Every so often a profound innovation disrupts commerce, wiping out businesses and creating new ones, what Schumpeter called “creative destruction”.
When we founded Phoenix 26 years ago it was the internet. It wiped out old industries, birthed new ones, and fundamentally reshaped the survivors by altering consumer behaviour.
We believe we are on the cusp of another disruptive wave coming from the rise of AI. There is no escape for investors, especially stock pickers, so we need a way to think about this and then a strategy of either minimising risk or seeking opportunity. We are trying to do both. We approach this with humility, acknowledging that we cannot predict with confidence how AI will develop and impact commerce. Our goal is to navigate this complex landscape whilst preserving and growing our investors' capital. To that end, here is a simplified framework for evaluating how AI might affect a business.
The essence of every business evaluation boils down to four key components:
I. Demand. What are the forces that create demand for a company’s product or service? We seek businesses where demand is likely to grow.
II. Competition. How intense is the competition, and does the company have an edge that protects its market share? Warren Buffett calls this a “moat,” and we only invest in companies with a strong one.
III. Pricing Power. Some businesses have a degree of control over their profitability because they have some form of pricing power whereas many businesses are at the mercy of fluctuating costs and competitive pressures. We only invest in the former.
IV. Returns on Capital. Different business models yield different returns on capital driven by the nature of the activity, i.e. how much capital it needs and the extent of pricing power. We only invest in businesses we expect to earn high and enduring returns.
Applying this framework to the impact of AI let’s start with a major holding of ours, housebuilder Barratt Redrow. (i.) AI isn’t likely to change the nature of demand which is largely demographic. (ii.) It isn’t likely to change the competitive landscape. (iii.) Pricing power which is exerted against the landowner is unlikely to be impacted. The use of robots in housing construction could lower the cost of production but that reduction, as we have seen with other changes in the cost of production, would impact the value of land not the margin of housebuilders assuming they can all apply the same technology. (iv.) The returns on capital are unlikely to be impacted, the biggest driver of capital requirement is how slow the planning system is.
So the value of Barratt Redrow does not look threatened by AI from what we currently know. It is a safe haven in the storm with the added benefit of being very cheap. Now consider another major holding of ours, Frasers. i.) The forces of demand for fashion and sports clothing are not likely to be particularly affected. ii.) Competition could change a lot. AI assists in prediction, creativity and productivity. The rise of Shein is already an example of how that can happen. Given the low barriers to entry in the industry we can expect more new competition. AI could also help Frasers improve their ability to predict demand. Frasers pricing power (iii.) comes from being the low cost producer and AI could either help them if they continue to adapt ahead of competitors or impact them if not. The need to hold, discount and clear unsold stock is a failure of prediction and so an improvement using AI will have a positive impact on return on capital (iv.).
For Frasers, AI presents both opportunity and risk. The key question is whether management remains agile and alert to these, the company’s culture of continuous improvement and innovation gives us confidence. And like Barratt, Frasers is very attractively priced. It’s a great starting point.
“Aurora UK Alpha plc (ARR LN) is a closed end fund that is listed and trades on the London Stock Exchange. Aurora UK Alpha’s portfolio has been managed by Phoenix Asset Management Partners since December 2015.
It is a long-term investment vehicle investing predominantly in UK equities with a business and value oriented approach, achieved through investments in companies demonstrating a high return on capital and control over their profitability through the strength of their franchise. Aurora UK Alpha’s portfolio is concentrated and it typically invests in a small number of deeply researched stocks, which can result in above average volatility.”
