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Equity Perspectives

Why Lord Abbett foresees outsized growth in six big rivers of opportunity.

The developed world today finds itself in the midst of a painful deleveraging process, with social headwinds to boot. Growth will likely be subdued, if not scarce, for quite some time. Only capitalism can revive growth, and creative destruction, the “perennial gale” described by renowned economist Joseph Schumpeter, is the only mechanism by which this can possibly occur. Fortunately, there is evidence that such winds of change are driving six big rivers of growth.

Growth Challenged by Deleveraging
The developed world is mired in debt. (See Table 1.) The ending of the post–World War II debt expansion, long past the point of diminishing returns, ushered in the Great Recession. Aggressive monetary policy has been employed to fight deflation (and avert a great depression), providing time, but not the impetus for growth. The latter must come from the capitalist system.


Table 1. Huge Increases in Debt Have Dampened Growth in the United States
($ in billions)

Source: Ned Davis Research Group.
* Last 5.25 years, using most recent data available.


Social Headwinds Also Hamper the Growth Outlook
As if the deleveraging process weren’t enough of a challenge to growth, social considerations are compounding the problem. The U.S. economy faces additional, daunting headwinds that will limit future potential growth, particularly consumption per capita, said Northwestern University economics professor Robert J. Gordon in an August 2012 white paper.1 These headwinds include an aging population; a plateau in educational attainment; rising inequality; and necessary environmental expenditures. “Even if innovation were to continue into the future at the rate of the two decades before 2007, [these headwinds] are in the process of dragging long-term growth to half or less of the 1.9% annual rate experienced between 1860 and 2007,” Gordon concluded. We would add excessive regulation of business to the list of headwinds.

Creative Destruction to the Rescue
As Schumpeter noted, capitalism is by nature a method of economic change whereby new consumers, goods, methods of production, and markets incessantly destroy the old ones and create new ones. Creative destruction—a term he popularized—is the essential fact about capitalism. It is the fundamental impulse that sets and keeps the capitalist engine in motion.

Throughout history, the innovation of companies that are growth leaders has transformed industries. This process is alive and well today, and our investment process is designed to identify the companies that become growth leaders by engaging in creative destruction. These companies disrupt the established economic order with new products and services, enabling them to grow at a significantly faster rate than that of the general economy. Schumpeter would say that these companies present a competitive threat analogous to a bombardment, versus the mere forcing of a door.

The Six Big Growth Rivers
Based on our fundamental analysis of hundreds of companies over the past decade, we see compelling evidence that creative destruction is evident in six big rivers of growth. First is the ongoing digitization of society, which is seen in the substantial new markets enabled by the Internet, including e-commerce, hosted software, social networks, mobility, and cloud computing. Second is U.S. mass consumerism, which relentlessly finds new ways to serve man—“perpetually wanting animals,” as noted psychologist Abraham Maslow put it—and does so in a way that is teed up for a world of the “winner take most.” Third is the growth of emerging nations, which are happily embracing American capitalism. Fourth is modern medicine, which after extraordinary breakthroughs achieved in the wars and the colonization of nations during the nineteenth and twentieth centuries, now has vastly superior laboratories to grind out future conquests. Fifth is the American manufacturing renaissance, enabled by an improved comparative advantage, much bigger markets to sell into, and a technology-driven surge in productivity. Sixth is the North American energy revival, enabled by the shale boom and alternative energy sources, especially solar energy.

1. The Ongoing Digitization of Society
According to Gordon, computers and the Internet underpin the Third Industrial Revolution. In our view, that technological juggernaut has created multiple investment opportunities in three major stages. In its initial phase, the Internet gave rise to new business and consumer markets, such as e-commerce (sales over the Internet); hosted software (the delivery of software from a site where it is hosted on the Internet); and social networking (platforms that connect individuals and businesses. These are now substantial markets. Meanwhile, the Internet has enabled a mobility boom by linking itself to telecommunications networks. This has led to a proliferation in advanced wireless devices and changed the way consumers and businesses communicate. Overburdened by the enormous complexity all of this creates, the Internet’s infrastructure is being upgraded through cloud computing, thereby elevating itself to a new functional level. These growth engines are bringing about an ongoing digitization of society.

The New Markets
By allowing transactions to be conducted in the virtual world, e-commerce facilitates creative solutions to previously unmet needs and drives costs lower. E-commerce has already come to comprise a significant percentage of overall gross domestic product (GDP),2 and this seems likely to keep growing over the next 10 years. Increasingly, this commerce is being conducted on the go through mobile devices using the Internet.

In the past, software resided within company premises. It was a huge breakthrough when software came to be hosted on remote servers and delivered over the Internet. The new single point of reference had powerful leverage, allowing continuous upgrades and delivery at a substantial cost savings. A vast array of specialized software solutions that automate companies’ internal and external functions has ensued. The new, more focused software slashes costs and facilitates more nimble businesses.

The most recent new market and fastest growing area produced by the Internet is social networking. Seemingly overnight, people now spend nearly one-sixth of their time online, networking with friends and business acquaintances. The social networks have unleashed extraordinary viral growth in which the users themselves generate growth. Social networking sites have coalesced into a powerful advertising medium and a platform for startups that offer add-on services, reported MIT’s Technology Review.

The Mobility Boom
By combining with telecommunications networks, the Internet has given rise to a revolution in communication and mobility. Individuals can now demand information at anytime and anywhere. (See Chart 1.) The wireless world is “growing exponentially complex with the increasing choices in devices, [operating system] platforms, network technology, and an increased demand for bandwidth,” as one leading participant in this industry put it.


Chart 1. Mobile Internet Devices Poised for Huge Growth

Reduced Usage Friction via Better Processing Power + Improved User Interface + Smaller Form Factor + Lower Prices + Expanded Service = 10x More Devices

Source: Morgan Stanley.


Mobility beneficiaries include makers of wireless devices, and those that make them more capable. Those who can transfer and process the data far more efficiently also benefit. These companies operate in a seismically shifting environment marked by powerful converging trends and vast complexity.

Cloud Computing
The development of large Internet markets, combined with the mobility boom, entails enormous data requirements. To function optimally, these data must reside on the Internet rather than the locations of its billions of users. This has given rise to yet another substantial new market commonly referred to as cloud computing. The “cloud” is a vast network of remote servers that have added unprecedented functionality to the entire technology ecosystem.

Cloud computing is taking the Internet to a new level, enabling vast gains in functionality and ubiquitous connectivity—all in an instant. Lord Abbett’s growth investment team sees cloud builders, users, and protectors as the biggest beneficiaries of this megatrend.

The cloud is a new infrastructure whose promise lies in becoming a single point of reference for the Internet. Cloud infrastructure specialists, who can help to enhance the capacity and performance of modern technology, will help the cloud realize its potential. One of these happens to be the world’s dominant e-commerce retailer, which has become the leading cloud services company.

The cloud is taking the three big markets initially created by the Internet to a higher level of functionality. This is especially so for hosted software companies, because the cloud is a platform for software development. The cloud elevates software to the top of the value-creation food chain.

However, the downside is that all this cyber activity has also attracted all kinds of potential crime. In recent years, an alarming increase in hacking has victimized individuals, major companies, and government agencies. As a result, we believe providers of advanced security technology have the potential to generate strong growth for years to come.

Traditional companies must embrace the Internet to turn a threat into an opportunity. As one leading media executive put it, “The fundamental fact is [that] we’re giving people more of what they want, and it costs us nothing more to do that.” The mass scale of this company’s addressable market speaks to the ongoing digitization of society.

2. U.S. Mass Consumerism
In Civilization—The West and the Rest, historian Niall Ferguson explained the uniqueness of the United States’ consumer society—so all-pervasive today that it is easy to assume that it has always existed. Yet, in a larger historical context, it is one of the more recent innovations that propelled the West ahead of the rest of other nations. A dynamic consumer society grew out of the Industrial Revolution during the eighteenth and nineteenth centuries, characterized by an almost infinitely elastic demand for cheap clothes. The “magic” of industrialization was that the worker was at one and the same time a consumer. Ferguson noted that the consumption dynamic that started with clothes has grown to become “an entire popular culture that extends through music and movies, to say nothing of soft drinks and fast food.” The most striking characteristic of the consumer society, according to Ferguson, is its seemingly irresistible appeal.

The key to understanding how the consumer society is evolving is exemplified in the hierarchy of needs pyramid created by psychologist Abraham Maslow. (See Figure 1.) As professed by Maslow, especially in his seminal article, “A Theory of Human Motivation” (1943), human needs arrange themselves in hierarchies of “pre-potency,” where the appearance of needs rest on the prior satisfaction of other, more pre-potent needs; hence, his credo that man is a “perpetually wanting animal.”


Figure 1. No Matter How Bad the Economy Gets, a Hierarchy of Human Needs Drives Growth

Source: Abraham Maslow, “A Theory of Human Motivation,” 1943.


Consumers need to first satisfy their physiological and safety needs. Then they need to belong, if not be loved. After that, they will strive for achievement and independence and to be held in good regard by others. Ultimately, consumers want to be what they are capable of becoming (self-actualization). Meeting the evolving needs of the human wanting animal is what change and growth in the U.S. consumer society is all about. A case in point is the enormous growth of coffee makers and retailers.

Ferguson also thought it one of the greatest paradoxes of modern history that an economic system designed to offer nearly limitless choice to the individual has ended up homogenizing humanity. We actually think this was just part of an enduring grand bargain between the consumer and capitalism. Homogenization was necessary for capitalism to produce vast quantities of the goods and services consumers wanted. However, as the tastes of U.S. consumer society continue to evolve, goods and services are getting more personalized. And that itself is a source of growth.

We also think there is an additional point to be made about this homogenization of humanity—namely, that it sets the stage for a “winner take most” competitive environment. In other words, companies that disrupt the established order can quickly seize a huge share of the large opportunities the consumer society presents.

Although consumer spending in the developed world may grow at a subdued pace, creative destruction, in the form of innovative products and services, roils many consumer markets. Simply put, consumer companies are helping consumers look good and feel good. This enhances their self-esteem. Such firms are also providing consumers with much more convenience through a growing market in at-home products and services. Social networking sites are empowering individuals to take full advantage of this.

These trends open up big new markets for winner-take-most companies. These include apparel manufacturers and retailers, as well as a wide variety of makers of beauty products. Compelling approaches to basic human needs or desires, such as sleep, beauty, and health, also make us feel good.

Luxury is a disruptive market in the ongoing evolution of mass consumerism. “More demanding customers, generational shifts, new loyalty rules, an increasingly integrated offline and digital customer experience, and the continued growth of China and other fast-growing markets are transforming the luxury industry,” noted Claudia D’Arpizio, a specialist on luxury spending trends. Luxury manufacturers and retailers that connote status due to their style and craftsmanship are growth leaders in mass consumerism.

Innovation at home is another growth category. Companies have developed brewing machines to allow single servings of a cup of coffee and carbonated beverages with healthier and tastier ingredients. Household chores, such as vacuuming and floor washing, are now performed by robots. These are making consumers’ lives more convenient and economical.

Against that backdrop, social networking sites have injected an unprecedented gratification dynamic into the top three echelons of Maslow’s hierarchy of needs. Consumers have never had such a platform where they can participate in a network of people, strive for self-esteem, and reach for self-actualization.

3. Emerging Nations
The superior growth rates of emerging nations relative to the developed world are creating stronger economic environments for their citizens, helping to lift them out of poverty. (See Table 2.) This is now giving rise to a growing middle class in these nations. Ferguson noted that the U.S. consumer society is a “killer application” that the rest of the world has generally yearned to download.


Table 2. The Fastest Growth Continues to Be Overseas

Source: World Development Indicators, World Bank.
Past performance is no guarantee of future results.
The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions.


Table 3. The Asia-Pacific Middle Class Is Expected to Soar by 2030

Numbers (in millions) and share (%) of the global middle class

Source: “The Emerging Middle Class in Developing Countries,” Organization for Economic Co-operation and Development (OECD), January 2010.


The implications for increased spending are staggering. Ernst & Young, for example, predicts that three billion people will join the middle class by 2030, mostly in Asia.4 As the Organization for Economic Co-operation and Development (OECD) put it in a 2010 report, the middle class in Asia-Pacific spent just less than $5 trillion in 2009; by 2030, that figure could rise to almost $33 trillion.5

Consider the growth dynamics in China and India, the two most populous nations on earth. China has passed Germany and Japan to become the world’s second-largest economy, and may be larger than the United States by 2029. (See Chart 2.) Meanwhile, India is not far behind.


Chart 2. China’s Economy Is Expected to Pass the United States; India Could Pass Germany and Japan Even Sooner

Source: World Bank, World Development Indicators; Euromonitor, Countries and Consumers, Economy and Finance; International Monetary Fund, Data and Statistics, World Economic Outlook Database, October 2010; Timothy Moe, Caesar Massry, and Richard Tang, “EM Equity in Two Decades: A Changing Landscape,” Goldman Sachs Global Economics Paper 204, September 8, 2010.


The agents of change of the creative destruction that is transforming emerging nations include U.S. and foreign companies. Leading foreign companies whose shares are listed as U.S. securities enable direct exposure to emerging nation growth. Many of these companies are close replicas of leading U.S. companies. Emerging markets also enhance the growth potential of U.S. companies, especially those that are tapping into the expanding consumer society.

Rapid industrialization of emerging nations has had a substantial impact on U.S. companies and manufacturers over the past decade. The developing world, formerly dependent on the developed world for economic growth and the price of commodities, now drives world economic growth and sets the price of commodities. This industrialization boom, however, shows signs of maturation.

We think emerging nation growth this decade will gradually shift away from the sectors tied to industrialization and toward the consumer sector. The increasing rate of disposable income has particularly benefited the consumer, healthcare, and technology areas. Emerging nations will gladly download U.S. consumerism, especially as Chinese industrialization slows.

4. Modern Medicine (Feeling Better)
While a growing middle-class and affluent society strives to look good and feel good, susceptibility to a host of ailments and diseases is a constant. This condition drives strong demand for health care. Three areas of innovation in health care that are designed to make us feel better include genomics, biotechnology, and minimally invasive devices and procedures.

Ferguson characterized modern medicine as the West’s most remarkable killer application. For example, around 1800, the average global life expectancy at birth was just 28.5 years; two centuries later, it had more than doubled to 66.6 years. The laboratory for much of this progress was the battlefield as well as the harsh conditions within colonized nations. Today, modern medicine has a dramatically better laboratory—world-class facilities and technologies—to generate its future breakthroughs.

Genomics
Finding the genes that contribute to common maladies, such as cancer, heart disease, and stroke, has been terribly difficult. However, in recent years, significant progress in identifying genetic defects has led to breakthrough diagnostics, targeted drug therapies, and preventive medicine. This transformative innovation, as evidenced by the plummeting cost of sequencing the human genome (see Chart 3), is taking modern medicine to a higher level. The appeal for growth investors is the early stage of the genomics industry. “We are on the leading edge of a true revolution in medicine,” said Francis Collins, director of the National Institutes of Health.6


Chart 3. The Cost of Sequencing a Human Genome Has Plummeted Since 2001

Source: National Human Genome Research Institute (NHGRI).
Note: To illustrate the significant decline in DNA sequencing costs, this graph shows hypothetical data reflecting Moore’s Law, which in its simplest form states that processor speeds, or overall processing power for computers, will double every two years. It is widely believed that technology improvements that keep pace with Moore’s Law are doing exceedingly well, mak ing it useful for comparison, according to the National Human Genome Research Institute (NHGRI).


Several early innovators in the field of genomics are of interest to growth investors. One company has created systems that are enabling studies of genetic variation and function that were not even imaginable just a few years ago—a move some observers consider a significant step toward the realization of personalized medicine. Much will depend on how this enterprise’s innovative approach can serve as tools for disease research, drug development, and the development of molecular tests in the clinic. This company has helped to achieve a dramatic decline in the cost of gene sequencing.

Biotechnology
The biotechnology industry is a major beneficiary of the greater understanding of human genetics and physiology. Scientists at biotechnology companies have used this knowledge to fundamentally change the drug-discovery process, leading to new and better medicines in many fields. This is certainly a better setting for this killer app than the battlefield or the swamp.

Biotechnology companies are developing new drugs they believe will be more effective and/or safer. One company’s website expresses this simply: “[We exist] to place new therapies into the hands of those battling serious disease.” The leading biotech companies are focused on major diseases (such as cancer, diabetes, and heart ailments) and large healthcare problems (such as inflammation, and sexual and urological disorders), as well as a multitude of rare diseases.

Minimally Invasive Devices and Procedures
Minimally invasive surgery has become one of the fastest growing segments in health care. Among the benefits are smaller incisions, less pain, fewer complications, and a faster return to normal activities. These solutions are focused on the cardiology, diabetes, and spinal markets, among others.

In the diabetes market, two companies are transforming the way diabetics of all ages will manage their disease: one makes continuous glucose-monitoring systems and the other makes an insulin-infusion system for people with insulin-dependent diabetes.

5. America’s Manufacturing Renaissance
Three trends have converged to create a renaissance for American manufacturers. These include a dramatic change in the economic comparative advantage of U.S. companies (thanks in part to a falling dollar; see Chart 4), much larger sources of demand for their products, and a technology-driven surge in productivity. These developments have transformed domestic cyclical manufacturers into international growth businesses and productivity enhancers. The “Made in America” label has been restored to its former glory.


Chart 4. The Falling Dollar Has Led to a Big Rise in Exports

Source: U.S. Commerce Department; data as of June 25, 2013.


Comparative Advantage
The comparative advantage of American manufacturers has improved over the past 20 years. The U.S. dollar has fallen relative to other currencies, wages have risen sharply in emerging nations, and energy costs have increased the cost of importing goods from abroad. These factors combined have sharply enhanced U.S. competitiveness, benefiting a range of industries, from consumer products such as athletic and casual apparel, cosmetics, and jewelry, to commercial and military aviation, industrial products, infrastructure, and materials. Global manufacturers have begun to target the United States for new factories.

A more recent benefit, which adds to the aforementioned positive influences, is the low price of U.S. natural gas, an input for many American manufacturers, including the chemicals industry. As Lord Abbett Research Analyst Jonathan Chung put it, “The U.S. chemicals industry benefits disproportionately and [has] become a global leader.”

New Sources of Demand
Thanks to the growth of emerging nations, American manufacturers now have much bigger markets to sell into. Consider how much U.S. exports to China alone have accelerated: a whopping 583% between 2000 and 2012 (see Chart 5), led by computer and electronic products, agricultural products, chemicals, transportation equipment, and machinery, according to the U.S. Department of Commerce.


Chart 5. U.S. Export Growth, 2000–12

Source: U.S. Department of Commerce.


New industrial strength is most prevalent in the industries in which U.S. companies dominate, such as the commercial aerospace industry, where the Federal Aviation Administration dictates manufacturing guidelines for any plane that flies into the United States, and, therefore, favors domestic companies. One beneficiary is a producer of carbon fiber, a next-generation material for new planes that helps them become more fuel efficient, requires less maintenance, and allows higher humidity levels in cabins (low humidity is one cause of jet lag).

Technology-Led Improvements in Productivity
In conjunction with this revival, American manufacturers are looking for ways to reduce their energy, materials, and labor costs. A leading provider of industrial automation solutions notes, “A $50 billion investment in retooling factories to be more productive and competitive has the capacity to generate up to $120 billion in revenue for the United States. Highly automated, advanced facilities help protect workers from job injuries, improve industrial energy efficiency, and can better track and trace materials to help ensure consumers get safer, higher-quality goods and comply with pending carbon emissions regulations.”

Growth opportunities may reside in leading providers of advanced technology and training that will increase industrial productivity, flexibility, and efficiency while lowering costs and making manufacturing competitive globally. These include the leading provider of fiber lasers used in cutting and welding applications, a producer of vision systems and surface inspection systems, and a provider of 3-D measurement and imaging systems. The dramatic improvements in 3-D software and printing technology speed time to market, a competitive advantage in the medical, motor vehicle, and aerospace sectors. 3-D technology has also begun to enable potentially substantial consumer and direct digital manufacturing markets.

6. North American Energy Revival
The Shale Energy Boom
The growth of the emerging nations requires vastly higher levels of energy. The higher cost of oil, air pollution from the use of coal, and concerns about the safety of nuclear power are driving demand for new fuel sources. North American energy and production companies are now extracting oil and natural gas directly from shale rock. Thanks to horizontal drilling and hydrofracking technology that breaks open shale rock by pumping high-pressure fluids into the ground, this unconventional energy source is now abundantly accessible. According to some experts, the United States alone has a 200-year supply of shale gas.

The federal Energy Information Administration (EIA) estimates that shale gas production will grow almost fourfold from 2009 to 2035, and eventually comprise 47% of total U.S. production—up considerably from the 16% share in 2009. (See Chart 6.) Beneficiaries include shale energy producers and providers of equipment, materials, and services used in the production process.


Chart 6. Shale Gas Production Is Likely to Soar

Source: EIA Annual Energy Outlook, 2011.


Aside from providing an energy source to help relieve the price pressure from the booming demand for energy, the natural gas extracted from shale is well positioned to meet the demand for clean energy solutions. Internal combustion engines that run on this fuel become increasingly attractive. Shale producers have been so prodigious that they have created a supply/demand imbalance. For now, users of the cheap natural gas are the biggest beneficiaries, including a maker of equipment used to compress and liquefy natural gas.

Solar Shines Again
Following a boom and bust cycle that transpired between 2006 and 2011, the solar energy industry has undergone a dramatic consolidation and lowering of production costs. The two trends have allowed solar producers to realize higher prices and profits. Meanwhile, demand has strengthened. Sharp appreciation in solar stocks has resulted this year.

A growing number of utilities and consumers have joined large corporations in embracing solar. This is why solar energy production rose an astounding 500% in 2012, according to the EIA. The increasingly affordable solar energy, thanks to sharply lower polysilicon prices, should allow utilities and consumers to reduce their long-term energy costs—not to mention the considerable, intangible benefits of going green.

Conclusion
Although there are social and economic headwinds, innovation continues to thrive, and growing companies continue to develop new products and services and exploit new markets. These are the progenitors of creative destruction that give big growth rivers the potential to flow a long distance.

We seek to identify exceptional U.S. and foreign companies that demonstrate above-average, long-term growth potential. These companies have good business models, strong management, leading market shares, and operate in healthy industries. We believe these companies hold the potential to be market leaders in a slow growth era.  


1 Robert J. Gordon, "Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds," Working Paper 18315, National Bureau of Economic Research, August 2012.
2
 Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.
3
 Debt/GDP compares the total amount of debt outstanding to the gross economic output.
4 "Innovating for the Next Three Billion," Ernst & Young, November 2011. The report was based on two studies conducted in September 2011: an online survey of 547 C-suite executives, board directors, and senior managers in rapid-growth markets, and in-depth interviews with senior executives and thought leaders. The survey focused on developed market companies with rapid-growth market operations and rapid-growth market companies in Brazil, Russia, India, China, Mexico, Turkey, Indonesia, and South Korea. Half of the companies surveyed have more than US$1b in revenue, and 70% reported EBITDA growth in excess of 5% in 2011, Ernst & Young said.
5
 Homi Kharas, "The Emerging Middle Class in Developing Countries," Working Paper No. 285, OECD Development Centre, January 2010.
6 Francis Collins, The Language of Life (New York: Harper Collins, 2010).

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