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It had to end sometime, but this was brutal. A 13-year run of outperformance by growth stocks has ended abruptly. Events ranging from war in Europe to pandemic-induced supply chain constraints to labour shortages to rampant inflation have left us wondering what’s next for growth investors.
Do great growth investment ideas even still exist? It’s a fair question. Maybe they don’t. This is an attempt to consider that possibility.
Deconstructing growth: the roles of supply and demand
Predicting the future of growth requires an understanding of where growth comes from in the first place.
The essential variables that count are
1. demand
2. supply
3. forces affecting the above
Simply put, growth happens when the supply of a product or service meets demand in the shape of a need or a problem and money changes hands.
That’s step one. Step two occurs when a critical mass of these transactions is made. And how do they come to be made? In multiple ways.
The many engines of growth
Neither supply nor demand is static and a number of ‘engines’ power the process. These ignite when:
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demand grows, and supply rises to meet it (expansionary growth)
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demand doesn’t grow, but supply innovates to meet existing demand better (disruptive growth)
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new demand supersedes old demand following changes elsewhere in the system (replacement growth)
Let’s dismantle each of these engines, assess which ones have driven growth over the past decade and consider where they might take us in the decade to come.
Engine No.1: Expansionary growth
Demand grows, and supply rises to meet it
The most obvious route to growth is with the expansionary engine, when a company’s growth is boosted by the growth in the system it’s part of.
Expansionary engines rev up when demand for a product simply grows. Or when a company expands into a new region to find and serve more demand. In either case, fresh demand is created, and supply must rise to meet it.
But how does this new demand come about? From diverse sources.
Macroeconomics: Over the past decade, such expansionary growth has benefited from loose fiscal policy, low interest rates, low inflation, globalization, and an entrenched neoliberal political order that lubricated global markets.
Innovation: A stimulus that awakens previously dormant demand. Such stimuli come in different forms, but they typically involve the removal of impediments to demand. A simple form involves ‘reach’. When a technology reaches a part of the market that wasn’t previously covered, new demand is awakened. For example? Consider the opportunities unlocked for Apple (and thousands of app developers) as the mobile broadband infrastructure was built out.
Beyond reach, business model innovations invite people to participate in a market who previously chose not to – or who weren’t invited. A good example of this democratization is software as a service (SaaS). Demand was awakened when certain types of software were offered at an affordable monthly subscription payment instead of a large upfront capital investment. New customers flooded the system. The business model innovation didn’t just replace the old model, it expanded the opportunity set.
So what is the state of these expansionary growth engines today?
It’s fair to call them mixed. There are two big concerns, stemming from the macroeconomic context and the slowing down that happens when a technology matures.
On the first of these: The global economy is a complex beast. I can’t predict the future, but it seems unlikely that macroeconomic forces will power growth as much in the next decade as in the last.
The question of maturation is also worth more consideration. Since 2005, global fixed broadband subscriptions have more than quintupled, meaning that of the 1.3 billion installed, 85 per cent have been added since 2005. Mobile broadband figures are even more extreme, with virtually all six billion global subscriptions coming after 2007. Each network can be viewed as a new type of infrastructure that has unleashed immeasurable new demand. The opportunities are not exhausted, but in terms of reach, hasn’t the exciting part already happened?
New tools, new users, new things
There are still grounds for optimism. If we deconstruct how, for example, broadband opened new markets, the magic formula was allowing new users to do new value-creating things. This begs the question of whether similar tools will emerge in the future and whether there will be entrepreneurs who know what to do with them. Will they have new tools with which to open new opportunities?
Cloud computing and agile software development are doing this for everyday companies. Another example involves the notion of data itself. While we’ve lived in a data-driven world for a while, how it is being used – and by whom – is changing. Over the past decade, much of its value has been confined to making existing businesses run more effectively or efficiently. But for other businesses, it represents a new tool that lets new users do new things.
Thus, for some, data is acting as an engine of expansion. It is creating new value and unlocking fresh demand. Good examples of its impact can be found in life sciences, healthcare and synthetic biology. The problems these markets aim to solve are increasingly data problems, not science problems. Entrepreneurs are being equipped with massive amounts of highly valuable new data that can unlock fresh insights every day.
Another possible example, in time, is the metaverse: the shared virtual world in which social media, online gaming, and commerce coalesce in ways that allow users to interact. If expanding the reach of, say, mobile broadband helped create massive new markets 15 years ago, then what might the emergence of an entirely new digital world such as the metaverse open up?
Not only does the metaverse offer a new type of gameplay and new ways to socialize, but it also promises a new canvas on which new types of users can create content. Online game platform Roblox, to take one example, is for creators as much as it is for gamers.
Come to think of it, if we’re looking for new tools that let new users do new things, might the platforms that instigate and unleash human creativity be growth engines that are still just revving up? Are creators just a niche group? Or is creating things part of the wider human condition? It’s a ‘what if…?’ question worth pondering.
Some of the great growth businesses of our time addressed needs that are part of being human. For example:
- Google answered a need to access knowledge
- Facebook answered a need for community
- Netflix answered a need for entertainment
- Amazon answered a need for goods and services
It might seem a stretch to add ‘a need to be creative’ to this list, but the 9.5 million amateurs who create content on Roblox or the 55 per cent of TikTok users who also create content might disagree. Both Roblox and the metaverse could even answer the need for community and the need for entertainment simultaneously.
But that’s not all expansionary engines can do. There is still room for the previously referenced ‘democratization’ to create new markets. What SaaS did for the software industry was, essentially, to offer a compelling solution at a price that millions could, at last, afford. Aren’t we witnessing the same thing in education as more and more learning and credentialing is provided outside traditional universities? For example, each month nearly 50 million users (and growing) help language-learning app Duolingo fulfil its mission to provide universal access to education. Another example involves the advertising industry and how performance-based advertising, for which you pay by results, opened new markets in social and search for small and mid-sized businesses. What will happen when tools, are in place to let those same advertisers place ads on TV ads which, in a non-digital world, had previously only been available to big brands with big budgets? New markets will be created.
Engine No. 2: Disruptive growth
Demand doesn’t grow, but supply innovates to meet existing demand better
More encouraging growth news comes from supply and demand meeting in new ways, such as when supply changes for the better.
In this case, demand doesn’t necessarily grow, but how it can be served – or how we’d like it to be served – change in ways that allow it to be better met.
Streaming video is a good example. My own demand for video entertainment hasn’t grown in the past decade, but how I want it delivered has changed. Similarly, my dog’s demand for food is the same as it ever was, but ecommerce has changed how that demand is addressed, in his case via the slick 'autoship' facility of Chewy, the online pet food leader. Technology-based shifts in entertainment and shopping can be seen as disruptive as opposed to expansionary engines of growth.
In the past decade, these growth engines have contributed mightily to growth investors’ portfolios. Ecommerce as a percentage of all retail in the US has more than doubled. Spending on cloud infrastructure now dwarfs investment in traditional datacentres. Electric vehicle sales have passed the inflection point, reaching 6.6 million units (around 9 per cent of the global car market) in 2021, up from about 130,000 in 2012.
These growth engines are still going strong in large markets experiencing the early stages of disruption. Neither inflation, the actions of the Fed, or recession can put the disruption genie back in the bottle. Nothing can prevent more commerce from going online. More IT will migrate to the cloud, healthcare will become more personalized, transportation will get more electrified, and so on.
The broader point is that this growth engine is not dependent on the growth of the system itself. Dynamic disruption is the trigger.
Engine No. 3: Replacement growth
New demand supersedes old demand following changes elsewhere in the system
The third and final growth engine to highlight is demand that is not growing but changing.
If we agree that growth happens when supply and demand meet in new ways, it follows that changing demand translates into new problems for entrepreneurs to solve in order to grow a business.
What causes these demand changes?
They’re the natural result of dynamism within a system. A paradigm shift among the participants in a system is one example. To take one example, we are witnessing this with attitudes about climate change and sustainability. There is now a demand for clean energy that simply didn’t exist – or that lay dormant – 20 years ago. At other times, growth in one part of the system creates new pain points elsewhere in the system. Sometimes, expansion and contraction of the system itself trigger something similar, as we’ll discuss in the next section. But the important point, once again, is that as a system changes, so do its problems. And new problems mean new business opportunities.
Dynamism, abundance and scarcity
But there’s a catch. In my earlier deconstruction of where growth comes from, I mentioned three variables:
1. demand
2. supply
3. forces affecting the above
We need to consider this third variable. For example, it’s great that ‘video on demand’ models provide a new and better way to supply my entertainment needs, but if I can’t afford the service, this demand won’t translate into a transaction. Similarly, a young life sciences company revealing insights from petabytes of data may promise much, but if it can’t find investors to provide the capital it needs to survive it can’t supply new goods or services.
In times of economic adversity, we investors need to scrutinize, case-by-case, how portfolio companies might be affected. However, broadly speaking, contraction still doesn’t prevent growth opportunities from arising. As a system contracts, the previously mentioned expansionary growth engines may stall, but the pain points within the system shift about, and with those shifts come new opportunities.
Outsourcing IT to India is a classic example from 20 years ago. It proliferated after the bursting of the tech bubble thanks to its do-more-with-less value proposition. A whole new category containing phenomenal long-term investment opportunities rose from the ashes.
To draw on this point further, let’s consider notions of abundance and scarcity within a system, and the changes afoot. At the risk of oversimplifying, ‘abundance’ captures the zeitgeist of the past 10 to 15 years of technology. Online, individuals have been able to find the answer to just about any question. Similarly, we’ve been able to reach – and instantly connect with – anyone in the world, buy just about anything and have it delivered to our door in two days, and binge on an endless variety of content in TV’s ‘golden age’. Meanwhile, advertisers had an endless stream of data to help them target consumers. And we’ve had an economic and regulatory structure that largely supported all this.
But in the past two years, scarcity has entered our lives, reintroducing friction. Most painfully, we were locked down in our homes for the better part of two years. The scarce resources in that period were mobility, freedom and social interaction, but it goes well beyond that. Advertisers and regulators have limited the availability of certain types of data, while Apple has curtailed the ability of third-party apps to track users’ online activity. Is data now ‘scarce’ in a literal sense? No, but the pendulum is swinging towards where leverage – and value – reside inside the system. Elsewhere, labour is scarce, with a shortage of workers in just about every corner of the economy. Inflation is making the cost of doing business greater. And the likelihood that many global economies will enter recession keeps rising.
Why does this matter? Because, when relative abundance shifts to relative scarcity, the systematic problems to solve – or demands to address – also change. In periods of abundance, the key problem is aggregating demand and making sense of abundance by organizing it. Here, value accrues to companies that can do just that (see Alphabet, Meta, Amazon, Netflix, etc). In contrast, in periods of scarcity, new problems emerge. That is, value accrues to those who either control the scarce resource or who can supply alternative resources. The point here is not that the companies that thrived amid abundance have suddenly seen their growth prospects disappear. The point is that relative scarcity brings forth new opportunities.
Given this scarcity, companies that can exploit their first-party data – customer data they collect and own – seem well-placed. As do companies that sell productivity and automation in anticipation of labour shortages. Most of all, if systemic, expansionary growth gets harder to come by, then anything in and around digital transformation stands to benefit, ie the cloud, data science, agile software development, etc. How will the entities within, say, the Forbes Global 2000 grow if the overall pie is not growing or even shrinking? Answer: by out-competing other slices of the pie. And how will they do that? By embracing digital transformation.
Granted, given the disruption wrought by the internet and the cloud, even in good times there has been a growing need for companies to re-invent and transform themselves. But if economic growth slows, won’t this need become more pressing?
Fans of the technology development scholar Carlota Perez may notice some similarities with the changes accompanying the second half of the ‘technological revolutions’ she describes: the phase when the technologies of the day are redeployed to address the different demands that arose during the revolution. The subsequent infusion of capital is driven as much by incumbent companies’ finance departments as it is by financiers. ‘Digital transformation’ fits this conceptual frame. I am also reminded of the post-Enlightenment ‘convergence club’, a term that economists use to describe the group of countries that embraced the knowledge, technology, and science of the Age of Enlightenment. Those that did went on to thrive. Those that didn’t found themselves on a very different path – towards the ‘developing world’ basket. We are witnessing something similar today. It is becoming clearer that companies that embrace leading-edge technology will be fitter for whatever the future holds. This fitness is what is sold by companies tied to digital transformation.
While the path to digital transformation is already well-trodden by growth investors, its potency and duration are still underappreciated. The very term ‘digital transformation’ forces one to think of a world migrating from analogue point A to digital point B. This can lead one to think that when point B is reached, the transformation is complete. As in, ‘Ok, we’ve moved to the cloud. Glad that’s done!’. But this misses an extremely important point.
Point B is not an end state. It is just a beginning. The digital world contains new, infinitely scalable tools (software, data, compute capacity) that can be put to use in infinitely scalable ways. And not only is the infrastructure we have installed over the past few decades infinitely scalable but so too is the resource that uses it best: human ingenuity and our capacity to solve tomorrow’s problems.
Isn’t that the most powerful growth engine of all?
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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in October 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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