THE POWERFUL RELATIONSHIP OF TECHNOLOGYAND ECONOMIC MOATS
Internet-related technologies and other digital innovations are racing through the economy and helping leading businesses disrupt their respective industries by developing new products and services. This important trend is particularly noteworthy among smaller, nimble businesses that are quickly capturing market share and displacing legacy companies by launching products that are changing business processes and virtually every aspect of our daily lives. In the process, leading companies are strengthening their economic moats, which may make them potentially attractive investment opportunities. An economic moat represents a company’s sustainable competitive advantage. At Weatherbie Capital, we conduct in-depth fundamental research when selecting smaller cap companies for our portfolios. Based on our research, we believe smaller companies that are either pursuing untapped niches or creating new niches with innovative products have strong potential to outperform. As rapidly growing businesses that are investing in new technology, many of these companies are also expanding their moats. On a broader scale, the benefits of moats among smaller companies are not readily apparent because the category of companies is less closely followed by analysts at broker-dealers or other research firms. However, the power of economic moats is illustrated by large companies where ample data exists. According to Morningstar, equities of larger companies with wide moats have outperformed over the past one, three and five years (See Fig. 1). In our view, the significance of moats and the fact that moats are not readily apparent among smaller companies underscores the importance of conducting fundamental research when investing in smaller cap stocks. According to Morningstar, there are five factors in determining a moat: switching costs (impediments that prevent customers from switching from one product to
Matt Weatherbie, CFA CH I E F E X ECU T I V E O F F I C E R CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
H. George Dai, Ph.D. S EN I OR MANAG I NG D I R ECTOR CO - CH I E F I NV E S TMEN T O F F I C E R WE AT H E RB I E CA P I TA L , L LC
Figure 1: Wide Moats, Wide Outperformance (%)
Joshua D. Bennett, CFA S EN I OR MANAG I NG D I R ECTOR D I R ECTOR O F R E S E A RCH WE AT H E RB I E CA P I TA L , L LC
Morningstar Wide Moat Index
S&P 500 Index
Morningstar No Moat Index
Source: Morningstar, Inc. as of 4/30/19. Note: Returns for greater than one year are annualized.
Past performance is not an indication or guarantee of future results.
Dusty and squeaky chalkboards eventually gave way to whiteboards. Today, Chegg, Inc. is further revolutionizing the learning experience.
another), the network effect (the value of the product increases as more people use it), intangible assets (brand identity, government licenses and patents), cost advantage (producing goods at a lower cost than competitors) and efficient scale (average unit cost declines as production volume increases). An Industry Long Overdue for Digitization Innovation is the hallmark of exciting growth-oriented sectors, such as Information Technology, but as Alger CEO Dan Chung explains in his blog on Internet 3.0, the powerful surge of digital technology is extending to all industries and business practices. Human resources (HR), a business area long overdue for change, is an example. HR records have traditionally been paper based and information that has been captured electronically has been stored in different databases, which has made it difficult to analyze information and conduct other HR functions. In the face of those challenges, businesses are using cloud computing to streamline HR functions (See Fig. 2). Paylocity, which provides cloud-based payroll and human capital management technology primarily to smaller to mid-sized companies, is a beneficiary of businesses increasingly digitizing HR functions. Among other services, Paylocity offers tax-advantaged programs, such as Flexible Savings Accounts and Health Savings Accounts, that enhance an employee’s experience. We believe the following factors are helping the company to either sustain or enhance its competitive moat: • The cloud structure of Paylocity’s technology enables firms to digitize their operations and conduct HR processes faster, better and less expensively than by using services frommore traditional competitors. • The robustness of Paylocity’s offerings and breadth of services for clients make the company’s user base inherently sticky. • By adding clients, Paylocity benefits from efficient scale while expanding its technology offering. Education Gets Smarter Dusty and squeaky chalkboards eventually gave way to whiteboards. Today, Chegg, Inc. is further revolutionizing the learning experience. The company provides textbook rentals, study aids, writing assistance, tutoring and math EATHERBIE CAPITAL
MSCI EAFE P/E Relative to S&P 500
Figure 2: Companies Are Increasingly Using the Cloud for HR
Using the Cloud
Percentage of Companies
Companies with a Core HR System in the Cloud
Companies with at Least One HR Process in the Cloud
Companies Planning to Migrate to the Cloud in the Next 12-18 Months
Source: 2017 PricewaterhouseCoopers HR Technology Survey of over 300 Companies.
We believe EPAM is a valuable provider of services and it is increasing its own competitive moat accordingly. This relationship of EPAM’s services and its competitive moat continues to expand with the company currently at the forefront of new technology that it offers to its clients.
problem solving services to students. It has dominant market share and its moat is widening. Consistent with our theme of seeking smaller innovative companies leveraging technology to drive their businesses, Chegg invests approximately 30% of its revenue in research and development, including building a unique library of content and delivering its services via its technology platform through real time video conferencing or chatting. Chegg services enhance the learning of millions of students. By developing new content and continuing to enhance its technology, Chegg may strengthen its already considerable competitive moat. An Agent of Change Many companies lack internal resources for effectuating significant change such as digitizing business processes that are required to expand their own economic moats. However, third-party firms are providing these services, including helping clients build enterprise software such as e-commerce applications. As these consulting firms continuously develop new technology, they in turn strengthen their own moats by expanding the resources that they offer to clients. EPAM Systems is an information technology services firm with expertise in emerging technologies that helps clients execute digital transformation of their businesses. EPAM engages with customers in a consultative way to help design and build customized software solutions, including websites, databases and mobile applications. Among other projects, it has developed software that lets a leading beauty product company market and sell products through mobile phones. By developing these resources for its clients, EPAM may strengthen its clients’ moats and in turn may become a significant vendor resource. We believe EPAM is a valuable provider of services and it is increasing its own competitive moat accordingly. This relationship of EPAM’s services and its competitive moat continues to expand with the company currently at the forefront of new technology that it offers to its clients. Going Forward As investors in what we believe are high-quality smaller cap growth companies, we believe the accelerating pace of change driven by innovation underscores the importance of thorough fundamental research on businesses that we consider investing in. As the pace of change continues to accelerate, adoption of new technology and business models are increasingly becoming high stakes endeavors as companies that fail to embrace innovation may lose out to competitors and become irrelevant. At Weatherbie Capital, we will continue to conduct in-depth fundamental research as we seek innovative companies with compelling business models that are growing their economic moats.
Matt Weatherbie, CFA Chief Executive Officer Co-Chief Investment Officer
Joshua D. Bennett, CFA Senior Managing Director Director of Research
H. George Dai, Ph.D. Senior Managing Director Co-Chief Investment Officer
The views expressed are the views of Fred Alger Management, Inc. and Alger Management Ltd. (together with their affiliated entities “Alger”) as of May 2019. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Alger. Risk Disclosures: Investing in the stock market involves certain risks, and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. Technology and healthcare companies may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. 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(company house number 8634056, domiciled at 78 Brook Street, London W1K 5EF, UK) is authorised and regulated by the Financial Conduct Authority, for the distribution of regulated financial products and services. FAM and/or Weatherbie Capital, LLC, U.S. registered investment advisors, serve as sub-portfo- lio manager to financial products distributed by Alger Management, Ltd. Fred Alger & Company, Incorporated is not an authorized person for the purposes of the Financial Services and Markets Act 2000 of the United Kingdom (“FSMA”) and this material has not been approved by an authorized person for the purposes of Section 21(2)(b) of the FSMA. The Morningstar Wide Moat Index is a float market cap weighted index of all securities in the Morningstar US Market Index with a ‘Wide Moat’ rating. The Morningstar No Moat index consists of all securities in the Morningstar US Market Index where Morningstar expects the company to be unable to achieve high returns on invested capital relative to cost of capital and has little to no competitive advantage. The security weights are determined by free-float market capitalization. S&P 500®: An index of large company stocks considered to be representative of the U.S. stock market. Investors cannot invest directly in any index. Index performance does not reflect deductions for fees, expenses or taxes. Performance data quoted represents past performance. Past performance is not a guarantee of future results. The following positions represented the noted percentages of Alger assets under management as of February 28, 2019: Paylocity, 0.30%; EPAM Systems, 0.31%; and Chegg, Inc., 0.53%.
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