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Investing in Rapid Innovations
The following is a transcript of the Investing in Rapid Innovations Podcast.
Hello, this is Brad Neuman, Investment Strategist at Alger. And you’re listening to the Alger Podcast. From eSports, to self-driving cars, to the predominance of AI and machine learning, radical shifts in technology appear more frequently each day, and seem likely to drive economic growth and investing. For investors, simply trying to sort through all of these changes can be daunting. To help provide some clarity is Alger Vice President and Technology Sector analyst, Ben Reynolds. Ben, thanks so much for joining me today.
Ben, I know that – like most Alger analysts – you’re someone who’s very passionate about your sector. The other day in the hallway, you were talking my ear off about one theme you’re currently tracking, which is eSports. Can you elaborate on that?
So, eSports, which is literally teams playing video games against other teams – you’ll have five people playing or just a group playing against each other but people playing against another team. So, it’s the Rockets versus the Warriors like in the NBA, except it’s computer-controlled by these video game whizzes. The biggest formats are League of Legends; Overwatch is another one where you’ve got teams of either five or six players playing each other, and they’ve got these tournaments and leagues where there’s real prize money. And I think someone said the average gamer is making, like, $350,000 in salary, and if you win tournaments, you can be making seven figures, and so there’s a lot of money going into this. I believe the world championships of League of Legends is going to be at the Barclays Center which is roughly a 20,000-person arena in July. They sold out Madison Square Garden for a big tournament last year. So, these are actual real things with a lot of people watching them, and it’s literally growing up very similar to NBA or NFL where you’re having that level of participation.
I’d say it’s bigger in Asia now, but it’s growing in the U.S. So, millennials, that’s the sports that they watch, and we’re really in the formation days. We believe each game is going to have its own league. It’ll have a U.S. league. It’ll have one in China. It’ll have one in Europe, and these will all play each other, and people will, we think, pay subscription money to watch it, or it’ll be ad-supported. But we believe it’s going to be a multibillion dollar industry in the next decade, and by multibillion, I mean $50 billion, $100 billion of industry.
And which companies do you think are likely to benefit the most from the escalation of this format?
So, the people who create the games will be, in my opinion, probably the biggest beneficiaries because they’re going to control the leagues since they control the IP, and so, they’ll effectively own the league. So, Overwatch is a game that has been selling team franchises for $20 million last year. They sold I think ten or 12 different franchise fees, so that’s $240 million they took just for someone to take a team, and I think the franchise fee is going up this year.
They’re going to make money that way, and then they’ll share in the money that they’re doing similar to broadcast deals. So, similar to what the NFL has with like CBS. They’re doing deals with the streaming platforms where they’re getting $90 million to stream two years of the league, and then those platforms are going out and either selling subscriptions against it or monetizing it on an advertising basis. So, big money for primarily the games. I think the platforms will make money too. I think eventually the money will get squeezed towards the gamers and the IP creators.
When you say, IP, that’s gaming-speak for “Intellectual Property”?
And the biggest gaming companies are now significantly investing in this space?
Many. Ex-China there’s probably three or four main streaming platforms that they’re on, but any company who has a hot IP game. We think there will be a league for pretty much every extremely popular video game that lends itself well to people watching. So, I mean dozens, probably more than dozens over time. There’ll probably be about a dozen really large ones.
And these companies are investable?
So, yes. You can invest in the video game makers, any of those companies that are publicly traded. And you can invest in the companies that have the large streaming platforms. And we are invested in both sides of that. This isn’t necessarily the thesis especially on the streaming side, but yes, we own several of those companies.
I know you’ve been keeping an eye on this corner of the gaming industry for a while. Compared to some of your other tech sector themes, where do you think this industry is in its lifecycle?
We believe we are in the very early parts of the S curve to the point where, on a revenue basis, it’s just slowly building and will probably accelerate to big dollars over the next five years. So, I think we’re very early on, and we’ll see rapid scaling. The one, I think, issue for any one publisher and any one game has is that – baseball, football, soccer, globally basketball, and hockey I guess – those five sports have been kind of the five sports for the last 100-plus years. Haven’t been a lot of changes. The primary team sports have been fairly stagnant.
This is different. There could be a new hit game every year. One of the biggest franchises just launched this year. It’s already one of the top games. It’s going to have a league. So, I think there’s some concern that any one game, the league might lose interest over time, but unlike baseball which has hardly changed at all over 100 years, these games are refreshed almost every year. And so that will actually keep them fresher and that should actually keep the IP lasting longer than it otherwise would. So, I would say of the things I’m tracking, there are a couple trends that I’d say we’re well up the S curve, and that would be sort of mobile, smart phones penetration, that we’re getting highly penetrated there.
eSports, I would put at we’re in the very nascent stages, but the monetization is more near-term than things like virtual reality, things like augmented reality, things like self-driving cars. So, I think we’ll be seeing sort of massive adoption of eSports and more revenue coming from that than some of these other things that are nascent but are going to take a little bit longer to monetize.
You mention augmented reality and virtual reality, both of which investors are now hearing about much more frequently. Can you give us an update on those technologies?
So, augmented reality, virtual reality. The use cases thus far I would describe as sort of entertainment purposes only. The kind of most obvious stuff are – and this isn’t even virtual because it’s going to be actual footage – but you’re going to be able to put cameras courtside at a playoff game and then you’ll be able to pay to have a courtside seat from your home. You put on your VR headset, and it’ll act like you’re at the game. You’ll be able to look around. You can look at this end of the court or that end of the court because the cameras will be capturing everything. That sort of thing I think is going to be real and will be able to be monetized pretty well. It’ll be great for video games, too. There will be video games you can play. You can now as well, but there will be applications there.
Combine this with eSports. Okay? So, you’ve got these big sort of battle royale eSport games. We think you eventually will be able to put yourself into that in a virtual reality experience where you as a spectator are on the battlefield while the New York team and the Shanghai team are battling it out, and you’re not watching it on your screen. You’re not streaming it or even in the arena watching it. You’re getting the experience as though you’re in the battlefield. That’s pretty powerful. We think people will pay for that.
Another tech topic that’s had significant traction for investors for the past few years is AI. I read recently that AI now permeates most of our consumer technologies. Do you think that’s true?
I think what people are getting more interested in now is probably the machine learning. And again, not to get too technical, but AI is literally just sort of any artificial computing that kind of mimics what a human may do. Machine learning is more about computers learning on their own and eventually teaching themselves what to do.
You’re getting a lot of companies talking about what they’re doing in AI and what they’re doing in machine learning. Most of them are just using the buzzword. But true machine learning is happening. And it’s becoming democratized. I think it’s going to take a lot of time just to figure out really how to apply it. The things that are coming out now are pretty impressive. You’ve got voice assistance now that these companies are developing that can actually have a conversation with someone on the other end who may or may not know that they’re talking to a virtual assistant. The application I’ve seen is that it was used to call up a restaurant to make a reservation and, the speech pattern was very mimicky of a human with “ums” and “ahas” put in. But also it was able to take the language back in and be conversational. So, take input of what was said to it and then ask follow-up questions, or if something unexpected came up, to adapt. And so, the applications like that are pretty powerful.
But it’s much, much more advanced than you call into a call center and you press one for this, press two for that. Why don’t you just tell me what you want, what we’ve seen, historically. At least the demos that we’ve been seeing are pretty impressive. Really what this stuff is doing at that level is just saving you time which I think is a lot of what this technology advance is about. We’re not into saving lives yet, but that in one form or another will come.
And among the companies you track, are you seeing a significant investment in machine learning?
I’m covering the large-scale Internet players. So, these companies are investing billions in R&D in these areas because they want to make sure that they have a piece of wherever the future’s going.
Ben, when we spoke earlier you said something very compelling, which is that, among the dominant tech companies there’s almost an obligation to be forward-looking and out-innovate one another – to the point where they regularly seek to actually disrupt their own businesses. Can you expand on that?
Sure. So, if you look throughout history, there have been very, very few companies in any industry that have remained dominant for very long. As platforms shifted, as things changed, they rose and fell, and a lot of companies over history have wanted to protect their cash flows, protect their, sort-of, bread and butter business and have often times stifled innovation to protect their core assets. There are many instances of companies not evolving because they had a cash cow that they didn’t want to mess with largely because investors expect a dividend or expect certain margins and don’t want those to go down.
The tech companies we’re seeing today, not entirely but in large part, I believe understand that they have to continue to invest for the future, and some of them will spend almost all of their cash doing this. Some of them will spend a great portion of their cash. Most of the companies I cover that are these scaled players, their core businesses are significantly more profitable and have higher margins than what they’re showing because they’re reinvesting 10 percent, 15 percent, however much of their profits into these new endeavors that may never pay off.
Some of them will not pay off for sure, but they want to stay ahead, and they’re willing to disrupt themselves. The largest search player was a desktop dominator and shifted heavily into mobile to make sure that they didn’t miss that trend. If you go back to the largest operating system from the ‘90s, it didn’t do that when we had a shift to mobile, and that cost a lot of market share and eyeballs. So, these companies now, I don’t think are afraid to disrupt themselves. They would rather disrupt themselves than be disrupted by someone else. That doesn’t mean that you’re not going to have new, powerful companies come out. You absolutely will. I just think that the winners today know what got them into the winner’s circle and are willing to do more to maintain that status versus worrying about protecting near-term cash flows.
And so this trend of self-disruption, is it a yardstick now? That is, if you don’t see the better companies doing that, does it become a warning sign to you?
As a growth investor, yes, you have to expect that. As growth equity investors, I think we can hold stocks longer now than I imagine we could have 20 years ago because, although there’s rapid innovation, it’s the winners that are doing a lot of the innovating as well, and so they can maintain or grow their dominance.
Moving on, I wanted to ask you about self-driving cars. Is this something that you think consumers and investors will eventually embrace?
So, self-driving is very interesting. That’s a technology that I think if you took the really technically advanced people, they probably thought it would be here by now. I remember having conversations in 2012 where very smart people were telling me that fully autonomous self-driving cars would be here by 2015, and that’s the commercial and on the roads and everywhere. That’s clearly not the case, and I don’t think we are a year or two away now either for fully autonomous, get in the car and it takes you anywhere with no input. But we believe that is definitely an industry that is happening.
It’s going to be in fits and starts. Every time there’s an accident, there’ll be a pullback. But I think it’s going to win out, and I think the implications there are huge on a couple levels. The first just being the fact that either your car or the car that you own, to the extent that the technology gets licensed to whoever, you will have a car that will be fully autonomous and you just literally get in. Tell it where you want to go and you go. I think it’s big for the ride-hailing industry as well. I think the global sort of taxi market is about $100 billion, and the ride-handling is already $30-ish billion overall globally. I think that’s going to, over the next ten-plus years, probably double to something over $250 billion, and whoever can develop the first truly autonomous vehicle for that and will be able to take share there. And you don’t have any human costs. So, that’s again $100-plus billion market just on the ride-hailing side.
Another huge market on the licensing of tech. Because whoever comes up with the best tech or the first couple people will be able to license it out – because even though all the car companies are working on some form of this, most of them are working on what I describe as very advanced cruise control versus fully autonomous driving. But once that’s developed and proven out, I think they’ll be able to license it to everybody. That’s another huge market.
Ben, I think one concern some investors may have with self-driving cars is simply a trust issue. That is, how quickly will consumers adopt the idea of getting in a car with no one driving. It’s like, when I get on a plane, I don’t necessarily know who’s flying the plane, but I know somebody’s flying it. Does this concern you?
Look. It’s a very good point. What it will take for mass consumer adoption will be reams and reams of studies and reports that demonstrate that it is safer. We’re too early in to prove that because I don’t know how many miles are driven in a year, but there just hasn’t been that many self-driving car miles driven yet. So yes, that will be an impediment. You’re basically going to have to have a lot of studies that demonstrate that it’s safer, which, we believe, over time will happen.
Then you’re going to have to give people incentive to try it. Then once they try it, they will become more and more comfortable with it. Absolutely a process. You’re also going to have the whole regulatory regime where maybe it’s legal in Arizona but it’s not legal in Wyoming. So, can you cross the line? You’re going to have cars. You’re going to have this hybrid model for a long time I think where you have to be able to flip the car. For a car that you buy, you’re going to have to be able to flip the car from autonomous mode into you-driving-it mode. But for ride-hailing, that’s different. Right? Because if you’re only in certain city areas that have accepted it, then you’ll be fine. So, you’ll see it grow out that way. But yes, that’ll take time.
And when this happens, will people abandon car ownership? Will the next big industry be car-sharing?
So, I think ride-sharing will go up as a percentage of miles driven. I think that’s true, but I don’t think it will eliminate car ownership. I think a lot of people will want to own cars especially outside of major cities. If you’re in a suburb or you’re further out, you’re not going to want ride-hailing. You’re going to want to own your car, and that won’t change. We have a car culture here. We’re not going to get rid of cars, but eventually the models will be self-driving.
One final question, you spend a fair amount of time pitching companies and ideas to your team and portfolio managers. Is there a particular type of company that you’re currently pitching?
I will say that the philosophy at Alger, we call it high unit volume growth, but in some ways, we’re looking at major themes, tectonic shifts in technology, consumer behavior, et cetera, and trying to find ways to invest in those themes and trends, the biggest trends of our day, mobile, cloud computing, there are numerous other ones.
There are a handful of companies that we can easily identify as the major innovators and the ones that are driving those changes. It goes back to these companies not being afraid to disrupt themselves and to change what they’re doing to stay winners, and I think what we try to do is find companies that aren’t afraid to do that and, as investors, have a long-term focus so that when the third quarter profit margin is down because they decided to make a big investment in this new area, we’re not shaken.
Even if the market makes the stock go down for a while, if we believe that the company is investing in the right trends and has a history of being able to capitalize on these trends after they invest into them, our philosophy is to stay with that and to stay the course. I think with the way these companies operate today, it’s made it a little bit easier for us to have faith in the long term.
Ben, thanks so much for your time today.
Thanks, Brad. Great talking with you.
And thank you for listening. For more insights and information regarding Alger investing, please visit Alger.com.
The views expressed are the views of Fred Alger Management, Inc. as of June 2018. These views are subject to change at any time and should not be interpreted as a guarantee of the future performance of the markets, any security or any strategy managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities.
Investing in the stock market involves gains and losses and may not be suitable for all investors. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Many technology companies have limited operating histories and prices of these companies' securities have historically been more volatile than other securities, especially over the short term. Technology companies may also face increased competition, government regulation, and risk of obsolescence due to progress in technological developments.
League of Legends is produced by a subsidiary of Tencent Holdings Limited (“Tencent”) and Overwatch is produced by a subsidiary of Activision Blizzard, Inc. (“Activision”). Neither Mr. Neuman nor Mr. Reynolds directly owns Tencent or Activision in their personal accounts. Fred Alger & Company, Incorporated and Fred Alger Management, Inc. (together “Alger”) do not own Tencent or Activision, and Alger does not perform any investment banking services on behalf of Tencent or Activision; however Alger advises client assets on Activision, $22.3K, and Tencent, $13.7M.
Distributor: Fred Alger & Company, Incorporated. Member NYSE Euronext, SIPC. NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE.
Founded in 1964, Fred Alger Management provides investment advisory services to institutional and individual investors through traditional and alternative strategies in a variety of products, including separate accounts, mutual funds and privately offered investment vehicles. For more information, please visit www.alger.com
BEN REYNOLDS, CFA
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