
Smart urban planning allowed New Orleans to make its comeback after Hurricane Katrina. The city devised a master rebuilding plan focused on three key goals: walkability, new business formation, and sustainable development using green technology and better transportation planning. The plan worked. In 2014, a boom in start-up activity resulted in New Orleans having new business formations 64% higher than the national average.
Suburbs like Bethesda, Maryland and Palo Alto, California have adopted similar urban planning measures to become walkable urban villages clustered around big cities. Increasingly, these wealthy, urban-like suburbs centered around transportation hubs extend urbanization outward. Suburbs without such amenities, by contrast, face a decline in population, jobs and tax revenues. As a result, they may soon be forced to cut services, as some cities and rural towns have been forced to do.
Not Just Demographics
Some observers dismiss the wealth migration to cities as the temporary result of a demographic bulge that will reverse as Millennials mature and choose to raise their families in the suburbs, as their parents and grandparents did. We agree there is a demographic factor at work here, but we think that Millennials are less likely to leave cities than previous generations, and those who do leave will likely move to urban-like suburbs.
Millennials, the generation born between 1981 and 1997, include some 47 million people and about 30% of the U.S. workforce. Having come of age during the last two recessions, many Millennials had difficulty starting a career. Many are also saddled with student debt. Both factors make it challenging to afford a family or buy a home. Largely as a result, homeownership for people under age 35 has fallen sharply from its peak in 2004.
Today, first-time homebuyers have been living in rental apartments for six years on average, longer than at any time in the last 50 years and more than double the average during the early 1970s. And Millennials are just the latest of several generations to wait longer to marry and start a family. The average age of first marriage and childbirth has been rising for nearly 50 years.
The revival of once blighted cities started in the 1980s, when falling crime rates and de-industrialization began to make many cities safer and cleaner. Young professionals pioneered the gentrification of urban neighborhoods such as New York City’s Upper West Side, Boston’s Back Bay, and Washington, D.C.’s Capitol Hill, in the 1980s and 1990s. Many of those young professionals stayed to raise families because they liked walking their children to school and stopping at a neighborhood cafe on the way home. Similar lifestyle shifts occurred in cities across the nation in subsequent decades as people sought shorter commutes and city planners designed mixed use developments of retail, housing and commercial space, creating true live, work, play environments.
Jobs Follow Talent
Both new and established companies want to be located near clusters of talent. As talented young professionals show a preference for cities over suburbs, companies are following.
- Rolls-Royce moved 2,500 employees from six primarily-suburban locations to a single downtown office in Indianapolis in 2011, to meet the wishes of students coming out of engineering school. These students were “looking for the downtown living environment,” according to a company report.
- Forty-four years after leaving New York City for a 70-acre suburban office park in Fairfield, Connecticut, GE will relocate its headquarters to downtown Boston in 2019.
- McDonald’s is moving its headquarters from a suburban office park in Oak Park, Illinois, to downtown Chicago.
- Marriott is moving from a suburban office park with limited public transit to downtown Bethesda, Maryland, adjacent to the metro rail and just outside of Washington, D.C.
- Amazon’s announcement in 2017 that it was seeking a second headquarters specified that it wanted to locate in a metropolitan area with a population over one million, strong technical talent, and access to mass transit.
The Knowledge-Based Economy
The service and technology sectors, often referred to as “knowledge industries,” continue to power the U.S. and global economies. Companies in these industries are increasingly city-based. More than half of new companies with at least $1 billion in market value are headquartered in downtown San Francisco or New York City. Most are tech firms.
An analysis of new business formations after cyclical downturns shows how this trend has evolved. Smaller cities and rural areas drove the economic recovery in the 1990s, together creating roughly 70% of new business formations. By contrast, in the 2000s recovery, large cities created 50% of U.S. jobs, as the tech-driven economy took off and suburban office parks began to decline. And in the most recent post-financial crisis recovery, large cities fueled four out of five new business formations and accounted for 60% of all new jobs, while new business creation in rural areas has stagnated.
The U.S. wealth migration to cities has investment implications that span sectors and industries. By studying this shift, we can better understand the evolution of new business models designed to take advantage of higher-density living, and assess the opportunity set of companies poised to benefit from these secular trends.
- A decade ago, we sought to invest in the growth of cities in emerging markets, particularly China. Our investment ideas back then centered on materials, infrastructure and manufacturing. In contrast, our current investments in the migration of U.S. wealth to urban areas are tilted toward technology, data and services.
- American consumers spend $13 trillion per year. Investment opportunities arise from understanding where and how that money will be spent. The answer to ‘where’ lies increasingly in urban areas.
- Urban dwellers now earn 30% more than their rural counterparts. With incomes and spending growing faster in urban areas than in America overall, we project that spending per square mile in urban areas will increase by 40% in 2020.
- Urban consumers spend differently than their rural counterparts. They spend more on housing, education, clothing, cosmetics and food outside the home—and far less on cars and transportation.
- New business models are emerging that capitalize on the concentration of people and wealth in urban areas. Many of these businesses focus on convenience and choice. Delivery businesses will continue to evolve for food and consumer goods; and mobility services, such as ride-sharing, will transform transportation.
- Older infill industrial properties will become increasingly valuable for redevelopment as fulfillment centers for e-commerce firms. At the same time, new retail construction will decrease as store footprints shrink. We expect a 5% to 10% contraction in retail square footage, with each one percent being the equivalent of 1,800 football fields.
- Significant chunks of suburban commercial real estate are likely to lose value, unless they find ways to become destinations. Strip malls and big box retailers appear most vulnerable.
In sum, the wealth migration to urban areas with distinct amenities is defining a growing ecosystem that we think will spawn innovative new economic activities for years to come.
- Saying economy is strengthening, Fed’s Powell suggests faster pace of interest rate hikes Posted in: Insights, Noteworthy - From The LA Times: During his first Capital Hill appearance since taking over as Fed Chair, Jerome H. Powell suggested Tuesday that the central bank could hike its key interest rate faster than anticipated. Craig Pernick, Head of Fixed Income weighs in.
New Federal Reserve Chairman Jerome H. Powell indicated Tuesday that the economy’s prospects have strengthened and that the central bank could lift short-term rates at a quicker pace than anticipated. Speaking before the House Financial Services Committee, Powell said, “We’ve seen some data that will, in my case, add some confidence to my view that inflation is moving to target. We’ve seen continued strength around the globe and we’ve seen fiscal policy become more simulative.”
Craig Pernick, Head of Fixed Income, commented, “He is saying more of the same, but he’s saying it with a tone with words like ‘tailwinds’ instead of headwinds and that the outlook remains strong.”
Read the full article here.
- Finding Opportunity in Disruptive Change: Retailing and Its Supply Chain Posted in: Insights, Noteworthy - As thematic investors, we look for phenomena that are transforming cash flows and profitability across multiple industries. Here, we discuss one of these phenomena—how the next generation of automation is impacting the retail industry.
As thematic investors, we look for phenomena that are transforming cash flows and profitability across multiple industries. Then, we seek to identify companies that will benefit, are investable through public equities with ample liquidity, and likely to pay off within three to five years. Here, we discuss one of these phenomena—how the next generation of automation is impacting the retail industry.
More than 20 major U.S. retail chains declared bankruptcy in 2017, from Sports Authority and Toys ‘R’ Us to Payless ShoeSource. Thousands of stores closed, more than in either of the recession years of 2001 and 2008. Yet, retail sales are booming, the economy is strong and unemployment is at a low of approximately 4%. What’s going on?
First, e-commerce is taking an ever increasing share of the $3 trillion in U.S. retail spending. E-commerce already accounts for more than 13% of retail spending and should more than double over the next ten years.
E-commerce’s growth and increased market share occurred against a backdrop of an already bloated retail sector. Retail square footage per capita rose by more than 50% in the U.S. from 1970 to 2016. As a result, according to PricewaterhouseCoopers, there was more than five times as much retail square footage per person in the U.S. than in Europe.
Brick and mortar retailers are responding by trying to move online themselves and adopting new, small-store formats to reduce costs and get closer to consumers. This is reversing the long-term trend toward big box stores.
Concurrently, a new generation of automation is upending the global supply chain, rearranging the logistics of retailing and changing the cost structure throughout the supply chain. Production and fulfillment centers are moving closer to the end consumer, reversing another long-term trend toward globalization of production.
Most warehouses today look much like they did 100 years ago, cavernous buildings filled with stacks of crates, shelves, pulleys and lifts. The process inside the warehouse is still largely manual. Five years ago, workers at a typical Amazon warehouse walked up to 12 miles a day, pushing a cart, locating items, taking them from shelves, and moving them to a packaging station.
Automating Warehouses and Fulfillment Centers
That’s changing. Amazon now has over 100,000 mobile robots operating inside fulfillment centers. These robots lift entire shelves and bring them to packaging stations, eliminating the need for pickers to walk the aisles locating items. Amazon’s new warehouses have miles of conveyor belts, automated shuttle systems and cameras that can read 80 barcodes per second.
Robots move faster, maneuver through narrower aisles, and retrieve goods from shelving up to five times higher. These changes have resulted in a 20% reduction in operating costs. As a result, there is a growing cost and efficiency advantage of e-commerce over traditional brick-and-mortar stores. In 2012, Amazon sold seven times more merchandise per square foot of real estate than the average brick-and-mortar store. Since then, warehouse automation has boosted Amazon’s efficiency premium to nine times the average of traditional stores, which have also become more efficient but are falling farther behind.
While Amazon continues to expand its robot fleet, it is also developing a next generation robot that can open boxes, identify and remove single items, and place those items in a different box. At an Amazon-hosted robotics contest in 2017, a robot that picked up a baby wipe was treated like a rock star. The celebration of this feat and the tasks being designed for the next generation of robots are examples of Moravec’s paradox. Hans Moravec, a futurist at the Robotics Institute of Carnegie Mellon University, determined that it was relatively easy for robots to be programmed to perform complex adult-like computational tasks, but much harder to replicate the simplest tasks of a toddler, like walking without falling, avoiding a misplaced piece of furniture, or placing a square peg in a square hole.
This next generation of automation will use cameras, sensors and software to enable robots to perceive and respond to their environment. They will operate around the clock in a “lights out” warehouse without the need for lunch breaks, vacations, sick days, or overtime.
Last-Mile Production & Delivery
Next-generation automation is also allowing consumer goods companies to speed time to market. Apparel companies today typically place orders as much as a year in advance—which doesn’t align well with constant demand for current fashion and customizable options. Nike says that the inability to react quickly to demand signals can result in hundreds of millions of dollars of lost profits. Today, most footwear and clothing are produced in Asia by a multitude of contractors and subcontractors. A shirt might be stitched in one factory from cloth woven, dyed, and cut in three separate factories owned by three different companies, with time between each step of production.
This system evolved to cut labor costs, which in Asia can be as little as one-tenth the labor cost in the U.S. Automation makes it possible to locate production closer to the end consumer. While labor costs in developed markets are higher, the cost is more than offset by reduced transportation costs, faster time to market and the need for fewer workers. An Atlanta-based company is producing automated sewing equipment for a t-shirt factory. The company claims its first-of-a-kind technology reduces labor by 90%, while nearly doubling output per hour. Similarly, Nike and Adidas have announced plans to use 3D printing and robotics to produce footwear and apparel here in the U.S. Nike already allows shoppers to order sneakers with customized features.
Amazon was recently granted a patent for equipment that uses a customer’s measurements to make personalized clothes in their fulfillment centers. To complement this strategy, it also purchased a company that makes highly accurate 3D models of each customer’s body. Executives who enjoy the convenience of being measured in their o ce for custom-made suits, typically wait weeks, if not months, for tailoring and delivery from Hong Kong. Amazon’s new system may soon provide custom-tailored suits faster.
E-commerce is also gaining market share by providing next-day and same-day delivery in major metropolitan areas. To provide this convenience, Amazon, Best Buy, and other e-tailers are locating fulfillment centers closer to the customer, typically in higher-cost urban and suburban areas, rather than rural industrial parks.
Amazon fulfillment centers are, on average, 60% closer to purchasers than they were a decade ago, yet still over 100 miles away. In Amazon’s top 25 markets, its fulfillment centers are almost three times closer to the end consumer than in smaller markets. Locating distribution centers 10 miles, rather than 100 miles, from consumers could reduce e-tailers’ transportation costs by 70%. We estimate that close-in fulfillment centers have the potential to reduce overall e-commerce logistics costs by another 30% over the next few years.
Eventually, e-commerce delivery costs will come down even more. Ruffaello D’Andrea, the co-Founder of Kiva, estimates that it will cost twenty cents to deliver a package with a drone compared with $2 to $8 per package for human delivery today. McKinsey & Co. projects that 80% of packages will be delivered autonomously by 2025.
New Store Formats
The increased cost advantages that e-tailing, automated warehouses and last-mile fulfillment have provided to e-commerce is putting some traditional retailers out of business and reducing new store construction. Retail construction fell 20% in 2016. We expect to see a 5% to 10% net reduction in retail space over the next few years. But, in our view, it won’t spell the end of brick-and-mortar stores. People still like going to stores to see displays, discover new products, touch fabrics, try on clothes, and interact with an in-store expert. These are unique advantages that traditional retailers can build on by enhancing the shopping experience, while slashing real estate and inventory costs.
To cut real estate costs, retailers are reducing or eliminating in-store inventory. We expect retailers to reduce inventory by nearly $200 billion, or up to 30%, over the next few years. One strategy is to maintain better information on inventory levels with Ultra High Frequency Radio Frequency Identification (UHF RFID) chips. Think of UHF RFID as bar codes that don’t require a carefully positioned reader. The chips send out a radio signal that informs the store’s inventory system exactly how many units of each item are on the premises.
Lululemon uses UHF RFID to enable customers to see real-time inventory levels in nearby stores on a mobile app; it also uses the data to balance inventory across its store network. Levi’s tags every pair of jeans with UHF RFID so stores can nd and sell scattered units during a big sale. This reduces odd lots the store would likely sell at clearance prices. We believe these strategies can boost revenues by 5%. For a store with 10% operating margins, boosting revenue by 5% without increasing costs could increase operating pro ts by 50%.
Other stores are exploring other approaches. Target has a trial store with some goods for sale, but no backroom inventory. Target treats the store like an e-commerce customer, delivering goods as needed from nearby fulfillment centers.
Wal-Mart, which built its empire on a low-price, low-service model, recently paid $310 million for Bonobos, acquiring a radically different way of doing business. Bonobos calls its stores “guide shops” because a trained guide introduces shoppers to its range of products and ensures that their personal tastes are met. Its shops have no inventory on site; orders arrive at the customer’s home two days later. Similarly, Nordstrom recently introduced Nordstrom Local, just 2% the size of a typical Nordstrom, offering personal shopping guides and amenities like a nail salon, but no on-site inventory.
We expect the retail store of the future to be small and uncluttered, and to offer personal shoppers, customized goods, and home delivery. Think of it as a return to bespoke neighborhood tailors—or the spread of luxury service à la Bergdorf Goodman but at much lower prices. The same next-generation automation now being used by e-tailers to put brick-and- mortar stores out of business will allow brick-and-mortar stores to reinvent themselves and provide a more desirable shopping experience.
Within the theme of next generation automation, many traditional elds and old-line business models are being disrupted. New business models are being created, some existing business models are being reinvented, and others are being subjected to creative destruction.
The impacts on the retail industry and its supply chain are profound and become the catalyst for even more changes. Importantly, the investment opportunities are diverse, seemingly unrelated, but connected by the threads we see in secular trends and our thematic research.
Here are some conclusions that shape our investment thinking:
- Emerging markets will lose an advantage over developed markets, as low-cost wages are no longer the determining factor in location of production facilities.
- Automation utilizing artificial intelligence and sensors will lower prototyping and small batch production costs, facilitating mass customization.
- Outsourced fulfillment will allow small brands and retailers to do what they do best, create unique products and connect with their customers, leveraging third-party supply chain infrastructure.
- Just-in-time inventory enabled by sensors, software, and local fulfillment will reduce inventory, waste, and overhead, and the need for pro t-destroying clearance sales.
- Mobile and alternative payment systems will continue to gain share as consumers move away from in-store cash transactions.
- These trends are deflationary as production costs decline and labor and real estate are repurposed.
- Shoppers will make fewer trips to physical stores, but when they do go, their intent to purchase will be higher. This will increase spending per visit and reward those retailers who can satisfy visitor expectations.
In sum, we’re in the early stages of a revolution in retailing that is creating compelling new investment opportunities.