A Coca Cola for the 21st Century

The Financial Times has just published a survey of the world’s top global brands. The world’s three most valuable are Google, IBM and Apple. Microsoft made it into fifth spot, behind Coca Cola. Tech companies took seven of the top ten positions and most of the top twenty positions.  We live in a technology dominated world, yet you often come across professional investors who would rather take a bath in battery acid than buy a tech share. 

The problem is that tech is two faced. On one side you find dozens of companies that look, for a moment like winners, then flare out. Others, like Sun, Compaq and Palm do well for years before evaporating Then there is tech’s other face, the totalitarian one. In its day, IBM controlled between 60% to 70% of the mainframe computer market. Intel takes around 90% of the microprocessor market, and there is not much worth fighting over in the PC software market that isn’t owned by Microsoft. Google rules the hill in search and Amazon has cornered the electronic sale of books.  These are businesses with moats around them, the kind of brand names that a young Warren Buffett would buy ahead of Coco Cola, or the Washington Post.

Now, I am going to make a crazed, typically top of the market prediction, within ten years Apple will be the largest consumer brand in the world. Furthermore, some media giants, it could be Disney, News Corp or Time, will ride the same jet stream. The key has to do with understanding where we are in the tech cycle and the rising power of the Asian consumer.  

Over the last week we have seen Corning increase sales by 57%, citing strong demand for flat screen TVs and computer monitors, particularly out of Asia. Likewise, Samsung Electronics, Asia’s largest technology company, has just reported that Chinese consumers are showing a keen interest in higher specified flat screen TVs. A few weeks ago it was Apple’s turn. Analysts had been expected around 7 m iPhones to be shipped, instead the company sold 8.7m and earned nearly 30% of its profit from Asia. In the previous quarter, 20% of the company’s profits came from Asia. 

Asian Demand

The strength of demand in Asia is the thread linking each of these results, but there is a noted change to the pattern of this demand. Chinese consumers, on the eastern seaboard, were the first to ship in container loads of high ticket luxury items and high tech goods. About 300 m live in eastern cities such as  Shenzhen, Shanghai and Beijing.  What has changed is that the 1bn or so Chinese consumers in the more Western provinces have begun spending. CLSA, the specialist Asian broker, estimates that these consumers have, when it comes to tech goods, close to the spending power that those on the eastern seaboard enjoyed in 2005. 

Salaries are rising in China, while at the time the price of tech goods is falling. Since 2004, the price of notebooks, PCs and handsets has been falling at 12% a year. For LCD TVs the rate of decline is more like 20%. If these trends continue then, by 2013, it has been estimated that China will be the largest market in the world for high tech goods. By 2012, when it comes to electronic goods, rural China will have the same buying power as those on the eastern seaboard have today. By 2013, China could account for close to 30% of the world’s LCD TVs and smartphones and one in five of the computers made.

The ability of the average Indian to afford such tech products will reach those that existed in China over the last couple of years, by 2014. Just as Western consumers have driven the purchase of PCs and smartphones during the first decade of the century, Asian consumers will take the lead during this decade. The song, therefore remains the same: consumers buying not corporate expenditure is what drives IT sales. Microsoft’s most recent results are further confirmation of this trend. 

The challenge for investors

One of the challenges facing investors will be to find the stocks that benefit most from this colossal shift in consumer spending. While the American consumer represents about $10.35 trillion dollars, compared to just $2 trillion for both China and India, Asia will dominate the growth in demand. This, of course, is the same pattern we saw in the oil market, as explained in the Energy Anomaly. Emerging markets represent 95% of the growth in demand for oil. Therefore, even as demand for oil dropped in the West the price rose because countries, like China, increased consumption. This shift will gain momentum just as Western consumers and governments enter the Great Contraction and cut spending to reduce debt. 

If you want a sign of the times then here is one. In the UK, the Governor of the Bank of England has just warned that which ever party wins next week’s general election, it is likely to be out of power for a generation after. The reason, because the decisions needed to reduce debt are going to be so harsh and unpopular. 

How to Play This Trend

Asia has a special affinity for technology. After all, tech products and computer games played an influential role in the rise of the Japanese economy. Accenture, the consultancy, has conducted research globally into consumer buying patterns and concluded that Asians are twice as likely as a westerner to have bought a computer, or mobile phone. Asia led the West in the use of the internet for building social communities and in the adoption of massively multi-user role playing games - MMPG. Across Japan, South Korea, Taiwan and now in China too, there is a problem with Asian youths becoming so addicted to the cyber life style that they withdraw from society. In Japan such youths are referred to as Otaku. Otaku culture is spreading rapidly across Asia. 

How best then to play the Asian high tech Tsunami? This is where we need to revisit the secret of those global brand names and reacquaint ourselves with the two faces of tech.

History shows us that it is fiendishly difficult to make money from hardware companies. With a few exceptions hardware shows us the wrong side of tech.  The pace of innovation is destructive and margins are atomized.

The 1980s were decade of the personal computer and it was also the decade that Sun, Microsoft, Compaq and names who would become leading tech companies went public. Yet, if you look at a chart of the market capitalization of US tech shares, as a per-centage of the overall market capitalization of US shares, you will see that as a group tech fell over the course of the decade. How can that be, when Sun, Microsoft, Intel and others were among the best investments of the 20th Century? Part of the answer is that most of the profits that were available in the PC industry were taken by two companies: Intel and Microsoft. The same pattern appears to be  happening today with the PC’s replacement, the smartphone.

Have you noticed that it is becoming harder to find smartphone stocks to make money from? In the first quarter of this year, smartphone sales probably rose by around 50% in unit terms. Yet, at Cykepartners, we estimate that Apple took around 40% of the smartphone sector’s operating profit. 

Apple is rampant while other smartphone makers, such as Nokia and even RIM, are finding it tough to stay with the pace. Don’t therefore be surprised if there are more rescue missions like the one that HP launched for Palm. 

The reason that Apple’s growth has gone up a gear is because of Asia. Sales in China, Taiwan, Japan and South Korea rose several hundred per cent. Nonetheless, skeptics will point out that a competitor might emerge with a cooler device that will topple the iPhone. They might also argue that the new iPad might yet underwhelm. The latter, though unlikely, might be true. As for another device wasting the iPhone, that would be a tall order. Apple only spends 3% of its sales on R&D, and apart from a few cosmetic changes, the iPhone hasn’t been fundamentally altered since it was launched in 2007. Increasingly, the key to its success is the Apps Store. Just as hundreds of thousands of developers were really the key to Microsoft’s dominance, those Apps developers are Apple’s foot soldiers. To beat Apple now someone is going to have to find a way of inducing those foot soldiers away. Google’s Android has the best shot, but I am not convinced it will be able to pull it off. The momentum looks unstoppable and like Intel, Microsoft and Google before it, Apple has a good chance of establishing a hammer lock on what is the fastest area of growth in consumer electronics. 

Therefore, as we saw in the age of the PC, power is being concentrated in a few hands when it comes to the smartphone. By 2012 there could be more than 500m of these devices on sale - which will be well ahead of the combined sales of laptop and desktop PCs. Besides Apple, and a handful of specialist chip and software companies, we still haven’t answered how will investors make money?

One answer is to look at content. We now live in an age of ubiquitous broadband, often it doesn’t feel that fast, but mostly we have access to it. By the end of last year there were 1.7bn internet subscribes and by 2012 there will be around 3 bn, close to half the population of the globe.    Households around the world will increasingly have WiFi and a broadband connection. With these networks in place the desire for electronic devices will multiply. Ericsson, the world’s leading telco equipment maker, believes that by 2020 there might be as many as 50 billion devices. If that sounds incredible, try counting how many digital cameras, music players, games consoles, PCs etc you have in your house; well over 20 would be my guess. 

In a world of devices and widespread networking, the stage is set for the consumption of digital content. Each minute of the day 24 hours of video are uploaded to Youtube. By December of last year mobile data traffic overtook mobile voice traffic despite there only being about 400m mobile broadband accounts world wide, which is a tenth of the number of mobile subscribers worldwide.

We have entered the content centric age and history shows that American content plays well around the world. Check out the performance of content shares over the course of this year. Stocks like News Corp (producer of Avatar), Disney and Time are out performing Google. With advertising rates rising and a revolution in high definition and 3D underway, media stocks are cheap and facing the benign version of a perfect storm. The iPhone and more lately the iPad point the way to future where digital content becomes pervasive and some of the big content names will shine as a result. My guess is that over time Apple itself will mutate more towards content, which is one reason why its recent move into mobile advertising is so interesting. 

Apple’s Xen like coolness, is appealing to aspiring Asian consumers in a way that no other high tech brand appears to be able to rival. It is early days but I think Apple’s first quarter revenues, where Asian sales leapt points the way to the future - this is the Coco Cola of the 21 st Century.

The Oil Anomaly

Anomalies, like some difficult people and risky jokes are where you find information, this is why we like them. The biggest anomaly out there can probably found in the global energy markets. The economic crisis that began in the second half of 2008, triggered a sharp decline in energy prices and consumption.  By the end of that year the price of oil had fallen by 75%, traded coal was down by 62% and the price of natural gas sold in the US, had fallen by 58%. The economic slowdown continued into 2009, and then something strange happened.

While prices for coal and gas continued to fall, the oil price stabilised and then staged a sharp recovery. From a low of $34 in December 2008, the price of oil rose to $71 in June 2009. In the wake of economic recovery the oil price has continued rising and is now over $80. Week in week out pundits attempt to call the oil price and most of the time they seem to call it wrong. The reason it is so difficult is that the energy markets are going through a change and change is always difficult to forecast.

Demand for oil in the OECD countries had started to fall in late 2005, long before the economic crisis broke. It continued dropping through 2006 and into 2007. Since 2007, oil consumption in OECD countries was down by 8%. Yet, in the five years to 2008, the price of oil rose by 370%, traded coal was up 460% and natural gas rose by 120%. For the answer to this anomaly we can largely ignore the machinations of hedge funds and other speculators, instead we should look at what is happening in emerging markets.

The only other time since World War II that prices rose by as much as they have during this decade was in the 1970s. Then demand for oil was driven by growth in the developed world. This time round 90% of the growth in demand for oil is coming from the developing economies.  

Emerging inefficiency

Emerging economies, like China and India, are not efficient consumers of energy.  Therefore, demand for energy exceeds the growth in GDP. At market exchange rates it takes 3.4 barrels of oil equivalent to produce $1000 of GDP in the non-OECD countries, compared to 1.1 barrels of oil equivalent in the OECD. One reason for this inefficiency is that many emerging markets subsidise the price of energy. There is a direct correlation between energy efficiency and energy prices so subsidies are not a helpful distortion if you are worried about carbon emissions. Besides green house gases distortions have other  implications for global economic growth. 

The American consumer represents about $11 trillion of global GDP, compared to about $2 trillion for both China and India. In the US, fuel taxes are low and as a result the price of oil has a more direct impact on the prices that consumers pay at the pump. With demand rocketing in the non OECD, both because of stronger growth and inefficiencies, American consumers are likely to suffer, even as growth in their own country stagnates. Fuel subsidies, therefore, are a distortion that are being felt all around the world. 

Fuel subsidies make the world a more unpredictable place. The other reason that unpredictability is rising is due to the different nature of growth in mature and developing markets. As Christof Ruhl, the chief economist of BP, from whom much of this article is derived, explains: in developed markets economic growth only gradually reshapes the sectoral composition of the GDP and employment; its principal affect is to expand the service sector, which is less energy intensive. In emerging market, growth is radically reshaping economies, making predictions about energy consumption harder to nail down successfully. Hundreds of millions of people have left low-energy-intensive activities, such as agriculture, for energy-intensive activities, such as construction and industry.  In the West, industry is becoming less energy intensive, whereas in emerging markets the drift is the other way.

As discretionary incomes rise in the developing world, due to urbanisation, lifestyles change. Mobility and the need for transportation increases, as we can see by the explosion of car sales into countries, such as China. These changes have shifted the growth in demand outside of the OECD.  Ruhl says that the entire net increase in global oil consumption since 1999, has come from outside of the OECD countries.

This rebalancing of consumption in favour of the emerging economies carries a heavy environmental cost. In the 1990s the growth in carbon emissions slowed, but since the turn of the century it has picked up on the back of emerging market demand.  The carbon intensity of energy itself has increased. From 1970 until the late 1990s, global emissions per unit of energy consumed fell steadily. But then, in 1999, reflecting the increasing share o coal in energy portfolios of the non-OECD countries, carbon emissions per unit of energy began to rise. Since the turn of the century they have increased by two per cent globally and by 3 per cent in the emerging world.

The Role of Opec

As we have just seen, the rise of the emerging markets is making it more difficult to predict energy consumption. However, as we saw above, the price of oil rose sharply while other energy sources, such as gas and coal were more directly correlated to the overall economic growth. The rise for the divergence is due to Opec. The oil price is supported by a cartel, whereas coal and gas are not. 

By 2008, the average annual price of crude had increased for 7 consecutive years, this had never happened before. One reason for this rally can be laid at the door of price fall, when the price for crude began to retreat from $80  a barrel, which was then a record high. To stop the decline, OPEC stepped in and cut production twice, in late 2006 and early 2007, by almost one million barrels a day. Crude oil then rallied from $50 to $147 in July 2008, their highest level ever, in both real and nominal terms.

What is extraordinary about this rise is that production was only cut by 1m barrels a day, where as daily consumption is 81m a day! Ruhl explains that like any complex system, the global oil market needs a degree of redundancy to operate smoothly. In the short term, inventories can provide this safety cushion; in the longer term, it is provided by spare production capacity. Following strong demand growth in 2003 and 2004, spare capacityin the global oil market was hovering around record lows, at little more than two percent of global production. Even after the OPEC cuts of 2006 and 2007, the global oil market was running at above 97 percent of capacity. At such a high level it is impossible to guarantee any meaningful stability in prices.

As growth picked up, an already tight market became tighter and prices exploded. As crude prices cruised through $120, Saudi Arabia unilaterally decided to increase production in an effort to help out the US, its largest customer. Curiously,  oil prices jumped on heels of both announcements; the market believed  that Saudi could not deliver the increase. The market was wrong. Not only was production increased in the Kingdom, it was rose from other Persian Gulf producers too. The timing could not have been worse because it coincided with the Great Recession. Prices fell from $147 a barrel in the summer to $34 by late December.

Production was cut by 4.2m barrels and by the first quarter of 2009, OPEC’s cuts finally met the fall in global demand. 

Where are we today?

Ruhl estimates that the oil market now has 6 m barrels a day spare capacity. He calculates that it would take three years to burn through this capacity and wind markets up as tight as they were last year. Now hear this: prices are not expected to spike over the next two or three years.

Stability may be a dream because it assumes that the deep structural changes that affect the oil market comply. Three factors are worth keeping in mind. The first is that OPEC retains inordinate power over the oil market, even though it only controls 40% of crude output. The main reason for this is that there has been barely increase in supply from non OPEC regions, despite the strong rise in the price between 2002 and 2008.

The second reason, as we have discussed, is that emerging economies now drive the price of oil. The last structural change in the oil market is energy efficiency. The entire increase in global oil consumption this century has come from outside of the OECD in countries where its price is subsidised. Estimates of future shifts in demand will therefore have to determine how subsidies are likely to affect demand outside the OECD countries, for example, in China or the Middle East.

Coal and Gas

Global coal consumption is led by China, which consumes 43% of global supply and represents 85% of the growth in coal consumption.  The market for coal is a lot less concentrated that that for oil. Coal trades internationally in smaller but highly competitive markets. During 2008, the price of coal rose and then collapsed as the Great Recession hit demand. It fell longer and further than oil because there is no cartel supporting the price.  The market has also become more competitive: in response to higher transport costs, Europe substituted coal from the Indian Ocean with imports from the US.

Another factor is that fact that coal can be substituted by cheaper natural gas, which is what happened in the European Union. Electricity production from gas rose by 8 percent, compared to a 9 percent drop in electricity production from coal. 

Natural gas got hit by the same one two punch that hit oil. Production increased just as economic growth went into a tailspin. The increase in gas production was partly due to technological advances in the US. Chief among these is horizontal drilling and hydraulic fracturing, which uses water pressure to release gas from hard rocks. Improvements in technology have led to an increase in the production of non-conventional gases.  Production of non-conventional gases, such as coal bed methane, tight gas and shale gas has doubled over the last decade. The share of these gas deposits in total US gas production has reached about 50 percent.  Like unconventional opinions unconventional gas is becoming the new normal.

As the technology that was pioneered in the US spreads the production of unconventional gases will increase. This is important because deposits of gas are less concentrated than those of oil.

Another change has been the development of an integrated market for LNG. About 8% of all internationally traded gas today is LNG. Traditionally, the relationship between LNG producers and consumers has mirrored that between piped-gas producers and consumers, which are connected by pipelines.  This system is now changing. Spot markets have been emerging, thanks to buyers who have tried to secure additional LNG by purchasing single cargoes. 

The emergence of a competitive market for LNG has the obvious effect of  linking prices between regional gas markets in Asia, Europe, and North America, which have historically been segmented. The second consequence is that with long-term contract pricing under pressure, competition will increase and efficiency will improve. Consumers will benefit if the price of natural gas is increasingly delinked from the pice of crude. Finally, the advent of a globally integrated LNG market will improve energy security by fostering diversification. 

We can already see the consequences of this: Russian and Central Asian gas deliveries to Europe are being affected by LNG prices. Whether the changes in the natural gas markets will have strategic significance will depend on two factors. The fist is whether more unconventional gas resources can be developed and where this occurs. The reason that coal is so popular is that it is available where it is needed - primarily, in China and India. By contrast, natural gas is, like oil, geologically concentrated: 60 percent of natural gas is consumed in regions that only control 14 percent of the reserves. Now if unconventional gases can be produced in places such as China, which currently are heavy users of coal, it could become the local fuel of choice, which would benefit carbon emissions. One kilowatt-hour of electricity with natural gas emits a little more than half the amount of carbon that producing the same amount of energy with coal does. 

Conclusion

What we have learned is that no matter how severe the current recession, its effects on global energy markets are likely to be dwarfed by the long-term impact of the industrialisation of the emerging-market economies. The pressure on energy and commodity markets may have been relieved for the short term, but over the medium and long terms, the need for greater energy efficiency is paramount.  Today, oil accounts for 35% of global primary energy consumption, coal for 29% and gas for 24%. Renewable energies, other than hydro and nuclear, are less than one percent.  It’s time to wake up and smell the methane, it will be decades before alternative energies ever have a meaningful impact on global energy consumption and carbon emissions. Where we can make an impact is through improved efficiencies. 

In the West industry has led the way in becoming more efficient.  As consumers in both the developed and developing world show an increased desire for electronic goods, such as flat screen TVs, lighting, computers, music players, video cameras and digital still cameras, the ability to deliver greater energy efficiency becomes more prized. This is one reason the share prices of companies involved in such technologies as LEDs will continue to outperform solar, wind or any other alternative energy in future.